Question

At the end of 2018, RQM, Ltd. issued zero-coupon bonds that mature in 2038. The face value of the bonds was $1,801 million, and they sold for $1,099 million on the issue date. The effective market interest rate was 2.5% on that date. At the end of 2025, RQM repurchased $257 million in face value of the notes for a purchase price of $174 million, resulting in a gain on the early extinguishment of debt.

Review what you have learned about bonds as well as the explanation of zero coupon bonds on p. 537 of your text, and answer the following questions, expressing all numbers in millions (for example, the face amount of the notes is $1,801). Please answer in complete sentences and show your calculations for numerical answers and journal entries. Please do not use decimals in any of your answers. Round to millions.

1. What journal entry did RQM, Ltd. enter to record the issuance of the bonds, assuming the issue date was 12/31/2018?
2. Prepare an amortization schedule for the bonds. Assume interest is calculated annually and use the effective interest method.
3. What amount of interest expense for the bonds did RQM report on its income statement in 2019?
4. Interest expense is deductible on the corporate tax return. Assuming a corporate tax rate of 21% in 2019, how much did RQM save in taxes by deducting the interest expense? What was the after-tax interest cost in 2019?
5. At the end of 2025, what was the book value of the bonds before the repurchase transaction? Name the two accounts and balances from the Balance Sheet that combine to determine the book value.
6. Prepare the journal entry to record the repurchase of some of the debt at the end of 2025. [Repurchasing some of the bonds before the maturity date is called “early extinguishment” of the debt. The company makes a payment to the bondholders, who relinquish the bonds and their right to collect the face value at maturity, and the debt is removed from the books. To record the early extinguishment, the company makes a journal entry to remove the appropriate book value and decrease cash by the amount paid to the bondholders. If those two amounts are not equal, a gain or loss is recorded to balance the journal entry. Look at your answer to #5, and note that a portion of each account related to this debt must be removed from the books. The journal entry is analogous to the entry you would use to remove a long-term asset from the books when it is sold.]
7. Why might company managers choose to issue zero-coupon bonds instead of interest-bearing bonds? Why might they decide to repurchase some of the bonds before the maturity date? Be sure to consider whether management may chose to repurchase when interest rate are increasing or decreasing and explain why.

Answer 1

	Face Value	$ 1801 million
	Book Value	$ 1099 million
(A)	Journal Entriy of Bond Issue
			(In $ million)
	Particulars	Debit	Credit
	Bank	1099
	Bond Discount	702
	Bond Payable		1801
(B)	Amortization schedule for the bonds
			( In $ million)
Period	Interest Exp (MKT Rate (2.5%) * Prev. Book Value)	Amortization of Bond Discount	Book Value of the Bond
12/31/18			1099
12/31/19	27	27	1126
12/31/20	28	28	1155
12/31/21	29	29	1184
12/31/22	30	30	1213
12/31/23	30	30	1243
12/31/24	31	31	1275
12/31/25	32	32	1306
12/31/26	33	33	1339
12/31/27	33	33	1373
12/31/28	34	34	1407
12/31/29	35	35	1442
12/31/30	36	36	1478
12/31/31	37	37	1515
12/31/32	38	38	1553
12/31/33	39	39	1592
12/31/34	40	40	1631
12/31/35	41	41	1672
12/31/36	42	42	1714
12/31/37	43	43	1757
12/31/38	44	44	1801
(C ) What amount of interest expense for the bonds did RQM report on its income statement in 2019?
Answer :	$ 27 million
(D) At the end of 2025, what was the book value of the bonds before the repurchase transaction?
Answer :	$ 1306 million
(E) Prepare the journal entry to record the repurchase of some of the debt at the end of 2025.
			(In $ million)
	Particulars	Debit	Credit
	Bond Payable	257
	Bank		174
	Gain on Retirement of Bonds		83