zero coupon discount rate

CFA Level I
#1

If a company issues zero coupon bond, what is the rate of interest that it uses to calculate interest expense? I read that it is uses company’s borrowing rate on book value of zero coupon bond to calculate interest expense. Is it correct? I remember reading that for all bonds market rate at the time of issue is used to calculate interest expense. I want to make sure my understanding. Thanks

#2

Market rate at issuance will be used

#3

You are right that the market rate of interest at the time of issuance is always applied to beginning period book value to calculate interest expense for that period. This applies for all bonds, including zero-coupon bonds.

#4

what about ongoing interest expense? doesnt it use the current market rate times the remaining book value?

#5

NEVER use the current market rate. Always rate at issuance.

#6

thanks, another ‘tip’ to remember… =)

#7

The reason the rate at issuance must be used to calculate interest expense is that the rate at issuance was used in the PV calculation that provided the initial liability amount. Only by using that same interest rate to calculate interest expense does the liability approach par value as maturity is approached.

#8

thanks chebyshev… does that mean that changes in the market rate have no effect on interest expense?

#9

Yes.

#10

changes in market rates don’t have an effect but changes in the book value of the liability does. for a discount bond expense increases and for a premium bond it decreases since they both approach par value but for premium initial liability is more than par and for discount less. which makes me say that the only time you have a constant interest expense related to a bond is when the bond is issued at par. am i wrong in saying that?

#11

I think that’s right, florinpop.

#12

^ True for fixed coupon bonds. You could work out all kinds of nutty schemes with variable coupons…