Question

Merle Company is seeking to borrow some money on a long-term basis.  This firm is considering pursuing one of two alternatives: (1) issuing twenty bonds with a face amount of $1,000 each or (2) signing a long-term note payable for $17,000.  Assume that both alternatives would provide cash to Merle on December 31, Year 1.

The terms of the two alternatives are presented below:

1. The bonds would have a coupon rate of 8% and a market rate [effective rate] of 10%.  The bonds would pay interest semiannually on June 30 and Dec. 31 and would have a maturity date on Dec. 31, Year 12.
2. The note payable would have an interest rate of 8% and would be paid off over 5 years with equal quarterly installments starting three months after Dec. 31, Year 1.  These payments would fully amortize the note’s principal and interest.  Amortize means ‘pay off.’ This is a long-term Note Payable as it extends for longer than one year.

If using the PV/FV tables, do not round the factors from the way they are shown in the tables. Present your answers in whole dollar amounts only, without '$' signs and without commas.

#1. How much cash would issuing the bonds on Dec. 31, Year 1, provide to Merle on that date? This is the issue price. _______

#2. How much Interest Expense would the firm recognize in Year 2 if it issued the Bonds Payable? Year 2 ends on Dec. 31, Year 2. _________

#3. How much Interest Expense would the firm recognize in Year 2 if it borrows using the Note Payable? Year 2 ends on Dec. 31, Year 2. ________

#4. How much cash will Merle have to pay out in Year 3 if issuing the Bonds Payable? _______

#5. How much cash will Merle have to pay out in Year 3 if issuing the long-term Note Payable? _______

#6. What would the carrying value of the Note Payable be on Dec. 31, Year 5, after making the sixteenth loan payment on that date? ______

#7. What would the carrying value of the Bonds Payable be on Dec. 31, Year 5, after making the interest payment on that date? ______

Answer 1

1. Cash on issue of bonds = 1000*20 = 20000

twenty bonds with a face amount of 1000 each

2. Interest expense on Bonds in year 2 = 20000 * (4% + 4%) = 1600

since interest is paying on semi-annually , 4+4 shown for the understanding

3. In the case of note payable, since principal is also paying back on quarterly basis, interest has to be calculated on quarter basis

quarterly pay back of principal portion is 850 . (17000/5*4)

Interest calulation as follows

Q1 = 17000 * 2% = 340

Q2 = (17000-850) * 2% = 16150 * 2% = 323

Q3 = (16150-850) * 2% = 15300 * 2% = 306

Q4 = (15300-850) * 2% = 14450 * 2% = 289

Interest expense on Notes in year 2 = 340+323+306+289 = 1258

4. Cash payable on Bonds in year 3 = 20000 * (4% + 4%) = 1600

only interest has to be paid and that too on the issued amount

5. In year 3 in case of note, 4 installments of 850 along with interest has to be paid

Interest calulation as follows

Q1 = (14450-850) * 2% = 13600 * 2% = 272

Q2 = (13600-850) * 2% = 12750 * 2% = 255

Q3 = (12750-850) * 2% = 11900 * 2% = 238

Q4 = (11900-850) * 2% = 11050 * 2% = 221

Cash payable on Notes in year 3 = (850*4)+272+255+238+221 = 4386

6. Carrying value of the Note Payable be on Dec. 31, Year 5 = 17000 - (850*16) = 3400

7. Carrying value of the Bonds Payable be on Dec. 31, Year 5 = 20000 itself since no portion of the same has not been paid back