Question

A bond issue with a face amount of $800.000 bears interest at the rate of 9%. The current market rate of interest is 11%. These bonds will sell at a price that is: Multiple Choice More than $800,000 Equal to $800,000 Less than $800,000 The answer cannot be determined from the information provided.

Answer 1

The issue price of a bond is based on the relationship between the interest rate that the bond pays and the market interest rate being paid on the same date

If the present value (issue price) of the bond is less than its face value, it is evident that the interest rate being paid on the bond is lower than the market rate. Investors are therefore bidding its price down in order to achieve an effective interest rate that matches the market rate.

If the present value of the bond is price higher than the face value of the bond, then the interest rate being paid on the bond would be higher than the market rate.

Note - Workings based on the assumption that life of bond is 5 years.

Year	Particulars	Cash flow	Present Value Factor @11%	Present Value of cash flow
5	Face value - for 5th year	$ 8,00,000.00	0.5935	$    4,74,800.00
1-5	Interest @ 9% for 5years cumulative	$   72,000.00	3.6959	$    2,66,104.80
	Present value of bond	$ 7,40,904.80

Note:-

1.Interest is calclulated as 9% interest rate of bond on face value ( $8,00,000*9/100= $ 72,000)

2. Present Value Factor ia taken at 11% on crrent market rates.

Answer - option D answer cannot be computed from the information given. It is because life of the bond is not given, as in the given format, life of bond is essential for calcluating the present value of the bond.

On the basis of the assumption taken, life is 5years and present value of bond in 5 years is less than face value of the bond, thus it is evident that the interest rate being paid on the bond is lower than the market rate. Thus bonds will be sold at rates less than face value(8lakhs).