Question

This is a free-response question, which will be graded after all HW submissions are in. Your HW grade will not reflect these 5 points until this portion is graded by the TA's

Prompt:

KASE is in need of $300,000 to build a new prototype. Upon looking at its options, it finds it can get $300,000 in one of two ways:

• On 1/1/20X1, issuing a $300,000 of 2.5%, 4-year bond, dated 1/1/20X1, which matures 1/1/20X5, and must pay interest twice a year (semi-annually) every first of July and first of January
• On 1/1/20X1, borrowing $300,000 on a 6-year, 5.5% installment note payable. The terms of the note require KASE to pay 6 equal payments each December 31 for 6 years

Question:

If KASE wanted the most pre-tax Income Statement profit over 6 years, which way would she choose, and why?

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Answer 1

Answer - Option 1 for issuing bond.

Bond has to be issued forn $ 300000 of 2.5%. interest is payable semiannualy on 1 july and 1 january respectively. hence the rate would be (2.5*2) = 5%

Hence the interest expense would be = 300000* 5% * 4yrs = $ 60000

the cost of bond for redemption   = $ 300000

hence total cost for issuing bond will be $ 360000.

Option 2 for taking a loan

Loan will be taken for $ 300000 @ 5.5% for six years and it will be payable in six equal installments each on 31 december. hence amount of each installment would be = $ [300000 * (1.055)^6 ] /6

= $ 68942.14

KASE Wanted the most pre tax income statement over 6 years, hence it should issue the bond instead of taking the loan because the cost of issuing bond is less than the cost of taking a loan.