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Financial Accounting: In an Economic Context by Jamie Pratt

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THE DETERMINATION OF BOND PRICES

This chapter states that bond prices are determined by the dollar amount investors are willing to pay for them. That is, what will investors pay for the right to receive the semiannual interest payments and a cash payment in the amount of the face value at maturity? This appendix identifies and discusses factors considered by debt investors when deciding whether to purchase bonds. These factors have a direct bearing on bond prices.

Suppose, for example, that on June 9, 2011, you were reading the Wall Street Journal, looking to purchase a bond. You note that on that day Treetley Enterprises lists bonds with the following terms:

Face value $1,000
Time to maturity 18 years
Stated annual interest rate (paid every 6 months) 8%
Current price 85¼, or $853

The decision to buy the bond involves three steps: (1) determine the effective rate of return, (2) determine your required rate of return, and (3) compare the effective rate to the required rate.

Determine the Effective (Actual) Rate of Return

The procedure used to determine the effective rate of return is discussed in this chapter. Recall that the effective rate is that rate which, when used to discount the bond's future cash flows, results in a present value equal to the bond price. The effective rate of the Treetley bond is approximately 10 percent.

Determine the Required Rate of Return

Now that you have determined the effective rate, you must decide whether it is large enough to satisfy ...

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