CPA Exam - FAR (Financial Accounting and Reporting)Financial ReportingMedium
A company issues 10-year, $1,000,000 face value bonds with a stated interest rate of 6% when the market interest rate is 7%. Interest is paid annually. Which of the following statements is true regarding the issuance of these bonds?
- AThe bonds will be issued at a discount.
- BThe bonds will be issued at a premium.
- CThe carrying value of the bonds will remain constant over their life.
- DThe stated interest rate will be adjusted to the market interest rate.
Show answer & explanationAnswer & explanation
Correct answer: A. The bonds will be issued at a discount.
When the stated (coupon) interest rate is lower than the market (effective) interest rate, the bonds will be issued at a discount. Investors demand a higher return (market rate), so they will pay less than face value for bonds offering a lower coupon rate to achieve that yield.
Why the other options are wrong
- B. A premium occurs when the stated interest rate is higher than the market interest rate.
- C. The carrying value of bonds issued at a discount (or premium) will change over their life as the discount (or premium) is amortized.
- D. The stated interest rate is fixed by the bond indenture; it is the market interest rate that determines the issue price, not the other way around.
Bond Issuance Price
The issuance price of a bond is the present value of its future cash flows (principal and interest payments), discounted at the market (effective) interest rate at the time of issuance.
- Stated Rate > Market Rate = Premium.
- Stated Rate < Market Rate = Discount.
- Stated Rate = Market Rate = Face Value.
- Market rate determines the effective interest expense over the bond's life.
Memory trick: Coupon vs Market: Price's start, amortization's art.