Question

Distinguish between the following interest rates for bonds payable:

(a)Yield rate

(b) Nominal Rate

(c) Stated rate

(d) Market rate

(e) Effective rate

Short answer

The yield rate is the rate actually earned by the bondholders. The nominal rate is the rate fixed by the one who issues the bonds, usually expressed as a percentage on par value. The stated rate is the specified rate listed on the bond. The market rate is the current rate prevailing in the market depending on various factors. The effective rateis the true rate on the bond, which takes into account the effects of compounding.

Step-by-step solution

Meaning of Bonds Payable

Bonds payable is a liability that arises when a company issues bonds to generate cash. The company is a borrower, thus creating a liability. Bonds can be issued at par, discount, and at a premium. The pricing depends on the difference between its coupon rate and its market yield.

(a) Yield rate

• Yield rate is the rate of return the bond generates. It can say what percent was made from an investment.
• A company can use this rate to compare various projects or investments to decide which is most profitable.
• Current Yield = Annual cash/ Bond price

(b) Nominal rate

• Nominal rate is the rate bond issuer promises to pay the bond purchaser.
• The rate is fixed, expressed as a percentage on par value, and is applied to the lifetime of the bond.
• It is the actual interest rate stated without considering the effect of compounding.
• Nominal rate = Annual Interest payment/ Face value

(c) Stated rate

• Stated rate is the actual rate listed on the bond
• It is the actual amount of interest paid by the bond issuer, similar to the nominal rate.
• Example, if an issuer pays $60 on a bond with the face value of $1000, then the stated interest rate is 6%.
• Stated rate = Bond payment/ Face value

(d) Market rate

• Market rate is the prevailing rate offered on cash deposits.
• It is determined by the current rate compared to the rate specified in the bond.
• It considers two things: The present value of the bond`s face value & Present value of the bond`s interest payments.
• This rate is driven by many factors such as the size and duration of deposits, the flow of funds in & out of the country, etc.
• Market rate = Bond`s face value * Bond`s price quote

(e) Effective rate

• Effective rate is the rate that will discount both the bond`s future. interest payments and the bond`s maturity value to a present value that is equal to the bond`s current market value.
• It is similar to market and yield rate, but it takes into account the effects of compounding.
• The more frequent the compounding period, the higher the rate.
• Effective rate = [ 1 + i/n ] ⁿ - 1