Question

JCPenney Company was one of the first companies to issue zero coupon bonds. An article in Forbes magazine discussed the JCPenney bonds and stated: "It's easy to see why corporations like to sell bonds that dont' pay interest. But why would anybody want to buy that kind of paper [bond]?" An example of a zero-coupon bond is the following: Bonds with a face (maturity) value of $400 million due in 3 years after issuance. There are no periodic interest payments on the bond (i.e., the coupon rate is 0$). When the bonds were sold to the public, similar bonds paid 9 percent effective interest (i.e., the market rate is 9%).

1. Explain why an investor would buy a zero coupon bond ONLY if it were sold at a discount?

2. Assuming the bond is issued in January 2014, complete the below amortization schedule for the bond. It will require you to calculate the present value of the bond.

Date	Coupon Payment	Interest Expense	Discount Amortization	Net Book Value
1/1/2014				328,506,931
12/31/2014
12/31/2015
12/31/2016

3. What journal entries would the firm make over the life of the bond?

4. Assuming the firm issued the bonds in January of 2014, how much interest expense will the firm recognize in 2014 on the bonds?

5. What would be the value of the bonds recognized on the firm's balance sheet at December 31, 2015?

Answer 1

1-	Zero coupon bonds are issued at discount and companies offer discount almost equal to rate of return that investors earned on coupon bonds. No coupon is paid on zero coupon bonds but these bonds capital gain yield almost equals to the YTM of the coupon bonds of the same maturity. Thus Investors remains indifferent between the coupon bonds and zero coupon bonds.
2-	Issue price of zero coupon bond	face value/(1+r)^n r=9%	400/(1.09)^3	308.873392
date	coupon payment	Interest expense = net book value*market rate of interest	discount amortization = interest expense	net book value = beginning balance+discount amortized
jan 1 2014				308.873392
dec 31 2014	0	27.79860528	27.798605	336.6719973
dec 31 2015	0	30.30047976	30.30048	366.9724771
dec 31 2016	0	33.02752294	33.027523	400
3-	date	explanation	debit	credit
	jan 1 2014	cash	308.87339
		discount on bonds payable	91.126608
		bonds payable		400
	dec 31 2014	Interest expense	27.798605
		discount on bonds payable		27.79860528
	dec 31 2015	Interest expense	30.30048
		discount on bonds payable		30.30047976
	dec 31 2016	Interest expense	33.027523
		discount on bonds payable		33.02752294
	dec 31 2016	bonds payable	400
		cash		400
4-	Interest to be recognized		27.798605
5-	value of bonds recognized in 2015		366.97248