Question

At the end of 2018, RQM, Ltd. issued zero-coupon bonds that mature in 2038. The face value of the bonds was $1,801 million, and they sold for $1,099 million on the issue date. The effective market interest rate was 2.5% on that date. At the end of 2025, RQM repurchased $257 million in face value of the bonds for a purchase price of $174 million, resulting in a gain on the early extinguishment of debt.Review what you have learned about bonds as well as the explanation of zero coupon bonds on p. 537 of your text, and answer the following questions, expressing all numbers in millions (for example, the face amount of the bonds is $1,801). Please answer in complete sentences and show your calculations for numerical answers and journal entries. Please do not use decimals in any of your answers. Round to millions.

1A. Name the two accounts and balances from the Balance Sheet that combine to determine the book value.

1B. Prepare the journal entry to record the repurchase of some of the debt at the end of 2025. [Repurchasing some of the bonds before the maturity date is called “early extinguishment” of the debt. The company makes a payment to the bondholders, who relinquish the bonds and their right to collect the face value at maturity, and the debt is removed from the books. To record the early extinguishment, the company makes a journal entry to remove the appropriate book value and decrease cash by the amount paid to the bondholders. If those two amounts are not equal, a gain or loss is recorded to balance the journal entry. The journal entry is analogous to the entry you would use to remove a long-term asset from the books when it is sold.]

1C. Why might company managers choose to issue zero-coupon bonds instead of interest-bearing bonds?

1D. Why might they decide to repurchase some of the bonds before the maturity date? Be sure to consider whether management may chose to repurchase when interest rate are increasing or decreasing and explain why.

Answer 1

1A. Amounts are in millions

Cash A/c	Dr.	$1099
Interest on Bond Payable	Dr.	$702
To Zero-Coupon Bonds Payable A/c	Cr.		$1801

Face Value of Bonds = $1801 million
Bonds issued at = $1099 million
Interest on Bonds Payable = $1801 - $1099 = $702 million

1B. Amounts are in millions

Zero-Coupon Bonds Payable A/c	Dr.	$257
To Interest on Bond Payable	Cr.		$83
To Cash A/c	Cr.		$174

Face Value of Bonds Repurchased = $257 million
Bonds purchased at = $174 million
Interest on Bonds Payable = $257 - $174 = $83 million

1C. Zero-Coupon bonds are known as deep discount bonds and do not carry any coupon rate. They are issued at a discount and redeemable at par. Company managers choose to issue Zero-Coupon bonds because it does not dilute the company ownership and does not drain the cash flow by yearly interest payments.

1D. Companies repurchase the bond before the maturity date because of market conditions, investment opportunities or interest rates, the interest rate being the most common reason why bonds are repurchased.
Managers repurchase the zero-coupon bonds when interest rate is falling because they can repurchase it and replace it with a cheaper rate of interest bond.