Business Debt and Bonds Practice Flashcards

Practice questions and answers covering debt financing, note calculations, and bond characteristics based on class notes.

How is a note classified as short-term versus long-term?

A note is short-term if it is due within one year (or operating cycle) and long-term if it is due after one year.

For a note payable of $72,000$ at an $8\%$ interest rate, what is the interest expense for Year 1?

$$72,000 \times 8\% = 5,760$$

If a payment of $16,246$ is made on a note with $5,760$ in interest, what is the principal reduction for Year 1?

$$16,246 - 5,760 = 10,486$$

What is the note balance at the end of Year 1 if the starting principal was $72,000$ and the principal reduction was $10,486$?

$$72,000 - 10,486 = 61,514$$

What is the interest expense for Year 2 on a note with a beginning balance of $61,514$ and an interest rate of $8\%$?

$61,514 \times 8\% = 4,921$ (rounded)

What is the balance of a note at the end of Year 2 if the beginning balance was $61,514$ and the Year 2 principal reduction was $11,325$?

$$61,514 - 11,325 = 50,189$$

What is the purpose of a line of credit for a business?

It allows a business to borrow funds as needed up to a certain limit.

What are the primary sources of debt financing for most large companies?

Bank loans and bonds.

What are some advantages of issuing bonds compared to borrowing from a bank?

Lower interest rates, access to larger amounts of money, and longer repayment periods.

What are the common disadvantages associated with issuing bonds?

High issuance costs, a complex process, and ongoing reporting requirements.

Why can companies usually issue bonds at a lower interest rate than bank loans?

Because bonds spread risk among many investors and often involve lower risk to each individual lender.

What effect does income tax have on the cost of borrowing for a business?

Interest is tax-deductible, which lowers the effective (after-tax) cost of borrowing.

What is the concept of financial leverage?

Using borrowed funds to increase the potential return on equity.

Which type of bond, secured or unsecured, is likely to have a lower interest rate and why?

Secured bonds, because they are backed by collateral, which reduces the risk to the lender.

What is the function of restrictive covenants in bond issues?

They protect lenders by limiting certain actions of the borrower, such as taking on more debt.

What is the difference between term bonds and serial bonds?

Term bonds mature all at once, whereas serial bonds mature in installments over time.

What is the purpose of establishing a sinking fund?

To set aside money over time to ensure the company can repay the bond principal at maturity.

What is the call price of a bond and how does it relate to face value?

It is the amount paid to retire a bond early; it is usually higher than the face value to compensate investors.

If Roc Co. issues $100,000$ of bonds at face value, what is the effect on the financial statements?

Cash increases by $100,000$ and Bonds Payable increases by $100,000$.

What is the annual interest expense for $100,000$ of $5\%$ bonds issued at face value?

$$100,000 \times 5\% = 5,000$$

What mechanism is used to adjust the stated interest rate of a bond to the market rate?

The bond's selling price (either a premium or a discount).

Does a bond sell at a discount or premium when the effective interest rate is higher than the stated rate?

A discount, because investors require a higher return than what is stated on the bond.

What type of transaction is the issuance of bonds by a company?

A financing transaction.

If a $1,000$ bond is selling at $97\frac{1}{2}$, how much cash does the company receive?

$$975$$

How is the carrying value of a bond computed?

Face value plus premium or minus discount.

If Gay Co. has a Bonds Payable balance of $25,000$ and a discount of $5,200$, what is the carrying value?

$$25,000 - 5,200 = 19,800$$

When the effective interest rate is higher than the stated rate, is interest expense higher or lower than interest paid?

Higher.

If a company has a $30\%$ tax rate and an interest expense of $10,000$, what is the after-tax cost of the debt?

$$10,000 \times (1 - 0.30) = 7,000$$

What information does the times-interest-earned ratio provide?

It shows how easily a company can cover its interest expense with its earnings.