Question

On January 1, 2019. $40 million face amount of 5%, 20 year bonds were issued. The bonds pay interest on a semiannual basis on June 30 and December 31 each year. The market interest rates were slightly higher than 5% when the bonds were sold. How much interest will be paid semiannually (each year on June 30 and on December 31) on these bonds?

a. $1.000.000

b. $2,000,000

c. Slightly less than $1.000.000

d. Slightly more than $2.000.000

Answer 1

Answer:

D. Slightly higher than $2,000,000 annually

Slightly higher than $1,000,000 semiannually

Explanation:

First we shall calculate the semiannual cashflow:

Annual cash flow = 5% x $40 million

Annual cash flow = $2,000,000

Since the bond pays semiannual interest, the semiannual cash flow will be:

Semiannual cash flow = $2,000,000 x 6/12

Semiannual cash flow = $1,000,000

Now, when the bond was issued the market interest rates were slightly higher than 5% which means that investors purchased the bond at a discount to the par value and will converge to par value as the bond reaches its maturity.

The interest income will include both cash flow of $2,000,000 annually ($1,000,000 semi annually) and discount factor making the payment slightly higher than $2,000,000 annually.

Following will be the journal entry:

Cash                           XXX

Discount on bond     XXX

        Interest income       XXX