A company took the following actions related to $5 million of lO-year bonds with a coupon rate of 8% payable semi-annually on 30 June and 31 December:
A. Issued on 1 January 2006, when the market rate of interest was 6%.
B. Bought back in an open market transaction on 1 January 2012, when the market rate of interest was 8%.
Which of the following statements best describes the effect of the bond repurchase on the financial statements for 20127 If the company uses the indirect method of calculating the cash from operations, there will be a:
C is correct. The book value of the bonds on 1 January 2012 is equal to the present value of the remaining coupon payments and principal discounted at the market rate at time of issue (3% per period).
Coupon = 0.08 × 1/2 × 5,000,000 = 200,000; there are four years remaining or eight coupon payments.
Book value = 200,000 PVAnnuity (n = 8, I = 3%) + 5,000,000 PV (n = 8, I = 3%)
= 1,403,938 + 3,947,046
= 5,350,984
Using a financial calculator: PMT = 200,000; FV = 5,000,000; I% =3%; N = 8;
Compute PV = 5,350,984
Because the market interest rate when the bonds are bought back (8%) is equal to the coupon rate, the company can buy back the bonds at par, $5,000,000:
Cost of repurchase $5,000,000
Book value 5,350,984
Gain on retirement 350,984
On the cash flow statement, the gain would be deducted from net income when calculating the cash from operations under the indirect method, and the cash paid to repurchase the bonds would be a cash outflow in the financing section.