Accounting Help?

Question

I have an assignment that I have to do that I am not understanding.

Stowers Research issues bonds dated January 1, 2005, that pay interest semiannually on June 30 and December 31. The bonds have a $20,000 par value, an annual contract rate of 10%, and mature in 10 years.
Required
For each of the following three separate situations, (a) determine the bonds’ issue price on January 1, 2005, and (b) prepare the journal entry to record their issuance.
1. Market rate at the date of issuance is 8%.
2. Market rate at the date of issuance is 10%.
3. Market rate at the date of issuance is 12%.

The market rate is what is throwing me off. Does the 8% mean there is a discount, the 10% means a par sale, and the 12% means it is issued at premium. Please help the assignment is due tonight.

Answer 1

Close... very close.

As you know, most assets and liabilities need to mark-to-market before recording them in the balance sheet. Therefore,

1. if the bonds pay a coupon of 10% and the market rate is 8% (bonds pay more than market) the price of the bonds will be recorded at a premium. Another way of thinking about this is if you have two different accounts and one pays more interest than the other (and both have the same risk) were would you put your money? obviously in the one with highest interest, same for bonds but with the caveat that there is a limited supply (only a certain amount of bonds that pay that interest) so based on Supply and Demand investors will start purchasing the 10% bond on favor of the 8% therefore driving the price of the bond up.

2. Bond rate = market rate then bonds are market at par value.

3. inverse of 1. higher market rate than bond rate, then investors will take money elsewhere therefore bond prices go down (bonds will be mark-to-market at a discount).

Hope this is helpful,

Answer 2

You have it backwards. If the coupon is 10% and the market rate is 8% then the bond will sell at a premium. If the market is 12%, it will sell at a discount.

Think about it this way...the market rate is what a bond that sells at par is paying. If you can pay par and get 12% interest, then you're not going to want to pay full price for this bond that's only paying 10%. It will have to be marked down. But if you can only get 8% coupon, then this bond looks pretty good, and you would be willing to pay up a little to get that extra coupon.

If you ahve a financial calculator you can set it up as follows to get your prices:

FV=100
PMT=5
N=20
I/YR = This will be different for each of the 3 different scenarios. It will be either 4%, 5% or 6%
Then solve for your PV. Multiply it by 10, and that's your price. It will be a negative number. Just make it positive. That's kind of a quirky thing about financial calculators.

Hope that helps!

Answer 3

That is backwards. If the market rate is lower, then the bonds were sold at a primium (pay more for a higher interest rate). If the market rate is higher, the bonds were sold at a discount. People expect a perk for buying a lower interest rate.