Question

On January 1, 2016, Plywood Homes, Inc., issued 20‐year, 4 percent bonds having a face value of $1 million. The interest on the bonds is payable semiannually on June 30 and December 31. The proceeds to the company were $975,000 (i.e., on the day they were issued the bonds had a market value of $975,000). On June 30, 2016, the company’s fiscal closing date, when the bonds were being traded at 98 ½, each of the following amounts was suggested as a possible valuation basis for reporting the bond liability on the balance sheet.

$975,625 (proceeds, plus six months’ straight‐line amortization)

$1 million (face value)

$1,780,000 (face value plus interest payments)

Required:

1) Distinguish between nominal and effective interest rates.

2) Explain the nature of the $25,000 difference between the face value and market value of the bonds on January 1, 2016.

3) Between January 1 and June 30, the market value of the company’s bonds increased from $975,000 to $985,000. Explain. Discuss the significance of the increase to the company.

4) Evaluate each of the three suggested alternatives for reporting the bond liability on the balance sheet, giving arguments for and against each alternative. Your answer should take the investor and the reporting company into consideration.

Answer 1