Final answer:
The Burton Corporation bonds were issued at a discount because the issue price was less than the face value. The value of bonds decreases when market interest rates rise, as seen with the Ford Motor Company bond, which would be less valuable if rates increased from 3% to 4%. The present value of bonds is calculated by discounting future cash flows at the market discount rate; an increase in rates decreases the present value of the bond.
Step-by-step explanation:
When a corporation issues bonds, they can be issued at a premium, at face value, or at a discount. The terms at which the bonds are issued depend on the market interest rates relative to the coupon rate of the bond itself.
Bond Issuance and Valuation
In the scenario with the Burton Corporation, the bonds were issued for less than their face value ($196,000 instead of $200,000), which means they were issued at a discount. This generally happens when the coupon rate on the bonds is lower than the current market interest rate, making the bonds less compelling to investors unless they can purchase them for less than face value.
Understanding the yield and bond price relationship is critically important in corporate finance. When market interest rates rise, existing bonds with lower coupon rates become less attractive, causing their market price to decrease to compensate investors for the lower coupon rate compared to the higher market rates.
Ford Motor Company Bond Example
Using the Ford Motor Company bond as an example, which pays a $150 annual coupon on a $5,000 face value, the initial interest rate Ford is paying can be calculated as ($150 / $5,000) * 100 = 3%. If the market interest rate increases from 3% to 4%, the value of the bond will decrease, as investors will demand a higher yield to compensate for the higher prevailing rates.
Considering a risk-free bond as another illustration, if interest rates rise, the bond’s issuing company or entity would have to discount the bond’s price below its face value in order to make the fixed coupon payments more attractive to investors.
Calculating Present Value of a Bond
For a two-year bond issued at $3,000 with an 8% rate, the yearly interest is $240. To determine the present value of this bond, one would discount the future cash flows (the interest payments and the principal repayment) back to their present value using the market discount rate. If the discount rate were 8%, the bond would be worth its face value. However, if the discount rate increases to 11%, the present value of those future cash flows would decrease.