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FINANCIAL ACCOUNTING – FINAL QUESTIONS AND ANSWERS WITH SOLUTIONS 2024
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FINANCIAL ACCOUNTING – FINALQUESTIONS AND ANSWERS WITH
SOLUTIONS 2024
***CHAPTER 10: BONDS (EFFECTIVE INTEREST METHOD)*** - ANSWER
From the perspective of the issuer, what are some advantages of issuing bonds instead of stock? -
ANSWER A company might choose to issue bonds instead of stock to:
1. Avoid diluting shareholders' interests
2. Benefit from the tax deductions associated with paying interest
3. Potentially increase the return to shareholders.
What are the primary characteristics of a bond?
For what purposes are bonds usually issued? - ANSWER - Bond
--A liability that is issued to the investing public to raise capital
- Bonds are traded on established exchanges, such as the New York Bond Exchange.
- When a company issues bonds it receives money from investors.
--Investors pay for the bonds in order to earn interest over the life of the bond.
--At the end of a bond's life, investors receive the bond principle amount back from the company.
Differentiate between a bond coupon rate and the market rate of interest. - ANSWER - Coupon rate (also
called the stated rate, contract rate, or nominal rate)
--The interest rate specified on a bond and is the rate used to compute the bond's periodic cash interest
payment
- Market rate of interest (also known as the yield or effective interest rate)
--The rate of return investors demand for a company's bonds on the date the bonds are issued.
Explain what determines whether a bond is issued at a discount or a premium. - ANSWER The difference
between a bond's coupon rate and the market rate of interest determines whether a bond is issued at a
discount or a premium.
- Discount
--When the coupon rate is lower than the market rate of interest
- Premium
--When the coupon rate is higher than the market rate of interest
When calculating the present value of a bond's future cash flows, do investors use the coupon rate or
market interest rate as the discount rate? - ANSWER - The market interest rate
--Reflects the return investor demand to invest in a security with a given level of risk
What is the book value of a bond? - ANSWER - The book value of a bond is the bond's principle amount
plus any premium or minus any discount.
, - A bond's book value is what a company reports on its balance sheet.
What is the formula used for calculating the cash payment bond investors will receive for interest each
period?
What is the formula used to calculate interest expense each period? - ANSWER - Cash payment bond
investors receive for interest each period is
--Principle amount x coupon rate.
- Interest expense reported each period is
--Book value of the bond at the beginning of the period x the market rate of interest on the date of
issuance.
When market interest rates increase, do bond prices increase or decrease? - ANSWER - When market
interest rates increase, bond prices decrease.
- This concept is easily understood by remembering that the market rate of interest is the discount rate
used to calculate the present value of a bond's future cash flows
- The higher the discount rate the lower the present value of the bond.
You have just started your first job as a financial analyst for a large stock brokerage company. Your boss, a
senior analyst, has finished a detailed report evaluating bonds issued by two different companies.
She stopped by your desk and asked for help: "I have compared two ratios for the companies and found
something interesting."
She went on to explain that the debt-to-equity ratio for Applied Engineering is much lower than the
industry average and that the one for Innovative Engineering is much higher. On the other hand, the
times interest earned ratio for Applied Engineering is much higher than the industry average, and the
ratio for Innovative Engineering is much lower.
Your boss then asked you to think about what the ratios indicate about the two companies so that she
could include the explanation in her report.
How would you respond to your boss? - ANSWER - Applied Engineering's ratios look better than
Innovative Engineering's ratios.
- Applied Engineering has a lower debt-to-equity ratio than Innovative Engineering.
--This means that they have less debt relative to equity in their capital structure, and therefore, are a less
leveraged company and have less risk than Innovative Engineering.
- Applied Engineering's times interest earned ratio is higher than the ratio for Innovative Engineering.
--This also makes Applied Engineering a less risky company than Innovative Engineering because Applied
Engineering generates a larger amount of income compared to its interest expense than does Innovative
Engineering.
***APPENDIX A: PASSIVE INVESTMENTS*** - ANSWER
Explain the difference between a short-term investment and a long-term investment. - ANSWER - Short-
term investment is one that meets:
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