BOND MATH: The Theory Behind the Formulas

Basic Bond Taxation

Let's start with the character of the cash flows on a standard coupon bond. Suppose that a corporation issues a 4%, annual payment, 4-year note at a price of 99.342 (percent of par value). Remember from Chapter 3 that the yield to maturity on this bond is 4.182%. Each year, the investor has taxable ordinary interest income in the amount of $40 per $1,000 of par value, and the issuer has equivalent ordinary interest expense. Importantly, that interest expense is deductible for the corporate issuer, creating the well-known tax advantage to debt financing compared to equity.

If the investor holds the bond to maturity and redeems it at par value or sells the bond prior to maturity at a price above 99.342, will there be a capital ...