Question

Redlands Inc. issued a $1,000, 0% bonds when the market rate of interest was 6%. The annual effective interest rate and the annual amount of cash paid for interest, respectively, was

a. 0% effective interest rate and $0 cash paid for interest.

b. 6% effective interest rate and $0 cash paid for interest.

c. 0% effective interest rate and $60 cash paid for interest.

d. 6% effective interest rate and $60 cash paid for interest.

Answer 1

Statement b. is correct

Justification for correct option:-

Zero coupon bonds are generally issued at huge discount and redeemable at par. In the similar case no coupon is paid for the period to investor hence cash paid for interest in the case will be $0. The bonds are issued at huge discount and the discounting was generally done by taking the market rate of interest which give the bond its effective interest rate as market rate of interest.

Justification for wrong answer:

Statement a will be incorrect because 0% effective interest rate arises if the market rate of interest will be 0% which is not in this case.

Statement c is incorrect because 0% effective interest rate arises if the market rate of interest will be 0% which is not in this case, also coupon are issued at 0% hence cash paid for interest in this case $0.

statement d is incorrect because coupon are issued at 0% hence cash paid for interest in this case $0.