Practice problem 4Today is 1/1/2006. The Flame Corp. has been operating for a number of years. As of today, The Flame has a zero-coupon bond (Series A bond), which was issued on 1/1/2003 at a price of $1,016,600. The Series A bond matures 10 years after issuance and has a facevalue of $2,000,000. On 1/1/2006, the market value of the zero-coupon (Series A) bond is $1,421,400. On this day, The Flame issues a new series of bonds (Series B). The market rate on the Series B bonds is the same as the rate implied in the market value of the zero-coupon bond. The Series B bonds have a face value of $3,000,000 and a stated rate of 6%. Series B bonds make annual coupon payments starting on 12/31/2006 and will mature on 12/31/2012. a. What was the market rate of interest on 1/1/2003, when The Flame issued its zero-coupon Series A bond? To find the interest rate, you need to equate the market value of the bond to the present value of the bond’s future payments OR you equate the future value of the current market value to 2,000,000. Since this is a zero-coupon bond, it would be easy to use the tables of PV/FV as follows:1,016,600*FVss(10,r)=2,000,000OR2,000,000*PVss(10,r)=1,016,600Solving either equation will yield r=7%.b. What is the book value of the zero-coupon bond on 1/1/2006? 1,016,600*FVss(3,7%) = 2,000,000*PVss(7,7%) = 1,245,400 c. What is the market rate related to Series A and Series B bonds on 1/1/2006? This is similar to part (a):1,421,400*FVss(7,r)=2,000,000OR12,000,000*PVss(7,r)=1,421,400r=5%d. Provide the journal entry for the issuance of Series B bonds on 1/1/2006? (5 points) Issue Price = PVss(5%,7)*3,000,000 + PVannuity(5%,7)*180,000 = 3,173,652Dr: Cash 3,173,652Cr: Premium 173,652Cr: Bonds Payable 3,000,000e. Provide the journal entries to record the interest expense in 2006 (for all bonds outstanding) assuming the company uses the effective-interest method. Series A bonds:Interest Expense = Book Value (1/1/2006) *Historical Rate =1,245,400*7% = 87,178Dr: Interest Expense 87,178Cr: Discount 87,178Series B bonds:Interest Expense = Book Value (1/1/2006) *Historical Rate =3,173,652*5% = 156,682.6Dr: Interest Expense 156,682.6Dr: Premium 21,317.4Cr: Cash
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