Final answer:
The discount amortization under the straight-line method is equal each period for bonds issued at a discount. This method does not account for the time value of money and simply spreads the discount evenly over the bond's life.
Step-by-step explanation:
The correct answer to how the straight-line method of discount amortization works on discount bonds is option A: The discount amortization will be the same each period. Under the straight-line method, the total amount of the discount on the bond is divided evenly across the life of the bond. This means that the same amount of discount is amortized each period, which effectively is an allocation of the discount as interest expense over the bond's life.
To understand the concept, let's consider a simple two-year bond. If the bond was issued at a discount due to a higher market interest rate compared to the coupon rate, the initial discount is spread out evenly across the bond's life. For example, if Urban Outfitters had a discount of $6,624, and the bond had a life of 10 years, each year $662.40 would be amortized (6,624 / 10 = 662.40). This method does not consider the time value of money, unlike the effective interest rate method where the discount amortization varies each period.
When considering the bond's present value at different discount rates, the present value is the sum of the discounted future payments. If the bond's coupon rate is below the market rate, the bond will sell at a discount, and if the coupon rate is higher, the bond will sell at a premium. Given this, when interest rates rise, the present value of the bond's future payments will decrease, meaning you would pay less than the bond's face value.