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Intercompany Investments For the purpose of the first two questions below, suppose that Sealy pays $100 for bonds on June 1, 2012

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Intercompany Investments

For the purpose of the first two questions below, suppose that Sealy pays $100 for bonds on June 1, 2012. The bonds pay $2 in interest on November 30, 2012 (Sealy's 2012 fiscal year end) and $2 on May 31, 2013. The bonds are trading at $110 on November 30, 2012 and Sealy sells them on May 31, 2013 for $105. Assume there are no tax consequences and that the cash used to buy the bonds would not otherwise have earned any money.

Relative to not having bought the bonds, how different (direction and amount) will pretax income and total shareholders equity be in fiscal 2012 and 2013 as a consequence of having purchased the bonds (include the total effect of having purchased the bonds).

 

Question: If the bonds were trading securities.

ANSWER:

2012:

Pretax Income: 2 + 10

Total SH Equity: 2 + 10

 

2013:

Pretax Income: 2 - 5

Total SH Equity: 12 + 2 - 5

 

Question:

If the bonds were securities available for sale:

ANSWER:

2012:

Pretax Income: 2

Total SH Equity: 2+10

 

2013:

Pretax Income: 2+5

Total SH Equity: 4+5

 

 

For purposes of the third question, suppose that Sealy pays $100 for bonds with a principle amount of $100 on June 1, 2012. The bonds pay $2 in interest on November 30, 2012 and $2 on May 31, 2013. The bonds are trading at $110 on November 30, 2012 and Sealy is paid back the principle of $100 on May 31, 2013. Assume there are no tax consequences and that the cash used to buy the bonds would not otherwise have earned any money.

 

Relative to not having bought the bonds, how different (direction and amount) will pretax income and shareholders equity be in fiscal 2012 and 2013 as a consequence of having purchased the bonds (make sure you include the total effect of having purchased the bonds).

 

QUESTION: If the bonds were held to maturity securities:

ANSWER:

2012

Pretax Income: 2

Total SH Equity: 2

 

2013

Pretax Income: 2

Total SH Equity: 4