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COPYRIGHT 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western aretrademarks used herein under license.
Debt Financing
Chapter 12
S t I c e | S t I c e | S k o u s e n
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
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Learning Objectives
1. Understand the various classification andmeasurement issues associated with debt.
2. Account for short-term debt obligations,including those expected to be refinanced,and describe the purpose of lines of credit.
3. Apply present value concepts to theaccounting for long-term debts such asmortgages.
4. Understand the various types of bonds,compute the price of a bond issue, andaccount for the issuance, interest, andredemption of bonds.
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Time Line of Business IssuesInvolved with Long-Term Debt
ISSUE
the debt
Notes
Payable
Mortgage
Payable
Bond
CHOOSE
themethod offinancing
PAY
interest
+/-RETIRE
the debt
ACCOUNT
for thespecific
aspects ofthe type of
debt
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Definition of Liabilities
The obligation of a particular entity totransfer assets or provide services.Must be the result of past
transactions or events.Probable transfer of assets (or
services) must be in the future.
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Classification of Liabilities
Current Liabilities-Paid within oneyear or the
operating cycle,whichever is longer.
NoncurrentLiabilities- Not paid
within one year orthe operating cycle,whichever is longer.
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Stop and Think
Look at Exhibit 12-3. The2004 current ratio of
McDonalds is only0.81. How willMcDonalds most likely
meet its current
obligations as they comedue?
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Measurement of Liabilities
For measurement purposes, liabilitiescan be divided into three categories:
1. Liabilities that are definite inamount.
2. Estimated liabilities.
3. Contingent liabilities.
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Accounting for Short-Term Debt
Short-Term obligations are due withinone year or an operating cycle.
Account Payable-the amount due forthe purchase of materials.
Notes Payablea formal writtenpromise to pay a sum of money in thefuture, also known as a promissorynote.
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Short-Term ObligationsExpected to be Refinanced
A short-term obligation that isexpected to be refinanced on a long-term basis should not be reported as a
current liability FASB Statement No. 6 requires that
both of the following conditions bemet before a short-term obligationmay be properly excluded from thecurrent liability classification:
1. Management must intend torefinancethe obligation on a long-
term basis.
2. Managementmustdemonstrate an ability to
refinancethe obligation.
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Short-Term ObligationsExpected to be Refinanced
An ability to refinance may bedemonstrated by:
Actually refinancing the obligation duringthe period between the balance sheet dateand the date the statements are issued.
Reaching a firm agreement that clearlyprovides for refinancing on a long-termbasis.
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Short-Term ObligationsExpected to be Refinanced
The terms of the refinancing agreementshould be non-cancelable as to all parties.
The terms of the refinancing agreement
should extend beyond the current year. The company should not be in violation ofthe agreement at the balance sheet date orthe date of issuance.
The lender or investor should be financiallycapable of meeting the refinancingrequirements.
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Lines of Credit
Line of credit-is a negotiated arrangementwith a lender in which the terms are agreedto prior to the need for borrowing.
A company with an established line ofcredit can access funds quickly without thered tape.
Once the line of credit is used to borrow
money, the company has a formal liability(current or noncurrent).
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Present Value of Long-TermDebt
A liability should be reported at theamount that would satisfy theobligation on the balance sheet date.
For a long-term obligation, thisamount is the present value of thefuture payments to be made.
The division of these payments intointerest and principal components isa process called loan amortization.
Example journal entry to record a
mortgagepayment:Interest Expense 2,000
Mortgage Payable 57
Cash 2,057
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Types of Loans
Mortgage-a loan backed by an asset thatserves as collateral for the loan.
If the borrower cannot repay the loan, thelender has the legal right to claim the
mortgaged asset and sell it in order torecover the loan amount. Secured loan-similar to a mortgage, a loan
backed by assets as collateral and can be
claimed by the lender if the borrowerdefaults.There is a reduction in risk for the lender with a
secured loan, thus a reduced interest cost forthe borrower.
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Financing with Bonds
Reasons management may choose to issuebonds instead of stock:
1. Present owners remain in control of the
corporation.2. Interest is a deductible expense in arriving at
taxable income; dividends are not.
3. Current market rates of interest may be
favorable relative to stock market prices.4. The charge against earnings for interest may
be less than the amount of dividends thatmight be expected by shareholders.
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Financing with Bonds
Disadvantages and limitations ofissuing debt securities:
1. It is only possible to use debt financingif the company is in satisfactoryfinancial condition.
2. Interest obligations must be paidregardless of the companys earningsand financial position.
3. If a company has losses and is unableto raise cash to pay interest payments,secured debt holders may take legal
action.
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Accounting for Bonds
There are three main considerationsin accounting for bonds:
1. Recording the issuance or purchase.
2. Recognizing the applicable interestduring the life of the bonds.
3. Accounting for the retirement of bonds
either at maturity or prior to thematurity date.
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Nature of Bonds
Bond Certificates-commonly referredto as bonds are issued indenominations of $1,000.
Face Value-the amount that will bepaid on a bond at maturity date. Alsoknown as par value or maturity value.
Bond indenture-a group contractbetween the corporation and thebondholders.
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Types of Bonds
Term bonds- Bonds that mature in onelump sum on a specified future date.
Serial bonds- Bonds that mature in a seriesof installments at future dates.
Collateral trust bonds- Bonds usuallysecured by stocks and bonds of othercorporations owned by the issuingcompany.
Unsecured (debenture) bonds- Bonds forwhich no specific collateral has beenpledged.
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Types of Bonds
Registered bonds- Bonds for which theissuing company keeps a record of thenames and addresses of all bondholders
and pays interest only to those individualswhose names are on file.
Bearer (coupon) bonds- Unregistered bondsfor which the issuer has no record of
current bondholders, but instead paysinterest to anyone who can show evidenceof ownership.
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Types of Bonds
Zero-interest bonds-Bonds that do not bearinterest but instead are sold at significantdiscounts.
Junk bond-High-risk, high-yield bondsissued by companies in a weak financialcondition.
Commodity-backed bonds-Bonds that maybe redeemed in terms of commodities.
Callable bonds-Bonds for which the issuerreserves the right to pay the obligation priorto the maturity date.
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Market Price of Bonds
Bond discount-The difference betweenthe face value and the sales pricewhen bonds are sold below their face
value. Bond premium-The difference between
the face value and the sales price
when bonds are sold above their facevalue.
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Market Price of Bonds
BondStatedInterest
Rate
10%
8% Premium
10% Face Value
12% Discount
Yield
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Market Price of Bonds
Ten-year, 8% bonds of $100,000 are to be sold on the bondissue date. On that date, the effective interest rate for
bonds of similar quality and maturity is 10%, compoundedsemiannually.
Part 1 Present value of principle (maturity value):
Maturity value of bond after 10 years(20 semiannual periods) $100,000
Effective interest rate = 10% per year(5% per semiannual period) $37,689
Part 2: Present value of 20 interest payments:
Semiannual payment, 4% of $100,000 4,000
Effective interest rate, 10% per year(5% per semiannual period) $49,849
Total present value (market price) of bond $87,538
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Stop and Think
In computing themarket price forbonds, what is
the only thingfor which thestated rate of
interest isused?
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Issuance of Bonds
1/1 Cash 100,000Bonds Payable 100,000
7/1 Interest Expense 4,000Cash 4,000
12/31 Interest Expense 4,000
Cash 4,000
Issuers Books
Investors Books
Cash 4,000
Interest Revenue 4,000
Bonds 100,000Cash 100,000
Cash 4,000Interest Revenue 4,000
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Bond Issued at a Discount onInterest Date
On January 1, $100,000, 8%, 10-year bondswere issued for $87,538 (which provided an
effective interest rate of 10% to theinvestor).
Issuers Books
Jan. 1 Cash 87,538Discount on Bonds Payable 12,462
Bonds Payable 100,000
Investors Books
Jan. 1 Bond Investment 87,538Cash 87,538
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Bond Issue at a Premium onInterest Date
On January 1, $100,000, 8%, 10-year bondswere issued for $107,106 (which provided aneffective interest rate of 7% to the investor).
Issuers Books
Jan. 1 Cash 107,106Prem. on Bonds Payable 7,106Bonds Payable 100,000
Investors Books
Jan. 1 Bond Investment 107,106Cash 107,106
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Bonds Issued at Par BetweenInterest Dates
On March 1, $100,000, 8%, 10-year bonds wereissued to yield 8 %. Interest for two months
has accrued on the bonds.
Issuers BooksMar. 1 Bond Investment 101,333
Bonds Payable 100,000Interest Payable 1,333
July 1 Interest Expense 2,667Interest Payable 1,333
Cash 4,000
$100,000 x 0.08 x 4/12
$100,000 x 0.08 x 2/12
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Bonds Issued at Par BetweenInterest Dates
Investors Books
Mar. 1 Bond Investment 100,000Interest Receivable 1,333
Cash 101,333
July 1 Cash 4,000Interest Receivable 1,333Interest Revenue 2,667
On March 1, $100,000, 8%, 10-year bondswere issued to yield 8 %. Interest for two
months has accrued on the bonds.
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When Bonds are Issued at aPremium or Discount:
The market acts to adjust the statedinterest rate to a market or effective interestrate.
The periodic interest payments made by the
issuer are not the total interest expense. An adjustment to interest expense
(amortization) associated with the cashpayment is necessary to reflect the effective
interest being incurred on the bonds. There are two methods used to amortize thepremium/ discount:Straight Line MethodEffective Interest Method
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Straight Line AmortizationDiscount
Previously, $100,000 of 8% bonds were issued at$87,538 (a discount of $12,462). Appropriateamortization entries must be made on both the
issuers books and the investors books.
Issuers Books
July 1 Interest Expense 4,623Disc on Bonds Payable 623
Cash 4,000
Dec 31 Interest Expense 4,623Disc on Bonds Payable 623Cash 4,000
$12,462/120 x 6 months
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Straight Line AmortizationDiscount
Investors Books
July 1 Cash 4,000Bond Investment 623
Interest Revenue 4,623
Dec 31 Interest Receivable 4,000Bond Investment 623
Interest Revenue 4,623
Previously, $100,000 of 8% bonds were issued at$87,538 (a discount of $12,462). Appropriateamortization entries must be made on both the
issuers books and the investors books.
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Straight Line AmortizationPremium
Previously, $100,000 of 8% bonds were issued at$107,106 (a premium of $7,106). Appropriateamortization entries must be made on both the
issuers books and the investors books.
Issuers Books
July 1 Interest Expense 3,645Premium on Bonds Payable 355
Cash 4,000
Dec 31 Interest Expense 3,645Premium on Bonds Payable 355
Cash 4,000
$7,106/120 x 6 months
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Straight Line AmortizationPremium
Investors Books
July 1 Cash 4,000Bond Investment 355
Interest Revenue 3,645
Dec 31 Interest Receivable 4,000Bond Investment 355Interest Revenue 4,623
Previously, $100,000 of 8% bonds were issued at$107,106 (a premium of $7,106). Appropriateamortization entries must be made on both the
issuers books and the investors books.
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Effective Interest MethodDiscount
Consider again the $100,000, 8%,10-year bonds sold for $87,538.
The effective rate for the bonds is
10%.
Effective rate for semiannual period 5 %
Stated rate per semiannual period 4 %Interest amount ($87,538 x 0.05) $4,377Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 377
Period One
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Effective Interest MethodDiscount
Consider again the $100,000, 8%,10-year bonds sold for $87,538.
The effective rate for the bonds is
10%.Period Two
Effective rate for semiannual period 5 %Stated rate per semiannual period 4 %Interest amount ($87,915 x 0.05) $4,396Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 396
$87,538 + $377
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Effective Interest MethodPremium
Consider again the $100,000, 8%,10-year bonds sold for $107,106.The effective rate for the bonds is
7%.
Effective rate for semiannual period 3.5 %
Stated rate per semiannual period 4 %Interest payment ($100,00 x 0.04) $4,000Interest amount ($107,106 x 0.35) 3,749Discount amortization $ 251
Period One
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Effective Interest MethodDiscount
Period Two
$107,106 - $251
Effective rate for semiannual period 3.5 %
Stated rate per semiannual period 4 %Interest payment ($100,00 x 0.04) $4,000Interest amount ($106,855 x 0.35) 3,740Discount amortization $ 260
Consider again the $100,000, 8%,10-year bonds sold for $107,106.The effective rate for the bonds is
7%.
Effective-Interest Method
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A B C D E
(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)
Prem. Unamort. Bond# Payment Int. Exp. Amort. Prem. Book
$7,106 $107,106
Effective-Interest Method
Premium
Effective-Interest Method
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A B C D E
(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)
Prem. Unamort. Bond# Payment Int. Exp. Amort. Prem. Book
$7,106 $107,106
Effective-Interest Method
Premium
1 $4,000 $3,749 $251 6,855 106,855
$107,106 x 0.035
Effective-Interest Method
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A B C D E
(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)
Prem. Unamort. Bond# Payment Int. Exp. Amort. Prem. Book
$7,106 $107,106
Effective-Interest Method
Premium
1 $4,000 $3,749 $251 6,855 106,855
$106,855 x 0.035
2 $4,000 $3,740 $260 6,595 106,595
Effective-Interest Method
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A B C D E
(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)
Prem. Unamort. Bond# Payment Int. Exp. Amort. Prem. Book
$7,106 $107,106
Effective-Interest Method
Premium
1 $4,000 $3,749 $251 6,855 106,855
2 $4,000 $3,740 $260 6,595 106,5953 $4,000 $3,731 $269 6,326 106,326
4 $4,000 $3,721 $279 6,047 106,047
5 $4,000 $3,712 $288 5,759 105,759
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Straight-Line vs. Effective-Interest Amortization Methods
Insert exhibit 12-7
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Stop & Think
When preparing a bondamortization schedule like the
one that follows, there arecertain numbers within that
schedule that you knowwithout having to do anyelaborate computations.
Which ONE of the followingnumbers can be determinedusing a very simple
computation?
i i h f b i
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Extinguishment of Debt Prior toMaturity
1. Bonds may be redeemedby the issuer bypurchasing the bonds on the open marketor by exercising the call provision (if
available).2. Bonds may be converted, that is,
exchanged for other securities.
3. Bonds may be refinancedby using the
proceeds from the sale of a new bondissue to retire outstanding bonds.
E i i h f D b P i
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Extinguishment of Debt Prior toMaturity
Triad, Inc.s $100,000, 8% bonds are notheld to maturity. They are redeemed on
February 1, 2007, at 97. The carrying valueof the bonds is $97,700 as of this date.
Interest payment dates are January 31 andJuly 31.
Issuers Books
Feb. 1 Bonds Payable 100,000Discount on Bonds Pay. 2,300Cash 97,000Extraordinary Gain on
Bond Redemption 700
Carry value of bonds, 1/1/02 $97,700Redemption price 97,000
Gain on bond redemption $ 700
Investors Books
Feb. 1 Cash 97,000Loss on Sale of Bonds 700
Bond Investment-Triad Inc. 97,700
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Convertible Bonds
Convertible debt securities usuallyhave the following features:
1. An interest rate lower than the issuer
could establish for nonconvertible debt.2. An initial conversion price higher thanthe market value of the common stockat time of issuance.
3. A call option retained by the issuer Convertible debt gives both the
issuer and the holder advantages.
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Convertible Bonds
Assume that 500 ten-year bonds,face value $1,000, are sold at 105($525,000). The bonds contain a
conversion privilege that provides forexchange of a $1,000 bond for 20
shares of stock, par value $1.
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Convertible Bonds
Debt and Equity Not Separated
Cash 525,000Bonds Payable 500,000
Premium on Bonds Payable 25,000
Debt and Equity Separated
Cash 525,000Discount on Bonds Payable 20,000Bonds Payable 500,000Paid-In Capital Arising from
Bond Conversion Feature 45,000
Par valueSelling price of
bond withoutconversionfeature
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Accounting for Conversion
Investors Books
Nov. 1 Investment in HiTec Co.Common Stock 10,400
Investment in HiTecCo. Bonds 9,850
Gain on Conversion ofHiTec Co. Bonds 550
The investor may choose not to recognize again or a loss. If so the investor would debitInvestment in HiTec Co. Common Stock for
&9,850.
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Accounting for Conversion
Issuers Books
Nov. 1 Bonds Payable 10,000Loss on Conversion of
Bonds 550Common Stock, $1 par 400Paid-In Capital in Excess
of Par Value 10,000
Discount on Bonds Payable 150
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Off-Balance-Sheet Financing
Off-Balance-Sheet-Financing-procedures toavoid disclosing all debt on the balancesheet in order to make the companysfinancial position look stronger.
Common techniques used:Leases
Unconsolidated subsidiaries
Variable interest entities (VIEs)
Joint ventures
Research and development arrangements
Project financing arrangements
A l i Fi D bt
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Analyzing a Firms DebtPosition
Debt-to-Equity Ratio-measures the relationshipbetween the debt and equity of an entity.
Formula: total debt total stockholders equity
Debt Ratio- indicates a companys overall ability torepay its debts.
Formula: total liabilities total assets.
Times Interest Earned- shows a companys ability
to meet interest payments.Formula: income before interest expense and income
taxes interest expense for the period.
Di l i D bt i th Fi i l
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Disclosing Debt in the FinancialStatements
Companies may want to disclose additionalinformation about long-term debt in thenotes like:Nature of the liabilities
Maturity dates Interest rates
Methods of liquidation
Conversion privileges
Sinking fund requirementsBorrowing restrictions
Assets pledged,
Dividend limitations
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Troubled Debt Restructuring
Troubled debt restructuring exists onlyif the creditor for economic or legal
reasons related to the debtorsfinancial difficulties grants a
concession to the debtor that it would
not otherwise consider. (SFAS 15.2)
Asset Swap
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No Not a troubleddebt restructure.
Disposal Gain/Loss= FMV AssetBook
Value of Asset
Asset SwapDebtor
FMV Asset< debt?
Yes
Remove debt andasset from books.
Restructuring Gain= DebtFMV Asset
Equity Swap
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YesRemove debt and
asset from books andrecord new equity.
Equity SwapDebtor
FMV Equity< debt?
No Not a troubleddebt restructure.
Restructuring Gain=DebtFMV Equity
Asset or Equity Swap
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Asset or Equity SwapCreditor
FMV Asset> loan?
Yes Not a troubleddebt
restructure.
Remove loanfrom books andrecord asset at
FMV.
No
Restructure Loss =
LoanFMV Asset
Modification of Terms
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Recognize gain onrestructuring.
Write-down debt tosum of future cash
flows.Record all future
payments as
principal payments.
NoTotal futurepayments < debt
book value?
Modification of TermsDebtor
Reclassify thedebt and amortize
using effectiveinterest method.Interest rate is
Yes