One reason is the cost of zeros because they pay no

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Unformatted text preview: get a steady stream of interest payments. So why would anyone buy a zero-coupon bond, which doesn’t offer that stream of cash flows? One reason is the cost of “zeros.” Because they pay no interest, zeros sell at a deep discount from par value: A $1,000, 30-year government agency zero-coupon bond might cost about $175. At maturity, the investor receives the $1,000 par value. The difference between the price of the bond and its par value is the return to the investor. Stated as an annual yield, the return reflects the compounding of interest, just as though the issuer had paid interest during bond term. In this example, the bond yields 6 percent. Even though a corporate issuer of a zero-coupon bond makes no cash interest payments, for tax purposes it can take an interest deduction. To calculate the annual implicit interest expense, the issuer must first determine the bond’s value at the beginning of 289 each year by using the formula M /(1 kd)n, where M the par value in dollars, kd the required return, and n the number of years to maturity. The difference in the bond’s value from year to year is the implicit interest. Assume that a corporation issues a 5-year zero-coupon bond with a $1,000 par value and a required yield of 6.5 percent. Applying the above formula, we discover that the initial price of this bond is $729.88 [$1,000/(1 0.065)5 $1,000/1.3700867]. Total implicit interest over the 5 years is $270.12 ($1,000 – $729.88). The following table uses the formula to calculate the bond’s value at the end of each year and the implicit interest expense that the corporation can deduct each year. Sources: Adapted from Hope Hamashige, “More than Zero,” Los Angeles Times (September 16, 1997), p. D-6; Donald Jay Korn, “Getting Something for Nothing,” Black Enterprise (April 2000), downloaded from; “Putting Compound Interest to Work Through Zero Coupon Bonds,” The Bond Market Association, PR Newswire (June 24, 1998), downloaded from www.ask.elib...
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