Financial Accounting: An Integrated Statements Approach, 2nd Edition

sell at a discount, or less than their face amount. If the market rate is lowerthan the

contract rate, the bonds will sell at a premium, or more than their face amount.

Why is this the case? Buyers are not willing to pay the face amount for bonds

whose contract rate is lower than the market rate. The discount, in effect, represents

the amount necessary to make up for the difference in the market and the contract in-

terest rates. In contrast, if the market rate is lower than the contract rate, the bonds will

sell at a premium, or for more than their face amount. In this case, buyers are willing

to pay more than the face amount for bonds whose contract rate is higher than the

market rate.

The face amount of the bonds and the periodic interest on the bonds represent

cash to be received in the future. The buyer determines how much to pay for the

bonds by computing the present value of these future cash receipts, using the market

rate of interest. Thus, the price of a bond is computed by adding (1) the present value

of the face amount and (2) the present value of the interest payments, as illustrated

in Exhibit 10. The contract rate determines the amountof periodic interest payments,

while the market rate determines the present value factorto be used to discount the

bond’s cash flows.

452 Chapter 10 Liabilities

Today

Present Value of Face Amount

1 period 2 period  n period

Face

Amount

Interest Interest Interest Interest

Present Value of

Face Amount

Present Value of

Interest Payments

Price of the Bond

Present Value of Interest Payments

CALCULATING THE

PRICE OF A BOND

 (n1 period)



Exhibit 10

Calculating the Price

of a Bond

Often, bonds will pay interest every six months. When this is the case, the contract rate

will be expressed as an annual interest rate to be paid semiannually. Thus, the annual

interest rate must be converted to a semiannual rate by multiplying the rate by –^12. For

example, on January 1, 2007, Moore Co. issues $100,000, 12%, five-year corporate

bonds that pay interest semiannually on June 30 and December 31. The 12% bonds pay

a semiannual rate of 6%. Thus, the amount of interest paid every six months is $6,000

($100,0006%).

Using the example above, assume that Moore Co. issues the $100,000, 12%, five-

year bonds when the market rate of interest is 12%. The price of the bond issue is

computed by adding the present value of the face amount of $100,000 and the present

value of the interest payments of $6,000. As illustrated in Exhibit 11, the combined pre-

sent value, or price, of the Moore Co. bonds is its face value, $100,000. This is because

the market rate of interest equals the contract rate of interest, so the bonds will sell at

their face amount.