Dektronik Corporation manufactures electrical test equipment. The company’s board of directors authorized a bond issue on January 1, 2009, with the following terms:

Maturity (par) value: $800,000

Interest: 8 percent per annum payable each December 31.

Maturity date: December 31, 2013.

Effective-interest rate when sold: 12 percent.

Required:

1. Compute the bond issue price. Explain why both the stated and effective-interest rates are used in this computation.

2. Assume that the company used the straight-line method to amortize the discount on the bond issue.

Compute the following amounts for each year (2009 – 2013):

a. Cash payment for bond interest.

b. Amortization of bond discount or premium.

c. Bond interest expense.

d. Effective-interest rate (Item c ÷ $800,000).

e. The straight-line rate is theoretically deficient when interest expense, d, is related to the net liability (i.e., book value of the debt). Explain.

3. Assume instead that the company used the effective-interest method to amortize the discount. Prepare an effective-interest bond amortization schedule similar to the one in the text. The effective interest method provides a constant interest rate when interest expense is related to the net liability. Explain by referring to the bond amortization schedule.

4. Which method should the company use to amortize the bond discount? As a financial analyst, would you prefer one method over the other? If so, why?