De Anza College

Accounting 1B

Bond Pricing Hints

The following discussion assumes that the bonds pay interest every 6 months (semiannually). Therefore, cut the annual rate of interest in half. Use the Face (Coupon) Rate only to calculate the semiannual interest payment. Use the Market (Effective) Rate when you go the present value tables.

Steps

1. Use the Face (Coupon) Rate only to calculate the semiannual interest payment. Multiply the principal (face) amount by the half of the annual Face Rate. This is the cash interest that will be paid every six months.

2. Go the the present value tables. Use half of the annual Market Rate as the interest rate (i) in the table. Double the number of years to get the compounding period (n). Find the present value factors for both a single sum (1$) and an annuity.

3. Multiply the single sum present value factor by the principal to be received at the end of the bond term. This is the present value of the principal payment.

4. Multiply the annuity present value factor by the semiannual interest payment (from Step 1 above) to be received every six months. This is the present value of the interest payments.

5. Add the amounts from Steps 3 and 4. In other words add the the present value of the principal payment to the present value of the interest payments. This is the BOND PRICE.

6. If the bond price is less than the principal you have a discount. This means that the market rate is higher than the face rate and investors will only buy the bonds if the price is reduced. The discount account is a contra liability and has a debit balance.

7. If the bond price is more than the principal you have a premium. This means that the market rate is lower than the face rate and investors will pay extra money to get the higher face rate. The premium account is a liability and has a credit balance.

8. For straight line amortization of the discount/premium divide the amount by the compounding period (n). (For example, for a 5 year bond, you would divide by 10). You will amortize the discount/premium every time you make an interest payment. Since the discount account has a debit balance, the amortization entry will credit it to reduce it. On the other hand, the premium account has a credit balance and the amortization entry will debit it to reduce it.