On 1 January 2010, Elegant Frangrances Company issues £1,000,000 face value, five year bonds with annual interest payments of £55,000 to be paid each 31 December. The market interest rate is 6.0 percent. Using the effective interest rate method of amortization, Elegant Fragrances is most likely to record:
a) an interest expense of £55,000 on its 2010 income statement.
b) a liability of £982,674 on the 31 December 2010 balance sheet.
c) a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.
ANSWER=B
I’ve been through the whole Schweser lecture on this and I still don’t get how the answer is derived. When I used the TVM and amortization functions on my calculator (which I know how to use) with the numbers given I just cannot get any of these answers.
I know it has something to do with the effective interest rate method and I am just not getting it. Funny how I don’t have a problem understanding DTAs and DTLs but this is a problem
Remember that the TVM buttons on your calculator are cash flow buttons: cash inflows are positive, cash outflows are negative. I always encourage my students to decide on a point of view – borrower or lender, it doesn’t matter which – and stick with it. If you always look at these problems from the same point of view, you’ll never make a mistake.
Your PV with N=4, I=6,… is called the prospective method. To get the value of a bond under the effective interest rate method at any point in time, one discounts the remaining cash flows at the effective rate. As a useful exercise, plug in N=3 leaving all other values the same and recalculate PV: the number should look familiar.
In your 2nd statement, the 58,960 is more of a rolling up of the outstanding balance with one year’s interest @ 6%. At the end of the year, the issuer makes a cash payment of 55,000 for the new outstanding balance of 986,635.
