Question

1. How is the price determined for a bond (or bond issue)?
2. Compare the two commonly used methods of determining interest on bonds.

Answer 1

The present discounted value of future cash flow generated by a bond is the bond price. It is the sum total of present values of all the coupon payments plus the present value of the par value at maturity. Discount the future cash flow to calculate the bond price. The price of a bond is linked to the credit rating of the borrower. There is always a default risk involved with a bond i. e the borrower might not be able to pay full or partial amount. Therefore bonds with low ratings are sold at lower prices than bonds with higher rating. The price of a bond is also linked to it's yield to maturity. When yield to maturity is higher than the coupon rate the price of a bond is less than the face value and vice versa.

The two commonly used methods of determining interest on bonds are:-

Straight Line Method :

The straight line amortization of discounts results in the same amount of interest expense ,amortization and cash interest in every year until the bond is repaid. It is the easiest way to account for discounts or premium on bond as the discount or premium ON the bond is amortized in equal amounts throughout the life of the bond. The straight line method results in more discounts or premium amortization during initial years than the effective interest method.

Effective Interest Method:

Effective interest method results in different amount of interest expense and amortization each year. The amount of cash interest paid on the bond does not change from year to year. The effective interest method results in more amortization in later years than straight line method. This method is more complex than the straight line method. The borrowers prefer this method because this method shows cost more effectively.