Question

Team Assignment #3 – Long-Term Debt

At the end of 2000, Nittany, Inc. issued zero-coupon bonds that mature in 2020. The face value of the bonds was $1.8 billion, and they sold for $968 million on the issue date. The effective market interest rate was 3.149% on that date. At the end of 2005, Nittany repurchased $257 million in face value of the notes for a purchase price of $127 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. 525 of your text, and answer the following questions, expressing all numbers in millions (for example, the face amount of the notes is $1,800). Please answer in complete sentences and show your calculations for numerical answers and journal entries.

1. What journal entry did Nittany, Inc. enter to record the issuance of the bonds, assuming the issue date was 12/31/2000?
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 Nittany report on its income statement in 2001?
4. Interest expense is deductible on the corporate tax return. Assuming a corporate tax rate of 35% in 2001, how much did Nittany save in taxes by deducting the interest expense? What was the after-tax interest cost in 2001?
5. At the end of 2005, what was the book value of the bonds before the repurchase transaction? Show the two accounts and balances that are combined to determine the book value.
6. Prepare the journal entry to record the repurchase of some of the debt at the end of 2005. [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?

Answer 1

ANSWER:

a)Record the following journal entry:

Date	Account title and explanations	Debit	Credit
2000	Cash	$968
	Discount on notes payable	$832
	Zero coupon notes payable		$1800
	To record zero coupon notes issued

b) PREPARE THE AMORTISATION SCHEDULE AS FOLLOW:

Year	cash interest	Effective interest	Discount reduction	Outstanding balance
2000	0			$968
2001	0	(968*3.149%) $30	$30	$998
2002	0	(998*3.149%) $31	$31	$1030
2003	0	(1030*3.149%) $32	$32	$1062
2004	0	$33	$33	$1096
2005	0	$35	$35	$1130
2006	0	$36	$36	$1166
2007	0	$37	$37	$1203
2008	0	$38	$38	$1240
2009	0	$39	$39	$1280
2010	0	$40	$40	$1320
2011	0	$42	$42	$1361
2012	0	$43	$43	$1404
2013	0	$44	$44	$1449
2014	0	$46	$46	$1494
2015	0	$47	$47	$1541
2016	0	$49	$49	$1590
2017	0	$50	$50	$1640
2018	0	$52	$52	$1691
2019	0	$53	$53	$1745
2020	0	$55	$55	$1800

c)

The company would report an interest expense of $30 million in 2001 income statement and therefore the net profit would be reduced by $19.5million..

Particulars	Amount
Interest expenses (968*3.149%)	30$
Deduct: Tax savings @35%	10.50$
After tax interest expense	$19.50

d)

The effect of zero coupon notes payable on financial statements is that it decrease net income and increase outstanding notes payable balance in balance sheet accounts over the 20 year term

e)

Record the journal entry

Date	Account title and explanation	Debit	Credit
2005	Zero coupon notes payable	$257
	Cash		$127
	Discount on notes payable		$96
	Gain on early extinguishment of debt		$34
	To record early extinguishment of debt

Note:

Face value of notes extinguished                                      $257

Deduct: book value of notes extinguished

($1130*$257 / $1800 )                                                       $161

Discount on notes payable                                                $96

f)

the advantage of zero coupon notes is that the company can deduct annual interest expenses as tax deductible expenses and postpone the related cash outflows until the notes are paid the company might have decided to repurchase some of the notes to take advantage of lower interest rates in the market when compared to interest rate offered on notes payable.