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Determining Bond Prices, Interest Rates, and Financial Statement Effects Deere & Company's 2018 10-K reports the following footnote relating to long-term debt for its equipment operations subsidiary
Determining Bond Prices, Interest Rates, and Financial Statement Effects
Deere & Company's 2018 10-K reports the following footnote relating to long-term debt for its equipment operations subsidiary. Deere's borrowings include $300 million, 7.125% notes, due in 2031 (highlighted below).
Long-term borrowings at October 28 consisted of the following in millions of dollars:
Notes and Debentures201820174.375% notes due 2019$7508-1/2% debentures due 2022$1051052.60% notes due 20221,0001,0006.55% debentures due 20282002005.375% notes due 20295005008.10% debentures due 20302502507.125% notes due 20313003003.90% notes due 20421,2501,250Other notes1,1901,136Total$4,714$5,491
A recent price quote (from Markets Insider) on Deere's 7.125% notes follows.
TypeIssuerPriceCoupon
(%)Maturity
Yield (%)Fitch
RatingCallableCorpDeere & CO131.037.12520312.82%A2No
This price quote indicates that Deere's 7.125% notes have a market price of 131.03 (131.03% of face value), resulting in a yield of 2.82%.
(a) Assuming that these notes were originally issued at par value, what does the market price reveal about interest rate changes since Deere issued its notes? (Assume that Deere's credit rating has remained the same.)
Interest rates have remained the same.
There is not enough information.
Interest rates have increased.
Interest rates have declined.
(b) Does the change in interest rates since the issuance of these notes affect the amount of interest expense that Deere reports in its income statement? Explain.
Yes, the decline in interest rates results in a decline in interest expense.
Because accounting is inherently conservative, declines in interest rates are not reflected in a reduction of interest expense. However, the increase in interest expense resulting from an increase in rates is recognized.
No, the change in interest rates since Deere issued the notes does not affect interest expense.
The change in interest rates only affects the required payment on the liability and, thus, cash flow.
(c) How much cash would Deere have to pay to repurchase the 7.125% notes at the quoted market price of 131.03%? (Assume no interest is owed when Deere repurchases the notes.)Round your answer to two decimal places.
$Answer
million
How would the repurchase affect Deere's current income?
The repurchase would result in a loss on repurchase of debentures, which would lower current pre-tax income.
Cash and bonds payable both decrease by the same amount. No gain or loss is recognized.
The repurchase only affects cash flow, not income.
Income is not affected because the liability has been reported at fair value since inception. As a result, the repurchase price is equal to the book value and no gain or loss is recognized.
(d) Assuming that the notes remain outstanding until their maturity, at what market price will the notes sell on their due date in 2031?
$Answer
million
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Expert Solution
A.) Assuming that these notes were originally issued at par value, what does the market price reveal about interest rate changes since Deere issued its notes? (Assume that Deere's credit rating has remained the same.)
=>
As we know that
There is an inverse relation between interest rates and bond prices, for confirming this statement look at the decreasing discount rate as the yield rate increases in present value tables of Appendix A. Since the interest rates are inversely related to the price of the bonds and the price of the bonds have increased.
Given that Deere's 7.125% debentures now trade at a premium (131.03) and assuming that Deere's credit ratings have not changed
So overall we conclude that Interest rates have declined.
B.) Does the change in interest rates since the issuance of these notes affect the amount of interest expense that Deere reports in its income statement? Explain.
=>
No, the change in interest rates since Deere issued the notes does not affect interest expense
the reason behind it is that The change in interest rates only affects the required payment on the liability and, thus, cash flow
Once the notes are recorded on the balance sheet, neither the coupon rate nor the yield (market) rate used to compute interest expense is changed. Bonds are recorded at historical cost and hence the interest is computed as per the coupon rate at which it was issued.
C.) How much cash would Deere have to pay to repurchase the 7.125% notes at the quoted market price of 131.03%? (Assume no interest is owed when Deere repurchases the notes.)Round your answer to two decimal places.
=>
Deere's borrowings = 300 million or 300000000
Market price = 131.03%
Amount paid to repurchase= 300*131.03%
Amount paid to repurchase= 393.09 million
How would the repurchase affect Deere's current income?
=> The repurchase would result in a loss on repurchase of debentures, which would lower current pre-tax income.
Repurchase would result in Loss on Bond Redemption
D.) Assuming that the notes remain outstanding until their maturity, at what market price will the notes sell on their due date in 2031?
=>
Deere must repay the face amount of the bonds at maturity. Because this is the only cash flow that the bondholders will receive, the market price of the bonds will be equal to the face amount at that time.
At maturity, the face value of the bonds are repayable. Hence $300 million will be the price at which notes sell.
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