Corporate bonds let companies borrow large sums by selling small-denomination debt instruments to many investors at once. The price investors pay depends on the relationship between the bond's stated interest rate and the current market rate: if the stated rate is higher, the bond sells at a premium; if lower, at a discount; if equal, at par (face value). Bond pricing is a present value calculation, discounting the future interest payments (an ordinary annuity) and the face value repayment at the effective market rate.
Difficulty: Intermediate. Prerequisites: comfort with time value of money (present value of $1 and present value of an ordinary annuity), basic journal entries, and the distinction between assets, liabilities, and equity.
Chapter 14 covers long-term debt financing through bonds, one of the two main ways companies raise capital (the other being equity). This material sits at the heart of intermediate financial accounting because bonds show up on both sides of the transaction: the issuer records a liability, and the investor records an asset. You need to understand present value mechanics from your earlier coursework, because bond pricing is entirely a PV problem. The chapter also connects to investment classifications (trading, available-for-sale, held-to-maturity) covered in earlier chapters on investments.
Face amount (principal / par value)
The dollar amount printed on the bond, which the issuer promises to repay at maturity. Think of it as the "sticker price" of the loan.
Maturity date
The date on which the issuer must repay the face amount to bondholders. In simple terms, this is the bond's expiry date, typically 10 to 40 years from issuance.
Indenture
The formal contract between the issuer and bondholders that spells out the stated rate, maturity date, payment schedule, and any special provisions (such as a sinking fund requirement). Think of it as the bond's rulebook.
Debenture bond
An unsecured bond backed only by the issuer's general creditworthiness, with no specific assets pledged as collateral. In simple terms, investors are trusting the company's reputation and financial health, not holding any collateral.
Sinking fund
A savings account the issuer contributes to regularly, as required by the indenture, to accumulate cash for repaying the bonds. Think of it as a forced savings plan to make sure the money is there at maturity.
Stated rate (coupon rate / nominal rate)
The annual interest rate printed on the bond that determines the cash interest paid to investors. In simple terms, this is the rate that sets your actual cash payment each period.
Effective market rate (market rate / yield)
The rate of return investors demand in the market for bonds of similar risk and maturity at the time of issuance. Think of it as what the market says the bond should earn, which may differ from the stated rate.
Ordinary annuity
A series of equal payments made at the end of each period for a set number of periods. In simple terms, the bond interest payments form an ordinary annuity because the first payment comes one period after the issue date.
Premium
The amount by which a bond's issue price exceeds its face value, arising when the stated rate is higher than the market rate. Think of it as the extra price investors willingly pay to lock in above-market interest.
Discount
The amount by which a bond's issue price falls below its face value, arising when the stated rate is lower than the market rate. In simple terms, investors pay less upfront to compensate for receiving below-market interest.
Carrying value (book value)
The net amount at which a bond appears on the balance sheet: face value plus any unamortised premium, or minus any unamortised discount. Think of it as the bond's current accounting value, which moves toward face value over time as the premium or discount is amortised.
Companies need financing to purchase assets and fund operations. Two sources exist: equity (money from owners) and debt (borrowing). Within debt, a company can take a bank loan (recorded as a note payable) or issue corporate bonds.
Bonds let the issuer borrow a very large sum by breaking it into small units sold to many investors in the financial markets. A $700,000 bond issue, for example, might consist of 700 individual bonds each with a $1,000 face value. This is often cheaper than bank borrowing.
Most corporate bonds are debenture bonds, meaning no specific assets are pledged as collateral. Investors rely entirely on the issuer's creditworthiness. If the company cannot pay, bondholders are general creditors with no assets to seize.
Interest is typically paid semi-annually (every 6 months), beginning one period after the issue date
This payment stream is an ordinary annuity
Only interest is paid during the bond's life; the principal is repaid at maturity or upon redemption
Cash interest each period = face amount x stated rate per period
When a bond pays semi-annually, two adjustments are needed:
Divide the annual stated rate by 2 to get the semi-annual rate
Multiply the number of years by 2 to get the total number of periods
Worked example: $100,000 face value, 5% annual interest, paid every 6 months.
Semi-annual rate = 5% / 2 = 2.5%
Cash interest per period = $100,000 x 0.025 = $2,500
A bond issue is a way to obtain cash from many investors at once
The issuer promises to pay cash interest at the stated rate on each interest date
The issuer repays the face amount at maturity or at a call date
Bond investment is a way to earn a return on idle cash
The investor receives regular interest at the stated rate (investment revenue)
The investor may hold to maturity, or sell the bonds in the secondary market before then
Investment risk depends on the issuer's ability to pay interest and principal when due
A bond's market price equals the present value of its future cash flows, discounted at the effective market rate. Those future cash flows are:
The interest payments (an ordinary annuity)
The face value repayment at maturity (a single lump sum)
The effective market rate reflects the riskiness of the issuing company and general market conditions at the time of issue. It is almost always different from the stated rate.
Stated rate = market rate: bond sells at par
The investor pays exactly face value because the bond's cash interest matches what the market demands.
Stated rate > market rate: bond sells at a premium
The bond pays more interest than the market requires, so investors bid the price above face value. They are willing to pay extra because the cash return exceeds what they could get elsewhere.
Stated rate < market rate: bond sells at a discount
The bond pays less interest than the market requires, so investors will only buy it below face value. The lower price compensates for the below-market interest stream.
Future cash flows in every scenario:
Semi-annual interest = $10,000 x 6% = $600, paid for 10 periods
Lump sum = $10,000 at the end of period 10
Scenario 1: Market rate = 12% (semi-annual 6%)
PV of annuity: $600 x 7.36009 = $4,416
PV of lump sum: $10,000 x 0.55839 = $5,584
Total price: $10,000 (sells at par)
Scenario 2: Market rate = 10% (semi-annual 5%)
PV of annuity: $600 x 7.72173 = $4,633
PV of lump sum: $10,000 x 0.61391 = $6,139
Total price: $10,772 (sells at a $772 premium)
Scenario 3: Market rate = 20% (semi-annual 10%)
PV of annuity: $600 x 6.14457 = $3,687
PV of lump sum: $10,000 x 0.38554 = $3,855
Total price: $7,542 (sells at a $2,458 discount)
The higher the discount rate (market rate), the lower the present value of future cash flows, and thus the lower the bond's price. A bond issued "at 98" means it sold at 98% of face value, a 2% discount.
\text{Bond Price} = (\text{Cash Interest} \times \text{PVA factor}_{n,i}) + (\text{Face Value} \times \text{PV factor}_{n,i})Where:
Cash Interest = Face Value x Stated Rate per period
n = total number of periods
i = market rate per period
PVA factor = present value of an ordinary annuity factor
PV factor = present value of $1 factor
i_{\text{semi-annual}} = \frac{\text{Annual Rate}}{2}n_{\text{periods}} = \text{Years to Maturity} \times 2\text{Cash Interest} = \text{Face Value} \times i_{\text{semi-annual stated}}Remember: cash interest is always calculated using the stated rate, never the market rate.
Companies issue bonds rather than taking bank loans when they need to raise very large amounts of capital and want to spread the borrowing across many investors. This is how major corporations fund expansions, acquisitions, and infrastructure projects. The bond market is also where interest rate expectations play out in real time: when market rates fall, existing bonds with higher stated rates become more valuable (premium), which is why bond prices and interest rates move inversely.
Students often confuse the stated rate with the market rate when calculating cash interest. Cash interest is always face value times the stated rate. The market rate is used only as the discount rate in the PV calculation.
Students sometimes think a premium means the issuer is being overcharged. A premium simply reflects that the bond's stated rate is more generous than the market demands, so investors pay extra for the higher cash flows.
Students frequently forget to convert annual rates and periods to semi-annual equivalents. If a bond pays semi-annually, you must halve the rate and double the periods before touching the PV tables.
Students occasionally believe that the face amount changes over the life of the bond. It does not. The carrying value changes (as the premium or discount amortises), but the face amount stays fixed until maturity.
⚠️ Be able to determine whether a bond sells at par, premium, or discount given any combination of stated rate and market rate. This is a near-certain exam question.
⚠️ Know how to compute the bond price using PV tables: PV of the annuity (interest) plus PV of $1 (face value), both at the market rate per period.
⚠️ Remember the semi-annual conversion: halve the annual rate, double the number of years. Getting this wrong cascades through the entire calculation.
⚠️ Understand the inverse relationship: higher market rate means lower bond price, and vice versa.
⚠️ Be ready for clicker-style conceptual questions, e.g. "At a market rate of 4%, bonds with a 5% stated rate sell at a ___" (answer: premium).
True or false: Cash interest paid to bondholders is calculated using the market rate. (False, it uses the stated rate.)
Fill in the blank: When the stated rate exceeds the market rate, a bond sells at a ___. (Premium.)
True or false: A debenture bond is backed by specific assets pledged as collateral. (False, debentures are unsecured.)
Fill in the blank: For semi-annual bonds, the number of periods equals years to maturity times ___. (Two.)
True or false: The higher the market rate used as the discount rate, the higher the bond's present value. (False, a higher discount rate produces a lower PV.)
Q: Apex Corporation sells bonds in the financial markets to raise money for expansion. Beta Corporation purchases a portion of those bonds. Which company is the issuer?
A: Apex Corporation is the issuer because it is borrowing the money. Beta is the investor.
Q: A $10,000, 5-year bond with a 12% stated rate pays interest semi-annually. The market rate is 10%. What is the bond's issue price?
A: Semi-annual cash interest = $600. Semi-annual market rate = 5%, n = 10 periods. PV of annuity = $600 x 7.72173 = $4,633. PV of face value = $10,000 x 0.61391 = $6,139. Issue price = $10,772 (a premium).
Q: At a time when the market rate of interest is 4%, bonds with a stated interest rate of 5% will sell at a ___?
A: Premium. The stated rate exceeds the market rate, so investors pay more than face value to receive the higher interest stream.
Q: What does it mean when a bond is issued "at 98"?
A: The bond sells at 98% of its face value, which is a 2% discount. If the face value is $100,000, the issue price is $98,000.
Q: Beta corp invested in $100,000 (face value) of Apex bonds. The stated rate is 5%, paid semi-annually. Beta purchased when the market rate was 4%. What is the semi-annual effective rate of interest?
A: 2.0%. The effective rate is the market rate per period: 4% / 2 = 2%.
This material connects directly to the time value of money concepts from earlier chapters: present value of $1 and present value of an ordinary annuity are the entire basis for bond pricing. It also links to the investment classifications chapter (trading securities, available-for-sale, held-to-maturity), since the investor side of bonds uses those same categories. The amortisation of premiums and discounts covered in Part 2 ties into the matching principle from introductory accounting, where expenses are recognised in the periods they relate to.
Corporate bonds, bond pricing, face value, par value, principal, coupon rate, stated rate, nominal rate, market rate, effective interest rate, yield, present value, PV of annuity, PV of $1, ordinary annuity, premium bonds, discount bonds, bonds at par, debenture, unsecured bonds, indenture, sinking fund, maturity date, semi-annual interest, bond valuation, ACCTG 472, intermediate financial accounting, Penn State, Chapter 14 bonds