Team Assignment #3 Long-Term Debt

At the end of 2000, Nittany, Inc. issued zero-coupon bonds that mature in 2020. The face value of the bonds was $1.8 billion, and they sold for $968 million on the issue date. The effective market interest rate was 3.149% on that date. At the end of 2005, Nittany repurchased $257 million in face value of the notes for a purchase price of $127 million, resulting in a gain on the early extinguishment of debt.

Review what you have learned about bonds as well as the explanation of zero coupon bonds on p. 525 of your text, and answer the following questions, expressing all numbers in millions (for example, the face amount of the notes is $1,800). Please answer in complete sentences and show your calculations for numerical answers and journal entries.

1. What journal entry did Nittany, Inc. enter to record the issuance of the bonds, assuming the issue date was 12/31/2000?
2. Prepare an amortization schedule for the bonds. Assume interest is calculated annually, and use the effective interest method.
3. What amount of interest expense for the bonds did Nittany report on its income statement in 2001?
4. Interest expense is deductible on the corporate tax return. Assuming a corporate tax rate of 35% in 2001, how much did Nittany save in taxes by deducting the interest expense? What was the after-tax interest cost in 2001?
5. At the end of 2005, what was the book value of the bonds before the repurchase transaction? Show the two accounts and balances that are combined to determine the book value.
6. Prepare the journal entry to record the repurchase of some of the debt at the end of 2005. [Repurchasing some of the bonds before the maturity date is called early extinguishment of the debt. The company makes a payment to the bondholders, who relinquish the bonds and their right to collect the face value at maturity, and the debt is removed from the books. To record the early extinguishment, the company makes a journal entry to remove the appropriate book value and decrease cash by the amount paid to the bondholders. If those two amounts are not equal, a gain or loss is recorded to balance the journal entry. Look at your answer to #5, and note that a portion of each account related to this debt must be removed from the books. The journal entry is analogous to the entry you would use to remove a long-term asset from the books when it is sold.]
7. Why might company managers choose to issue zero-coupon bonds instead of interest-bearing bonds? Why might they decide to repurchase some of the bonds before the maturity date?