Note: This case is unchanged from the Tenth Edition.
As with the earlier Joan Holtz cases, this one enables students to discuss some interesting issues, none of which requires a full class period. The instructor should be alert to newer situations to augment or supplant any of those described in the case. Also many of these issues tend eventually to result in an FASB, AICPA, or SEC pronouncement. Since seldom will a beginning student be aware of these pronouncements, they do not preclude continuing to use a part of this case, and then revealing at the end of that part's discussion whether the accounting rule-making body reached the same conclusion as the class did. Comments on Questions
1.The question is equivalent to asking, what is the future value of $100 invested at 10 percent compound interest, 127 years (1998 - 1871) from now? The answer is $100 (1,10)127 = $18,066,000. We subsequently read that the man, after giving his town officials a good scare, did not pursue the matter further, becausehad he prevailedit would have bankrupted the town. 2.a.For a future value of $1,000 received 8 years hence, and a 15 percent discount rate, the present value is $327; so, yes, the yield was 15 percent. (This result can be gotten using a calculator, or by noting in Appendix Table A that the 8 yr., 15% PV factor is 0.327.) b.The discount is $1,000 - 327 = $673; using straight-line amortization, that is $673 divided by 8 = $84.125/bond/yr., resulting in annual tax savings of $84.125 * 0.40 = $33.65. (Subsequent to the writing of the case, the U.S. Treasury reduced, but did not eliminate, the tax deductibility of original issue discount, so these zero-coupon bonds became less attractive.) Thus, the bond issuer contemplates the following cash flow pattern: Time Zero+ $327
Years 1-8+ $33.65/yr.
End of year 8- $1,000
(Actually, straight-line discount amortization is not permitted, but we wanted to keep the calculations as simple as possible.) We need to make the sum of the PVs of the eight-year stream and negative future flow equal $327, i.e., find the rate that gives an NPV of zero. By trial and error, this rate can be found to be approximately 8.5 percent. (A calculator shows it to be 8.63 percent.) c.With 15 percent bonds issued for par, the net-of-tax interest payment stream is simply $150 (1-0.40) = $90/bond/yr. for 8 years. If one makes a calculation like the one for part (b), but with Time Zero in flow equal to $1,000 (instead of $327) and the annual outflows equal to $90 (instead of $33.65 annual inflows), the rate giving an NPV of zero (remember the Year 8 $1,000 outflow, as well) is 9.0 percent. (Actually, trial-and-error or calculators aren't needed here; once the $90/year amount is determined, the rate of 9.0 percent is also determined, since $90 divided by $1,000 = 9.0 percent. The student who quickly realizes this understands the meaning of a "true" return on investment of 9.0 percent.) Thus, from the standpoint of the bondholder, ignoring taxes, the yield on either bond is 15%, but the cost to the issuer of the zero-coupon bond is lower. Actually, zero-coupon bonds are generally purchased by tax-exempt institutions, so this comparison ignoring taxes is valid. However, for taxable bondholder entities, the zero-coupon bond discount amortization is taxable as ordinary interest income. In the early 1980s, zero-coupon bond mutual funds have sprung up for use by IRAs. 3.Although the text describes refunding a bond issue, it does not explicitly describe early extinguishment of debt. Actually, refunding a bond issue is just a special case of early extinguishment: the proceeds to retire the current debt come from a new debt issue. In the "debt-for-equity swap" we're considering, the substance of the transaction is the same as if the company issued shares and then used the cash proceeds to buy its bonds on the open market; in effect, the company is simply paying an...