Final answer:
A company issues bonds to raise capital, offering to pay annual interest to investors who become bondholders. These bondholders can enforce payment if the issuing firm defaults, but there's a risk of not being fully repaid. Bond valuation depends on discount rates, where an increase in rates leads to a decrease in bond value.
Step-by-step explanation:
Understanding Bond Issuance and Interest Payments
When a firm needs to raise capital, it often issues bonds to borrow money from investors. For instance, a large company may issue $10 million in bonds with a commitment to pay 8% in annual interest ($800,000) and repay the principal amount after a set period, such as 10 years.
The total borrowed amount is divided into smaller denominations, so a firm aiming to raise $50 million might issue 10,000 bonds of $5,000 each, making it feasible for individual investors to lend money in increments of $5,000.
Investors who purchase these bonds become bondholders, who are entitled to periodic interest payments. If the issuing firm fails to make these payments, bondholders can legally enforce the payment, even if it requires the firm to liquidate assets. However, in cases of default, there's always the risk that the firm may not have enough assets to fully repay the bondholders.
To understand the present value of a bond, consider a simple two-year bond with a face value of $3,000 that pays 8% interest annually. If the current discount rate is 8%, the present value of the bond's future cash flows can be calculated using the present value formula. However, if interest rates rise and the discount rate becomes 11%, the bond's present value will decrease as a result of the higher discount rate applied to its future cash flows.