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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 www.findarticles.com; “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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