Question

MagTech Inc. requires funding to build a new factory and has decided to raise the additional capital by issuing $850,000 face value of bonds with a coupon rate of 10%. In discussions with investment bankers, it was determined that to help the sale of the bonds, detachable stock warrants should be issued at the rate of 5 warrants for each $1,000 bond sold. The value of the bonds without the warrants is considered to be $775,000, and the value of the war- rants in the market is $75,000. The bonds sold in the market at issuance for $825,000.

Instructions

(a) What entry should be made at the time of the issuance of the bonds and warrants?

       (b) If the warrants were nondetachable, would the entries be different? Discuss.

Answer 1

All amounts are in $

Answer of sub question (a) :

Bond Issue Price : 825,000 (given)

Face Value : 850,000 (given)

Market Value of the bonds without the warrants : 775,000(given)

Market Value of warrants : 75,000 (given)

The Market value of the Bonds and Warrants are given. Therefore we need to use the Market value Method.

Tota Market value : 775,000+75,000 = 850,000

To calculate Value assigned to Bonds :Value of Bonds without the warrants / total market value * Issue Price

= 775,000 / 850,000 * 825,000

= 752,206 (rounded to $ 1)

To calculate Value assigned to warrants = Value of warrants / total market value * Issue Price

= 75,000 / 850,000 * 825,000

= 72,794 (rounded to $ 1)

Discount on bond = Face value of bonds - Fair value of bonds

= 850,000 - 752,206

= 97,794

The Journal entry will be :

Cash 825,000

Discount on bonds 97,794

Bonds Payable 850,000

Paid in Capital Warrants 72,794

Answer to the sub question (b) :

If the warrants are non-detachable, separate recognition is not given to the warrants. In this case the debt and equity element cannot be seperated.

To calculate discount on bonds : Face Value of bonds - Issue price of bonds

= 850,000 - 825,000

= 25,000

The entry if warrants were non-detachable is:

Cash 825,000

Discount on bonds 25,000

Bonds Payable 850,000