Question

Week 2/CH 14 Discussion: Long-Term Liabilities

Discuss in detail why bonds may be sold or traded at a discount or a premium. Also explain in your own words what the amortization of a bond discount or a bond premium is and how it works.

Answer 1

Answer

• Before we get into details, remember that there are two kind of interest rates:
  #1 that is the coupon rate, that is stated on Bonds, at which investor will receive a regular interest income, and
  #2 that is the market interest rate which is the rate prevailing in the market.
• Now, coming to discussion as to why bonds may be sold at a discount or a premium.

--it mostly depends upon coupon rate and interest rate
--Consider the following example:
A company is issuing $ 1000 of bonds at coupon rate of 9%, while market interest rate is 10%.
Would you, as a knowledgeable investor, invest in such bonds??
NO, because why would you invest in them and earn 9% interest where you can invest same amount and earn interest at 10% in market.

--To make this offer attractive to investor, what will the issuing company do is that, it will issue these bonds at DISCOUNT say for $ 900.
--Now this will be come attractive to investor, because now he will only have to pay $ 900, and received interest at 9% on full $ 1000.

--Same situation gets reversed in case of Bonds Premium.

--To summarise

	Coupon rate	Market rate	Bonds Issued at…
Case #1	9%	10%	Discount
Case #2	10%	9%	Premium
Case #3	10%	10%	Face value, no discount or premium

• Amortisation of Bonds Discount or Premium.

--When the Bonds are issued at Discount or at premium, separate accounts for “Discount on Bonds payable” and “premium on Bonds payable” get created.
--These accounts are amortised by either of the two methods—(1) Straight line amortisation [where same amount is amortised with each interest payment], and (2) Effective Interest method [where amount gets amortised as the difference between Interest expense and interest actually paid].

--Amortisation of Premium or Discount makes the Bond’s Carrying book value at the time of maturity equal to its Face Value.

--Consider the following example, where Bonds are issued at premium, and amortised using Straight Line Amortisation:

A	Bonds Face value	$1,000,000
B	Bonds issued at	$1,100,000
C = B - A	Premium on Bonds Payable	$100,000
D	Term [years]	$5
E = C/D	Straight Line amortisation each year	$20,000

	Premium amortised	Unamortised premium	Carrying Value of Bonds
On issue date	$0	$100,000	$1,100,000
at end of Year 1	$20,000	$80,000	$1,080,000
at end of Year 2	$20,000	$60,000	$1,060,000
at end of Year 3	$20,000	$40,000	$1,040,000
at end of Year 4	$20,000	$20,000	$1,020,000
at end of Year 5	$20,000	$0	$1,000,000 = Becomes Equal to the Face value