Financing a Fourth Self-Storage Facility With Bonds and Stock: Pricing a 6% Bond Sold to Yield 7%, Amortizing the Discount, Recording the Share Issue, a Dividend and a Buyback, and Weighing Debt Against Equity
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ACC/291: Principles of Accounting II
Week 3 Assignment
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[Date]
The company and all figures are a composite written for a model paper.
A composite self-storage company operates three facilities in a growing suburban county, with about 1,900 units rented by the month to households, small contractors and online sellers who keep inventory close to home. Occupancy has run above 90% for two years, and the board has approved a fourth facility costing $2.8 million. The board's question is not whether to build but how to pay for it, and each answer leaves a different mark on the balance sheet. The company chose to raise most of the money by selling bonds and the rest by issuing new shares. This paper records both and compares them.
Current and Long-Term Liabilities
Before the new financing, the company's liabilities were mostly current: accounts payable to contractors, property taxes accrued for the year, and rent that tenants had paid in advance, which is unearned revenue until the month of storage has passed. Current liabilities are obligations due within one year (Weygandt et al., 2021). Bonds due in five years are long-term liabilities, and only the portion due within twelve months of a balance sheet date would move to current. Because these bonds are repaid in a single payment at maturity, they remain long-term until the final year.
Step 1: Pricing the Bonds
On January 1, the company issued $2,000,000 of five-year bonds with a stated rate of 6%, paying interest every June 30 and December 31. Each payment is $60,000. By the time the bonds were sold, lenders were asking 7% of companies with a similar credit record, so no investor would pay full face value for a 6% bond.
The price is the present value of the bond's cash flows at the market rate, using half the annual rate, 3.5%, and ten semiannual periods. The principal of $2,000,000 due in ten periods has a present value of $1,417,838. The ten interest payments of $60,000 have a present value of $498,996. The bonds therefore sell for $1,916,834, a discount of $83,166.
Entry: debit Cash $1,916,834; debit Discount on Bonds Payable $83,166; credit Bonds Payable $2,000,000.
The discount is not a loss. It is additional interest the company will pay at maturity, when it repays $2,000,000 for money it received as $1,916,834.
Step 2: Amortizing the Discount
Under the effective-interest method, interest expense each period equals the bonds' carrying value times the market rate per period. The difference between that expense and the $60,000 cash payment is the discount amortized.
June 30: interest expense is $1,916,834 times 3.5%, or $67,089. Cash paid is $60,000, so $7,089 of discount is amortized, and the carrying value rises to $1,923,923.
Entry: debit Interest Expense $67,089; credit Discount on Bonds Payable $7,089; credit Cash $60,000.
December 31: interest expense is $1,923,923 times 3.5%, or $67,337. The amortization is $7,337, and the carrying value rises to $1,931,260.
Interest expense for the first year is $134,426, even though the company paid only $120,000 in cash. Each period's expense grows slightly as the carrying value moves toward face value, and after the tenth payment the discount is fully amortized and the carrying value equals $2,000,000. The straight-line method would spread the discount evenly at $8,317 a period, but the effective-interest method is required when the difference is material, because it keeps the interest rate constant on the amount actually owed.
Step 3: Issuing New Shares
In March, the company sold 50,000 new shares of $1 par common stock at $18 per share, raising $900,000.
Entry: debit Cash $900,000; credit Common Stock $50,000; credit Paid-in Capital in Excess of Par $850,000.
Par value is a legal amount printed on the share, not a measure of its worth, which is why most of the proceeds go to paid-in capital. Together with the bond proceeds, the company raised $2,816,834 for the $2.8 million project.
Step 4: A Cash Dividend
On June 15, the board declared a dividend of $0.40 per share on the 450,000 shares then outstanding, payable July 20 to owners of record on June 30.
Declaration: debit Cash Dividends $180,000; credit Dividends Payable $180,000. The liability exists from the day the board declares it.
Record date: no entry; the company identifies who will be paid.
Payment: debit Dividends Payable $180,000; credit Cash $180,000.
Step 5: Buying Back Shares
In November, with the new facility open and cash to spare, the company bought 10,000 of its own shares at $20 each to hold as treasury stock.
Entry: debit Treasury Stock $200,000; credit Cash $200,000.
Treasury stock is subtracted in the equity section, and the shares are no longer outstanding, so they receive no dividends and have no vote. Outstanding shares fall to 440,000.
Step 6: Debt Against Equity
The two sources of money differ in three ways. First, cost after tax: interest is deductible, so at a 21% federal rate the first year's $134,426 of bond interest saves about $28,200 in tax, while dividends are paid from after-tax income. Graham (2000) estimated that the tax benefit of debt equals roughly 10% of the value of a typical firm and that many large, profitable firms could have used more debt than they did.
Second, risk: bond interest must be paid whether the new facility fills or not, while dividends can be cut. Surveyed chief financial officers named financial flexibility and credit ratings as the most important factors in their debt decisions, ranking tax savings lower (Graham & Harvey, 2001). The company has kept that flexibility by financing about a third of the project with equity.
Third, ownership: the new shares increased the share count by 12.5%, from 400,000 to 450,000, which spreads future earnings over more owners, while the bonds leave ownership unchanged. For a company whose existing facilities are full and whose cash flow is steady, the mix the board chose balances the cheaper cost of debt against the safety of equity.
Conclusion
The self-storage company financed its fourth facility with $1,916,834 from 6% bonds sold to yield 7% and $900,000 from 50,000 new shares. The bond discount of $83,166 becomes interest expense over five years through the effective-interest method, raising the first year's expense to $134,426. The equity entries show how issuing stock, paying a dividend and buying back shares each change the equity section in different ways. Debt was the cheaper money and equity the safer, and the balance sheet now shows both.
References
Graham, J. R. (2000). How big are the tax benefits of debt? The Journal of Finance, 55(5), 1901-1941. https://doi.org/10.1111/0022-1082.00277
Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2021). Accounting principles (14th ed.). Wiley.
How this ACC 291 Week 3 example is structured
The ACC/291 shelf page describes Week 3 as moving to liabilities, bonds and stockholders' equity accounts. The paper treats them as two halves of one financing decision, because that is how a company meets them. It prices the bond from the market rate first, since the price drives every later entry, and then shows how debt and equity differ in cost, risk and effect on the owners. Students search this week as ACC 291 Week 3, ACC291 Wk 3 or ACC/291 Wk 3; all three are the same assignment.
ACC/291 Week 3 questions, answered
What does ACC/291 Week 3 usually ask for?
The ACC/291 shelf describes Week 3 as moving to liabilities, bonds and stockholders' equity accounts. Many sections assign problems pricing bonds, recording interest and amortization, and recording stock issues, dividends and treasury stock.
Why do bonds sell at a discount?
When the market rate of interest is higher than the bond's stated rate, investors will pay less than face value so that their return equals the market rate. The discount is then amortized as extra interest expense over the life of the bond.
Is treasury stock an asset?
No. Shares a company buys back are a reduction of stockholders' equity, shown as a deduction in the equity section. The company cannot own itself, so the cost of the shares is subtracted from equity rather than listed with assets.
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