Herman Company received proceeds of $188,500 on 10-year, 8% bonds issued on January 1, 2009. The bonds had a face value of $200,000, pay interest semi-annually on June 30 and December 31, and have a call price of 101. Herman uses the straight-line method of amortization.
What is the amount of interest Herman must pay the bondholders in 2009?

Question

Quizplus · Accepted Answer

To calculate the amount of interest Herman must pay the bondholders in 2009, we need to determine the semi-annual interest payment and multiply it by the number of semi-annual periods in 2009.

Face value of bonds = $200,000
Coupon rate = 8% (annual)
Semi-annual coupon rate = 4%
Semi-annual interest payment = 4% x $200,000 = $8,000

Since interest is paid semi-annually, there are two periods in 2009: January 1 - June 30 and July 1 - December 31.

For the first period (January 1 - June 30), the bonds were outstanding for 181 days (since they were issued on January 1). Using the straight-line method of amortization, we can calculate the semi-annual amortization as:

Semi-annual amortization = (Face value - Call price) / Number of semi-annual periods
Semi-annual amortization = ($200,000 - $202,000) / 20
Semi-annual amortization = -$1,000

Note that the amortization is negative because the bond is issued at a premium (call price is greater than face value).

Therefore, the interest expense for the first period is:

Interest expense = Semi-annual interest payment - Semi-annual amortization
Interest expense = $8,000 - (-$1,000)
Interest expense = $9,000

For the second period (July 1 - December 31), the semi-annual amortization is the same:

Semi-annual amortization = ($200,000 - $202,000) / 20
Semi-annual amortization = -$1,000

But this time, the interest expense is also reduced by the amortization:

Interest expense = Semi-annual interest payment - Semi-annual amortization
Interest expense = $8,000 - (-$1,000)
Interest expense = $9,000

Therefore, the total interest expense for 2009 is:

Total interest expense = Interest expense (first period) + Interest expense (second period)
Total interest expense = $9,000 + $9,000
Total interest expense = $18,000

However, since the bonds were issued at a premium, Herman will have to pay back the face value of $200,000 when the bonds are called. Therefore, Herman's effective interest rate (which takes into account the premium) is lower than the coupon rate of 8%. We can use the effective interest rate to calculate the total interest expense over the life of the bonds. But for this question, we're only asked about the interest expense in 2009, so the answer is $16,000 (choice B).

Herman Company Received Proceeds of $188,500 on 10-Year, 8% Bonds