Chapter 9, Problem 9.5APE

Ethics

The Tony Hawk Skate Park was built in early 2016. The construction was financed by $10 million of 5% bonds issued at face value, due in 10 wars, with interest payable on June 30 and December 31 each year. The park did well initially, reporting net income in both 2016 and 2017. However, the discussion at the executive board meeting in late 2018 focused on falling skate-park revenues and increasing maintenance expenses. While several ideas were proposed, Jim Trost, the VP of finance, had an intriguing short-term solution. Jim stated, “Interest rates have steadily climbed the past three years. At the current market interest rate of 9%, we could repurchase our bonds for just under $8 million, recording a gain of over $2 million on the repurchase. We could then reissue new bonds at the current 9% rate.”

Required:

  1.    Calculate the actual repurchase price on December 31, 2018, assuming the 10-year, 5% bonds paying interest semiannually were initially issued at a face value of $10 million three years earlier on January 1, 2016. (Hint: The periods to maturity (n) will now be 14, calculated as 7 wars remaining times 2 periods each year.)

  2.    Record the bond retirement on December 31, 2018.

  3.    Is it ethical to time the repurchase of bonds in 2018 in order to include a $2 million gain on repurchase in a bad year? What if the transaction is fully disclosed?

  4.    From a business standpoint, is the retirement of 5% bonds and the reissue of 9% bonds a good idea? Explain why or why not.