SOLUTION (See pg 3): Acct 2210 Zeigler AQ#5 - Chp 10 -16 pts available

_____ 1. A “Line of Credit” (i.e. Credit Line) is a long-term financing arrangement often used to purchase long-term assets such as equipment and buildings.

  1. TRUEb. FALSE

A Line of Credit is a short-term, flexible financing arrangement often used to provide short-term cash flow for uncollected receivables and unsold inventory (current assets). Once A/R is collected, or inventory is sold, the LOC is promptly paid back to the bank.

Use the following information about for questions2-4 (NO PV tables are needed):

Sutherland, Inc. purchased a fancysports car on January 1, 2015 by signing a 5-year,$30,000 Installment Note with WendelBank & Trust Co. Due to the company’s favorable credit rating, the loan carried a low interest rate of 3% per year with monthly payments of$539.

_____ 2. Based on the information provided, how much of the first(Jan) payment would be applied toward the reduction ofthe principal balance of the loan?

  1. $539b.$464c. $75d. $0e. None of the above is within $5

$539 – $75 of interest expense ($30,000*.03/12)

_____ 3. Based on the information provided, how much of the second(Feb) payment would be interest expense (possibly rounded up to $1)?

a.$530b. $464c. $275d.$74e. None of the above is within $10

($30,000 principal - $464 above) = $29,536*.03/12 = $74 (period 2) interest expense

_____ 4. Based on the above, the Notes Payable Balance Sheet liability(i.e. theremaining loan principal balanceafter the second payment was made) on the February 28thBalance Sheet would be:

  1. $30,000 b. $29,536 c. $29,089 d. $29,071 e. None of the above is within $10

$30,000 -$464 principal (month #1) - $465 principal($539-$74 month #2) = $29,071

_____ 5. After reviewing pages 558/559, the “times-interest-earned” (TIE) ratio is calculated by which of the following?
a.Total assets divided by interest expense.
b.Earnings before interest and taxes (EBIT) divided by interest expense.
c.Net income divided by interest expense.
d.Earnings after interest and taxes (EAIT) divided by total assets.

_____ 6. Stoever & Blauwkamp, Inc. has a long-term notes payable in the amount of $2,687,500 with an annual interest rate of 8%. One way Analysts measure the ability of a company to meet its interest obligations is to calculate the company’s “times-interest-earned”(TIE) ratio. Assume the company earned net income of $645,000 for the year (which includedthe annual interest expense). Based upon this information, and ignoring income taxes, the TIE ratio would be:

a. 1.60 times

  1. 2.00 times
  2. 3.60 times
  3. 4.00 times($645,000 NI + $215,000 add back of interest) = $860,000 / $215,000

_____ 7. Which of the following conditions indicate a company has a relatively high level of financial risk?
a.A low debt to assets ratio.
b.A low times interest earned ratio.
c.A high return on equity.
d.A high current ratio.

_____ 8. If FalconCorporation issues a bond to an investor at “98”, which of following statements regarding the market rate of interest must be true?

  1. It is higher than the stated rate of interest on the bond.
  2. It is lower than the stated rate of interest on the bond.
  3. It is equal to the stated rate of interest on the bond.
  4. More information is needed to answer this question.

_____ 9. Which of the following statements regarding the “Effective Interest Method” of amortizing bond discounts is true?

a. The interest expense on a bond sold at a discount is calculated by taking the totaldiscount amount and dividing it by the term of the bond.

b. The interest expense on a bond sold at a discount is calculated by multiplying the carrying value of the bond by the market rate of interest each period.

c. The actual interest cash paymentpaid on a bond sold at a discount is calculated by using the stated (contract) rate of interest on the bond multiplied by the face value of the bond.

d. Both “b” and “c” are correct.(answer “c” logic applies for a premium as well)

_____ 10. Amortizing (the allocation of) a Premium on Bonds Payable, by the bond issuer, will:

a. have no effect on interest expense

b. increase interest expense

c. decrease interest expense

d. increase or decrease interest expense based upon the bond interest rate

Draw a timeline & use PV tables to answer the next three INDEPENDENT questions (2pts each)

_____ 11. IfSeiter& Gales, Inc.issues a $1,000, 4-year bond with a stated rate of interest of 7% (paid annually), what will the bond sell for (rounded) if the market rate of interest is 5%?

  1. $880
  2. $932

c. $1,000

d. $1,071 Using mkt rate, PV of Principal ($1,000*.8227)+PV of interest payments($70*3.546)

e. $1,213

Note: The only time the stated (contract) rate is used is to determine the cash interest payment(s)promised by the contract. All other calculations require use of the market rate.

_____ 12. If Hackworth & Thien, Inc. issues a $1,000, 4-year bond with a stated rate of interest of 5% (paid annually), what will the bond sell for (rounded) if the market rate of interest is 7%?

a. $763

b. $816

c. $932 PV of Principal + PV of interest payments (always use Market rate for PV work)

d. $1,000

e. $1,213

_____ 13. If Zeigler, Inc.issues a $1,000, 4-year bond with a stated rate of interest of 5% (paid annually), what will the bond sell for if the market rate of interest is 5%?

a. $823

b. $932

c. $1,000PV of Principal + PV of interest payments (always use Market rate for PV work)

d. $1,071

e. $1,213

In all three cases above, always use the market rate to “tailor” (price) the bond cash flows promised by the contract in order to meet the demands of the marketplace.

Optional, “Extra Practice”work using the Bee GeeBond Handout

Consider the solution commentary belowas example guidance for the GQ#4 Extra Credit.

Note: Complete the ORIGINAL Scenario #2 before working on this question

Facts for “Extra Practice” question:

Under Scenario #2 of the Bee Gee Movie handout (i.e. Discount scenario), what would the bond sell for if you, the investor, wanted to sell this bond (which is earning 10%)to another investor at the end of the 3rd year (i.e. 12/31/2018) when the market rate of interest has increased to 12%?

AQ#5 –“Extra Practice”Answer:

The price of any fixed interest bond is the present value of all remaining cash flows, discounted at the current market rate. That is why time value of money is critical to your understanding the accounting for bonds when using the “Effective Interest Rate Method” (pg 553-557). As a future investor, any student needs to understand this.

In this case, you are holding a 10% investment when the market requires a 12% return. You COULD keep the bond and still earn your 10%. In order to sell the bondat this point in time, however, you will incur a loss because no one will buy your bond unless it equates to the current 12% market rate.

To price this bond, at this time, you forget about all previous calculations and start over.

The remaining cash flows promised by this bond (to the new investor) are:

a)One interest payment left, plus

b) The principal amount of $1,000,000 received at maturity (i.e. end of next (4th) year).

One interest payment of $80,000 (as per the original, unchanging, bond contract) * the 12% PV factor from table 2 of 0.892857 = $71,429. Add to this the PV of the principal to be received in one year (same approach as above): $1,000,000 * .892857 = $892,857. The sum of the two cash flows equals the present value of all remaining payments, discounted at the current market rate, which is the price an investor would be willing to pay you for this bond to earn their required 12% rate of return:

Selling Price at 12/31/2018 = $964,286 ($71,429 + $892,857)

The carry value of the bond (for you, the investor)from the original handout is:

$981,818 (which equals the PV of remaining cash flows discounted at 10%).

As such, you would have a loss on the sale of the bond for the difference:

Cash (this is what your receive for your bond)964,286

Loss on bond sale (your loss) 17,532

Investment in Bond (your asset is gone) 981,818

In essence, you are selling a 10% bond in a 12% market. To attract a buyer, you must discount the bond and a loss will be incurred. Again, you COULD keep the bond and still earn a 10% rate of return (which, of course, is less than the current 12% market rate).

Note: Bee Gee Movie, Inc. is OUT of the picture here as you are selling your bond in the secondary market to another investor. The only information Bee Gee needs is anew name and address to send (pay) the remaining payments. Bee Gee’s cost of borrowing REMAINS at the original 10% market rate in effect at the time of the bond issuance.

See me with any questions and refer to this discussion for the GQ#4 Extra Credit.