fixed income

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Joined: Sat Mar 07, 2015 7:07 am

fixed income

Postby aanchalmaryada » Sun Mar 08, 2015 8:24 am

i am not able to understand the amortisation of bond discount process and why company amortise the discount. can you please explain me.

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fixed income

Postby edupristine » Sun Mar 08, 2015 7:10 pm

Hi, I will explain the process with an example. Company ABC intended to issue a bond with face value of $100,000 having a maturity of 5 years and annual coupon of 8%. At the time of issue however, the market interest rate was 10% and $92,420 was received from the bondholders.
So, in the first year interest expense based on market interest (10%) is $9,242 and interest payable is actually $100,000*8% which is $8,000. The amortization of bond discount for the first year is the difference between these two interest rates i.e. $1,242. Since it is a discount bond we will add back this difference ($1,242) to the amount $92,420 as the carrying amount of second year i.e. $93,662
In the second year we will repeat the same process. Interest on market rate will be 10%*$93,662 = $93,662 and interest payable will be 8%*$100,000 = $8,000. Difference of $1,336 will be added back to $93,662 for the third year i.e. $94,998. Repeating this process till year five will give the carrying amount of $100,000. Hence amortization does not change the face value of the bond that investor will receive at the expiration of bond term.

Companies don't amortize bond. Amortization is the difference between the stated interest rate given by the companies at the time of issuance of bond and actual market interest rate when bonds are active in the securities exchange. In case of discount when market interest rate is higher than stated this amortized amount is added to the carrying value. For the premium bonds where market interest is lower than stated interest rates, amortized amount is subtracted from carrying value each year to go back to actual face value of the bond.

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