For calculating bond issue price, one needs strong arithmetic.
It is worthwhile to include bonds in your portfolio. Investors earn interest on the amount invested in bonds. Usually the interest is paid twice a year, at intervals of six months. When the bond matures, the investor is paid the face value of the bond. When considering investing in bonds, you have to compare the rate of interest payable by the issuer of the bond and the prevailing rate of interest in the market. When the rate of interest in the market is more than the rate carried by the bond, the bond is sold at discounted price. The bond carries a premium if it pays more than the market rate of interest.
This is how you can proceed to find out the bond issue price:
1. Determine the earnings by way of interest the bond carries. Suppose you buy a bond with face value of $100,000, carrying an interest of five percent and the maturity period for the bond is two years. Let’s say the existing rate of market interest is four percent. So, the interest that you earn will be $100,000×5%=$5000. Since the interest is paid twice a year, you get $2,500 after every six months.
2. Next, using the Present Value Factor Table, find out the Present Value Factor of the bond. In this example, the market rate of interest being four is divided by two to get interest for six months. That means we should use 2% interest for four terms of six month each. The Present Value Factor in this example will be 0.9238.
3. Now, using the Present Value of an Annuity Factor Table, find out the Present Value of an Annuity Factor. As in case of finding the Present Value Factor, keeping the same market rate of interest of 4%, we need to use 2% interest for four terms of six month each. The Present Value of an Annuity Factor in this example comes to 3.8077.
4. Multiply the amount of interest payable by the Present Value of an Annuity Factor to find out the current value of interest payments. In the present case it comes to $2500×3.8077=$9529.25
5. For finding out the current face value of bond, multiply the Present Value Factor with face value of the bond. In the present case it comes to $100,000×0.9238=$92380.
6. For calculating current price of bond, add the current face value of the bond to the current value of payments via interest. So, in this example, it comes to$92,380 + $9,519.25= $101,899.30. This is more than the bond issue price of $100,000. That shows why the bond would fetch a premium as is promises more rate of interest that the prevailing market rate of interest.