Stumped on effective interest rate method of amortisation CFA EOC question

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CFA Level 1 Book 3 p529.
4. On 1 January 2010, Elegant Frangrances Company issues £1,000,000 face value, five year bonds with annual interest payments of £55,000 to be paid each 31 December. The market interest rate is 6.0 percent. Using the effective interest rate method of amortization, Elegant Fragrances is most likely to record:
a) an interest expense of £55,000 on its 2010 income statement.
b) a liability of £982,674 on the 31 December 2010 balance sheet.
c) a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.
ANSWER=B
I’ve been through the whole Schweser lecture on this and I still don’t get how the answer is derived. When I used the TVM and amortization functions on my calculator (which I know how to use) with the numbers given I just cannot get any of these answers.
I know it has something to do with the effective interest rate method and I am just not getting it. Funny how I don’t have a problem understanding DTAs and DTLs but this is a problem :(
Any help here would be appreciated
 
On 1/1/10:
n = 5
i = 6%
FV = 1,000,000
PMT = 55,000
Solve for PV = -978,938
On 12/31/10:
Interest = 978,938 × 6% = 58,736.
Coupon = 55,000.
Amortization = 58,736 – 55,000 = 3,736.
BV = 978,938 + 3,736 = 982,674.
Voilà!
 
Such a silly mistake I was making. I was putting in the PMT value as a negative number.
Thanks a million S2000magician!
 
capaldij wrote: Such a silly mistake I was making. I was putting in the PMT value as a negative number.
Click to expand...
Remember that the TVM buttons on your calculator are cash flow buttons: cash inflows are positive, cash outflows are negative. I always encourage my students to decide on a point of view – borrower or lender, it doesn’t matter which – and stick with it. If you always look at these problems from the same point of view, you’ll never make a mistake.
capaldij wrote: Thanks a million S2000magician!
Click to expand...
My pleasure. Glad to have helped.
 
Is B supposed to say December 2011?
Is this just a coincidence or is it anothert way to solve?
N = 4
I = 6
PMT = 55,000
FV = 1,000,000
PV = 982,674
S2000, question for you. Balance as of December 2012 would be
PV = 982,674.47
+ amortization of 58,960 - 55,000 = 3960 = 986,635
Is that right? I have issues with PV of discounted bonds
 
Dear Galli,
Your PV with N=4, I=6,… is called the prospective method. To get the value of a bond under the effective interest rate method at any point in time, one discounts the remaining cash flows at the effective rate. As a useful exercise, plug in N=3 leaving all other values the same and recalculate PV: the number should look familiar.
In your 2nd statement, the 58,960 is more of a rolling up of the outstanding balance with one year’s interest @ 6%. At the end of the year, the issuer makes a cash payment of 55,000 for the new outstanding balance of 986,635.
 
Galli wrote: Is B supposed to say December 2011?
Is this just a coincidence or is it anothert way to solve?
N = 4
I = 6
PMT = 55,000
FV = 1,000,000
PV = 982,674
Click to expand...
Another way to solve it.
Galli wrote: S2000, question for you. Balance as of December 2012 would be
PV = 982,674.47
+ amortization of 58,960 - 55,000 = 3960 = 986,635
Is that right?
Click to expand...
Yup.
Galli wrote: I have issues with PV of discounted bonds
Click to expand...
Sounds as though you understand them pretty well.
 
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