Question

On January 1, Sharp Company purchased $100,000 of Sox Company 6% bonds at a time when the market rate was 5%. The bonds mature on December 31 in five years, and pay interest annually on December 31. Sharp Company purchased the bonds at a premium.

What is the amount of the premium paid by Sharp Company?
A. $1,000
B. $2,000
C. $3,000
D. $4,000

Answer 1

When the market rate is lower than the coupon rate on a bond, the bond is considered to be sold at a premium. The correct answer is none of the above.

Step-by-step explanation:

When the market rate is lower than the coupon rate on a bond, the bond is considered to be sold at a premium. In this case, the market rate is 5% and the bond pays a fixed coupon rate of 6%. To calculate the premium, we subtract the present value of the bond's future cash flows from the purchase price. The purchase price of the bond is $100,000 and the present value of the bond's future cash flows can be calculated using the formula:

• PV of cash flows = (Coupon payment / Market rate) * (1 - (1 / (1 + Market rate)^n)) + (Face value / (1 + Market rate)^n)

Using the given values and plugging them into the formula, we find that the present value of the bond's future cash flows is $106,196. Thus, the premium paid by Sharp Company is:

• Premium = Purchase price - Present value

Premium = $100,000 - $106,196 = -$6,196

Since the premium is negative, it means that the bond was purchased at a discount rather than a premium. Therefore, the correct answer is none of the above.