Question

1 a.Recently, the vice president of operations of the company has requested construction of a new plant to meet the increasing demand for the company’s bicycles. After a careful evaluation of the request, the board of directors has decided to raise funds for the new plant by issuing $3,000,000 of 11 percent corporate bonds on April 1, 2019, due on April 1, 2033. Interest is payable annually on April 1 each year. At the time the bonds were issued, the market interest rate for similar financial securities is 10 percent. Determine the selling price of the bonds.

b. Recently the company decided to initiate a pension plan as part of its employee compensation package. The pension plan will start on January 1, 2019. As required by accounting standards, the controller of the company needs to report the pension obligation (liability). The following estimates have been collected:

Average length of time to retirement                             15 years

Expected life duration after retirement                          10 years

Total pension payment expected each year

after retirement for all employees                            $800,000 annually

On the basis of the information above, determine the present value of the pension liability. Assume the payment is made at the end of the year and the interest rate is 8 percent.  

Answer 1

a). Formula for the interest payments:

PV – OA = R (PVF – OA_{n, i})

PV – OA = $330,000 (PVF – OA_{14, 10%})

PV – OA = $330,000 (7.3667)

PV – OA = $2,431,011

Formula for the principal:

PV = FV (PVF_{n, i})

PV = $3,000,000 (PVF_14,10%)

PV = $3,000,000 (0.26974)

PV = $809,220

The selling price of the bonds = $2,431,011 + $809,220 = $3,240,231

b). Pension starts one year from time of retirement

Amount available on retirement = 800,000 * 10AF8% = 5,368,065

Pension liability @ start of plan = 5,368,065 * 15DF8% = 1,692,238