Question 3

(a) A company issues 1 million 1 bonds with a fixed annual interest rate of 5% issued at a price of 1.1 and issue costs are 5000.

The bonds are redeemable after four years at a price of 1.5, and redemption costs will be 3000.

Assume that the effective annual interest rate for this financial instrument is 12%.

(i) Calculate the total finance charge for the four-year period. (30 marks)

(ii) Show how the bonds should be accounted for in each of the four years. What is the residual liability if the effective annual interest rate is 12%? (30 marks)

(b) A company issues 1 million of 5% bonds at par. The bonds are redeemable after 3 years. The market rate of interest for similar debt is 6%. Calculate the value of the debt element that should be shown in the balance sheet. (40 marks)