A company has among its long-term debt, a bond due in 2015 that carries a face interest rate of 4.65 percent and pays interest annually. Recently this bond sold on the New York Bond Exchange at 103.39. Assume that the company uses the effective interest method to amortize its bonds. Answer the following true/false questions and then select the appropriate multiple choice response. The current market rate of interest on this bond is less than 4.65 percent. The current market rate of the bond affects the amount that the company pays in annual interest. The current market rate of interest affects the amount of interest expense for the current year.

A company with long-term debt

A. True/false questions:  

1. __TRUE___ The current market rate of interest on this bond is less than 4.65 percent. __FALSE___ The current market rate of the bond affects the amount that the company pays in annual interest. _FALSE The current market rate of interest affects the amount of interest expense for the current year.

B. The appropriate multiple choice response:

2. The current market rate of interest on this bond is less than 4.65 percent.

Explanation:

Since the bond is being sold on the New York Bond Exchange at 103.39, it implies that it is selling at a premium.  Therefore, the effective interest rate will be less than the face interest rate of 4.65%.  This is the reason for the bond to be selling at a premium.  That is, it is selling above the face value of 100 per bond.  Conversely, when a bond sells at a discount, say 98 per bond, the effective interest rate will be higher than the face interest rate.  The face interest rate is the stated interest rate while the effective interest rate is the market rate.

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