• On August 1, Terry issued a $1,600,000, semi-annual, 6 year, 4.5% bond. The market rate for similar bonds on that day was 5.0%. Terry uses the effective interest method to record the amortization or premiums and discounts. Terry’s management has decided to report net bonds on the balance sheet, instead of reporting the bond and its premium or discount separately. No entries have yet been made for the bond.
Terry’s management would like to know the effect of the sale on the following ratios:
-Debt to Equity Ratio (Total Liabilities / Total Equity)
1. Calculate each of the three (3) ratios before you make any adjustments.
2. Make the appropriate journal entries, if any, to account for the new bond and any accrued interest (including any necessary changes to income tax expense).
3. Make any necessary changes to the financial statements.
4. Calculate the three (3) ratios after you make any adjustments.
5. What do you think investors’ reaction will be to management’s decision to issue a new bond? In other words, based on your changes to the financial statements and the change in the ratios, do you think investors will be happy with the decision to issue the new debt? Why or why not?
6. Terry’s CFO has been concerned about the issuance of this bond. The company really doesn’t need the additional cash at the moment, despite some vague plans to expand in the near future. The rest of the management team, on the other hand, felt that the additional cash would allow them to repurchase shares and pay a larger dividend for the period, both of which would help to calm investors’ fears after all of the changes that needed to be made to the financial statements this period. Provide two (2) arguments that the CFO could have used to try to talk his colleagues out of issuing the bond.