Question

On July 1, 2019, $4.5 million face amount of 7%, 10-year bonds were issued. The bonds pay interest on an annual basis on June 30 each year. The market interest rates were slightly higher than 7% when the bonds were sold. Required: a. How much interest will be paid annually on these bonds? (Enter your answer in whole dollar, not in millions) b. Were the bonds issued at a premium or discount? c. Will the annual interest expense on these bonds be more than, equal to, or less than the amount of interest paid each year? | و | Annual interest payment Bonds issued Annual interest expense will be

Answer 1

a.

Annual Interest paid to investors is equal to face value of bonds multiplied by coupon rate.

Face value= $4.5 million

Coupon rate= 7%

Interest paid each year= 4,500,000*7%

=$315,000

b.

Market rate > coupon rate

As bonds are paying less than market interest rate, investors would be willing to earn atleast what market is giving so they will be paying less price than face value of bonds . Price paid by investors today for purchasing bonds would be the present value of interest payments and face value discounted at expected return of investors, which is market rate of interest. and since market rate > interest rate , the present value will be less than face value.

based on above explanation , if market rate is greater than coupon rate of bonds , bonds are issued at a discount.

c. when bonds are issued at a discount, discount on issue of bonds will be amortized each year and will actually be recognized as interest expense.

when company issue bonds at discount, there effective rate of interest becomes equal to market rate of interest. As bond discount is amortized as interest expense therefore, actual interest expense charged in income statement every year is greater than interest payments made .

eg- so if bond with Face value $100, 2% coupon,1 year, is issued at $98,

$2(100-98) will be amortized as interest expense so

total interest expense that will be recognized will be $4. ($2 interest payments made to investors(100*2%) and $2 amortization on bonds discount.)