Question

A company just issued a 5 year bond for a price of $100 that pays coupons every 6 months. The coupon rate is 3percent per annum, the yield is 3 percent per annum and the principal is $100. The bond buyer was also a company. Both the buying and selling companies are subject to a 30% corporate tax rate.

Which of the following statements is NOT correct? All things remaining equal, per one bond, every 6 months:

Select one:

a. The coupon paid will be $1.50.

b. The tax-deductible interest expense for the issuing company will be $1.50.

c. The extra interest tax shields generated for the issuing company due to the bond will be $1.50.

d. At the instant that the coupon is paid the bond price will fall by the amount of the coupon.

e. Just after the coupon is paid, the price is expected to be the same as the price 6 months earlier just after that previous coupon was paid.

Answer 1

e) No, the price of the bond is not expected to be same after the payment of coupon after a span of 6 months owing to the reason, that bond prices are determined with the help of prevailing market interest rate/disount rate as well as coupon rate. Accordingly, when the interest rate is more than the coupon rate, bond price will fall and on the other hand when the interest rate is lower than the coupon rate, the price of the bond will increase.

Why are the other options correct?

a) is correct because coupon payment will be calculated as 6/12 x 100 x 3/100 = $1.5

b) As, interest payable on debt is a tax deductible expense, so $1.50 will be the tax deductible interest.

c) yes, the tax shield will be $1.5 for the issuing company as explained above.

d) Yes, the price of the bond falls by the coupon amount after the coupon is paid.