Understanding Effective Interest Rate and Bond Valuation: FBGL Corporate Bonds Case Study

Why FBGL Paid More Than the Bond Face Value

On 1 January 2018 FBGL acquired some corporate bonds issued by Corporate Services Limited. These bonds had a ‘face value’ of $1 million and offered a coupon rate of interest of 10 per cent paid annually ($100,000 per year paid in arrears on 1 January). The principal of $1 million will be repaid on 1 January 2022. At the time, the market only required a rate of return of 8 per cent.  Assume there were no initial direct costs associated with buying the bonds.

Required:
Andrew has requested that you:
(a)Prepare a report to him explaining why FBGL had to pay more than $1 million for the bonds, and what is meant by the effective interest rate and its relevance under NZ IFRS 9 Financial Instruments. Illustrate this by calculating the fair value (present value of the future cash flows) of the bonds at the date of issue.

You are not required to include references to relevant paragraphs of NZ IFRS 9 or NZ IAS 32 in your report to Andrew. You must use your own words (i.e. you can paraphrase but not copy from the standards and other material. You do not need to cite your information sources).

(b)Using the fair value of the bonds at issue date from (a) above, prepare the amortisation schedule for the bonds in accordance with NZ IFRS 9 Financial Instruments (Andrew expects you to prepare the schedule on an Excel spreadsheet).

(c)Prepare the journal entries in respect of the bonds on 31 December 2020 and 1 January 2021.