Question

Crazy Cakes, a private company, is preparing to issue a bond to open a new bakery in an up-andcoming city. The bookkeeper, Sloan Baker, plans to amortize the bond using the effective interest method. For calculation purposes, assume the following information: The bond is expected to be a 4-year, $100,000 face value, 4% bond with an effective annual yield of 8%. Interest will be payable semiannually. If all goes well, the bond will be issued on March 1, 2021, and the first interest payment date will be September 1, 2021. The bonds are expected to be callable at 101 at any time on or after March 1, 2023.

Requirements You have been hired as an expert on bonds to write a memo to Sloan explaining how the call feature could affect their business. Be sure to include the following:

a) Educate the company on how bond redemptions work. What are the pros and cons of calling their bond before maturity? What are some things they should consider?

b) Include an amortization schedule using the effective interest method as an exhibit to follow your memo (you do not need to consider prorations).

Answer 1

Ans.(a)

A bond redemption is the full repayment of the principal amount (the amount you invested) and any interest owed to date. If redeemed at the time of maturity, an investor receives the par value or the face value of the security. Corporations that issue bonds or other securities may pay investors a redemption value when they buy back their securities on or before the maturity date. Interest payments generally stop before they do this.

Two kinds of bond redemptions
Bonds get paid back in two different ways. The most common is when a bond matures naturally. Every bond has a specified maturity date on which the bond issuer must repay the face value of the bond. On the date, bondholders have their bonds redeemed and receive a final cash payment.

The other type of bond redemption occurs before the stated maturity date. Some bonds have specific call provisions that allow the issuer to redeem the bond at specified dates prior to maturity at a stated price, which can be the same as or different from the bond's face value. In addition, companies sometimes do tender offers to buy back bonds on the open market, and when that happens, selling bondholders have their bonds redeemed in exchange for the agreed-upon payment.

Calculating gain or loss
In many cases, calculating the gain or loss on a bond redemption is fairly simple. If you take the redemption proceeds and subtract what you originally paid for the bond, then the difference will tell you the answer. If it's positive, then you have a gain. If it's negative, you've lost money on the bond.