There is a guide to understanding bonds to be repaid.
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Bonds are a type of debt.A bond is an IOU issued by a corporation and purchased by an investor for cash.A lender and bondholder is a corporation that borrows money from an investor.
The bond's formal contract to pay the interest and principal payments to the bondholders and to adhere to other conditions lower the cost of bonds over common stock.Bonds have a lower cost because the bond interest is deductible on the corporation's U.S. income tax return.
Changes in interest rates and the financial condition of the corporation that issued the bond will affect the market value of an existing bond.If market interest rates rise to 10%, an existing bond that pays 9% for the next 20 years will become less valuable.If market interest rates decrease to 8%, a 9% bond will become more valuable.When the financial condition of the issuing corporation gets worse, the market value of bonds will decline as well.
To determine a bond's market value and to calculate the true or effective interest rate paid by the corporation, present value calculations are used.A bond's fixed cash payments of interest and principal are discounted by the market interest rate.
The bond's interest payments are usually semiannually.As long as the bond is outstanding, the corporation will pay half of the annual interest at the end of each six-month period.The formula is used for calculating semiannual interest payments.
The term stated interest rate or stated rate will be used throughout our explanation of bonds payable.Bond interest rates are usually locked in for the life of the bond.
The dollar amount on the face of a bond is the principal payment.On the date that a bond matures or comes due, this is the amount that the issuing corporation must pay to the bondholders.Some names refer to the bond's principal amount.
We will interchangeably use these terms throughout our explanation.We assume that the bond's principal amount will be due on a single date.
To visualize the cash payments that a corporation promises to make, it is helpful to prepare a timeline.Cash payments for a 9% $100,000 bond maturing in 5 years are presented.
The corporation will make 10 semiannual interest payments of $4,500 to its bondholders.The interest payments are made at the end of each six-month period.The $100,000 principal payment is due at the end of the 10th six-month period.