a. Cybernetics would have raised $60,000,000 from the bond issue.
b. The interest and bond amortization for each of the three years would be as follows:
Year 1:
Interest expense: $60,000,000 x 8% = $4,800,000
Bond amortization: $60,000,000 x 5% = $3,000,000
Year 2:
Interest expense: $60,000,000 x 5% = $3,000,000
Bond amortization: $60,000,000 x 2% = $1,200,000
Year 3:
Interest expense: $60,000,000 x 2% = $1,200,000
Bond amortization: $60,000,000 x 0% = $0
c. The interest, unrealized gain/loss, and total expense for each of the three years would be
as follows:
Year 1:
Interest expense: $60,000,000 x 8% = $4,800,000
Unrealized gain/loss: $60,000,000 x (5%-8%) = $-900,000
Total expense: $4,800,000 + $-900,000 = $3,900,000
Year 2:
Interest expense: $60,000,000 x 5% = $3,000,000
Unrealized gain/loss: $60,000,000 x (2%-5%) = $-900,000
Total expense: $3,000,000 + $-900,000 = $2,100,000
Year 3:
Interest expense: $60,000,000 x 2% = $1,200,000
Unrealized gain/loss: $60,000,000 x (0%-2%) = $-1,200,000
Total expense: $1,200,000 + $-1,200,000 = $0
d. The amounts charged to income every year differ under the two methods because the
amortized cost method charges a constant amount of interest every year, while the fair
value method charges interest based on the current market rate.
The amount of amortization also differs because the amortized cost method charges
amortization based on the original value of the bond, while the fair value method does not
charge amortization.
formulas;
a. The amount of the bond issue is the present value of the bond payments, discounted at
the effective interest rate:
PV = PMT [(1 - (1 / (1 + i)^n)) / i]
PV = $60,000,000 [(1 - (1 / (1 + 8%)^3)) / 8%]
PV = $60,000,000
where:
PV = present value
PMT = bond payment
i = effective interest rate
n = number of payments
b. The interest expense and bond amortization for each year are calculated as follows:
Year 1:
Interest expense = PV x i
Interest expense = $60,000,000 x 8%
Interest expense = $4,800,000
Bond amortization = PV x (i - market rate)
Bond amortization = $60,000,000 x (8% - 5%)
Bond amortization = $3,000,000
Year 2:
Interest expense = PV x i
Interest expense = $60,000,000 x 5%
Interest expense = $3,000,000
Bond amortization = PV x (i - market rate)
Bond amortization = $60,000,000 x (5% - 2%)
Bond amortization = $1,200,000
Year 3:
Interest expense = PV x i
Interest expense = $60,000,000 x 2%
Interest expense = $1,200,000
Bond amortization = PV x (i - market rate)
Bond amortization = $60,000,000 x (2% - 0%)
Bond amortization = $0
Explanation:
c. The interest expense, unrealized gain/loss, and total expense for each year are
calculated as follows:
Year 1:
Interest expense = PV x i
Interest expense = $60,000,000 x 8%
Interest expense = $4,800,000
Unrealized gain/loss = PV x (market rate - i)
Unrealized gain/loss = $60,000,000 x (5% - 8%)
Unrealized gain/loss = $-900,000
Total expense = Interest expense + Unrealized gain/loss
Total expense = $4,800,000 + $-900,000
Total expense = $3,900,000
Year 2:
Interest expense = PV x i
Interest expense = $60,000,000 x 5%
Interest expense = $3,000,000
Unrealized gain/loss = PV x (market rate - i)
Unrealized gain/loss = $60,000,000 x (2% - 5%)
Unrealized gain/loss = $-900,000
Total expense = Interest expense + Unrealized gain/loss
Total expense = $3,000,000 + $-900,000
Total expense = $2,100,000
Year 3:
Interest expense = PV x i
Interest expense = $60,000,000 x 2%
Interest expense = $1,200,000
Unrealized gain/loss = PV x (market rate - i)
Unrealized gain/loss = $60,000,000 x (0% - 2%)
Unrealized gain/loss = $-1,200,000
Total expense = Interest expense + Unrealized gain/loss
Total expense = $1,200,000 + $-1,200,000
Total expense = $0
