Question

Innovative Component Inc. needed financing to build a new manufacturing plant. On January 1, 2014, Innovative Component issued $400,000 of 8% bonds that pay interests semiannually and mature in 10 years. The bonds were sold for $428,400 to yield a 7% annual rate.

1. Fill out the basic information needed for pricing the bonds Innovative Component issued in January 2014.

            Principal amount: ____________________

            Semiannual coupon rate: __________________  

Semiannual market rate: ___________________  

            Discount periods: _____________________  

b. Fill out the amortization table. Round every number to the nearest dollar amount.

	Interest Expense	Interest Paid	Premium Amortization	Bond Payable, Net
0	___	___	___
1

c. After the issuance of bonds in 2014, the market price of the bonds increased in year 2016. How does the increase in market price affect Innovative Component’s interest expense reported on its income statement for the year of 2016?  

Increase        Decrease       No change            (Circle one)

Answer 1

(a) Principal amount: $400,000

Semiannual coupon rate: 4%

Semiannual market rate: 3.50%

Discount periods: 20

(b) When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond's book value. This means that when a bond's book value decreases, the amount of interest expense will decrease.

A	B	C	D	E	F	G
Period	Interest Paid	Interest Expense	Premium Amortization	Credit balance in bond premium account	Credit balance in bonds payable account	Bond payable, net
	4%*F	Mkt 3.5%*Previous BP in G	C-B			F+E
0				28400	400000	428400
1	16000	14994	-1006	27394	400000	427394
2	16000	14959	-1041	26353	400000	426353
3	16000	14922	-1078	25275	400000	425275
4	16000	14885	-1115	24160	400000	424160
5	16000	14846	-1154	23005	400000	423005
6	16000	14805	-1195	21811	400000	421811
7	16000	14763	-1237	20574	400000	420574
8	16000	14720	-1280	19294	400000	419294
9	16000	14675	-1325	17969	400000	417969
10	16000	14629	-1371	16598	400000	416598
11	16000	14581	-1419	15179	400000	415179
12	16000	14531	-1469	13710	400000	413710
13	16000	14480	-1520	12190	400000	412190
14	16000	14427	-1573	10617	400000	410617
15	16000	14372	-1628	8989	400000	408989
16	16000	14315	-1685	7303	400000	407303
17	16000	14256	-1744	5559	400000	405559
18	16000	14195	-1805	3753	400000	403753
19	16000	14131	-1869	1885	400000	401885
20	16000	14115	-1885	0	400000	400000

(c) NO CHANGE

Effective interest method is used to amortize the bond premium earned at the time of issuance only. That's why, the interest expense calculation uses the market interest rate at the time the bonds were issued.

Any change in bond prices or bond's yield after issuance will have no effect on the amortization schedule.