Having recently studied liabilities and the concept of present value, Joanne Gotsinas was interested in discussing with the accounting professor several matters that had recently come to her attention in the newspaper and on television. Each of these matters is described below.

1. On a late-night talk show a guest described having found a bond in the attic of his home. The bond had been issued in 1871 by the town, apparently to finance a municipal water system. The bond was payable to the bearer (whoever happened to have the bond in his or her possession), rather than to a specifically named individual. The face amount of the bond was $100, and the stated interest rate was 10 percent. According to the terms of the bond, it could be redeemed at any future time of the bearer’s choosing for its face value plus accumulated compound interest. Ms. Gotsinas wanted to determine this bond’s worth because only the amount "several million dollars" had been mentioned on the show.
2. Ms. Gotsinas also had read about “zero-coupon” bonds, which are bonds that pay no interest. Therefore, they are offered at a substantial discount from par value, since the investor’s entire return is the difference between the discounted offering price and the par value. In particular, she had read that one company had issued eight-year, zero-coupon bonds at a price of $327 per $1,000 par value. Ms. Gotsinas wanted to discuss the following with the accounting professor: (a) Was the yield on these bonds 15 percent, as Ms. Gotsinas had calculated? (b) Assuming that bond discount amortization is tax deductible by the issuing corporation, that the issuer has a 40 percent income tax rate, and that for tax purposes a straight-line amortization of original discount is permissible, what is the effective or “true” after-tax interest rate to the issuer of this bond? And (c), if instead of issuing these zero-coupon bonds, the company had issued 15 percent coupon bonds with issue proceeds of $1,000 per bond (i.e., par value), what would the issuer’s effective after-tax interest rate have been?
3. Ms. Gotsinas had also read about a financing technique called a “debt-for-equity swap.” The technique was described as follows: A company’s bonds are currently trading on the New York Bond Exchange at a sizable discount because their coupon rate is well below current market interest rates. The company arranges with an investment banking firm to buy up these bonds on the open market. The company then issues new shares of common stock to the investment banker in exchange for the bonds (which are then retired). The shares issued have a value about 4 percent higher than the amount the investment banker has spent acquiring the bonds. Finally, the investment banker sells these shares on the open market, realizing the 4 percent profit

According to the article Ms. Gotsinas had read, Exxon Corporation had swapped 1.4 million common shares valued at $43 million for bonds with a face value of $72 million, thereby realizing a tax-free gain of $29 million. Ms. Gotsinas wondered two things about such a transaction: (a) Why doesn’t the company issue the shares directly and use the proceeds to buy back the bonds on the open market, instead of using an investment banker as an intermediary? And (b) should the gain on such a swap be treated as income for financial reporting purposes since, in a sense, the company has done nothing to earn it? . . .

Assignment

1. Give your “tentative answers” to each of the above issues. Illustrate the issue and your answer, whenever possible, with a numerical example.