[laurac]

Adidas issued 10 year, 8% bonds with a par value of $200,000. Interest is paid semiannually. The market rate on the issue date was 7.5%. Adidas received $206,948 in cash proceeds. Which of the following statements is true.

The options:
Adidas must pay $200,000 at maturity and no interest payments.
Adidas must pay $206, 948 at maturity and no interest payments
Adidas must pay $200,000 at maturity plus 20 interest payments of $8,000 each
Adidas must pay $206,948 at maturity plus 20 interest payments of $8,000 each
Adidas must pay $200,000 at maturity plus 20 interest payments of $7,500 each

I am very confused by this. By what I have read I think it is the last option. They have a premium of 6, 948 that they would have to pay?

Thanks!

[morgaine300]

You need to straighten out what interest rates mean what. The contract rate -- the rate always listed with the description of the bonds, not the market/yield/effective rate -- is what the bonds are really paying. When the company issues 8% bonds, they're paying 8%.

The market rate is used to figure out the current value of the bonds. The value of the bonds isn't the same thing as what the bonds are really paying in interest. Plus, the market rate can change all the time, so you could never figure out what interest payments are being made based on that rate if it changes all the time. The market rate might be 7.5% now, but it won't necessarily be that six months from now when the first payment is due.

BTW, the company is not paying a premium. The bondholders buying the bonds are paying the premium to the company. The company doesn't have to pay it back. They are "paying it back" by paying higher interest than what the market is paying. The difference in the interest rates gets made up for in the long run, but it's kind of screwy to think about until you understand bonds better.

You might want to do some reading here. Since you're already taking this online, I don't know how useful this will be.
Principles of Accounting Chapter 13

[laurac]

That site is helpful but I still am not understanding the question at hand. Is there any way you can help it to be more clear?

[morgaine300]

I already basically explained in the other post. They have to pay back the face value. You had that part right. But the actual interest payments are at the contract rate of 8%, not the market rate of 7.5%. You got the $7500 payments by using the 7.5% market rate, and you need to use 8% contract rate. And that I already explained in the other post. And I also already explained that no, they don't have to "pay" that premium. They are making up for the difference in the higher interest rate. That is the "question at hand," and I don't know what else to tell you.

Yes, I could go into a lot of other lengthy explanations, which could take 3 pages and a lot of time. That's why I gave you the link, so that you could hopefully get a better overall understanding of bonds. Having the answer to this one question (or to any one question) isn't going to accomplish that.