UpStudy Free Solution:

Selling bonds at a premium has the effect of:

Attracting investors that are willing to pay a lower rate of interest than on similar bonds

Here's why:

When bonds are sold at a premium, it means they are sold for more than their face (par) value. This generally occurs when the stated (coupon) interest rate on the bonds is higher than the prevailing market interest rates. Investors are willing to pay more for these bonds because they offer a higher interest rate than what is currently available in the market.

This does not raise the effective interest rate above the stated interest rate; rather, it lowers the effective interest rate. The premium received on the bonds reduces the overall cost of borrowing for the issuer, effectively lowering the interest expense over the life of the bond when amortized. Hence, the interest expense is lower than the bond interest paid.

So, the correct effect is:

Attracting investors that are willing to pay a lower rate of interest than on similar bonds

Supplemental Knowledge

When a bond is sold at a premium, it means the bond's price is higher than its face (par) value. This typically happens when the bond's coupon rate (the interest rate it pays) is higher than the current market interest rates. Investors are willing to pay more for these bonds because they provide a higher return compared to new issues at current lower rates.

For example, consider a bond with a face value of \(1,000 and a coupon rate of 6%, while the prevailing market interest rate is 4%. Investors will be willing to pay more than\)1,000 for this bond because it offers an interest payment of \(60 annually ( 6% of\)1,000), which is higher than what they would get from new bonds issued at the current market rate of 4%.

Selling bonds at a premium impacts both investors and issuers:

- Investors: They receive higher periodic interest payments compared to new bonds issued at lower rates.

- Issuers: They benefit from receiving more cash upfront than the face value but will amortize this premium over the life of the bond. This amortization reduces their effective cost of borrowing since part of each interest payment effectively returns some of the premium paid.

Understanding bond pricing works can be essential to making informed investment decisions or managing corporate finances effectively, so gaining more insight into it may be essential if you're hoping to delve deeper into financial matters or any of the other disciplines like mathematics, chemistry or physics. UpStudy offers step-by-step solutions for any homework problems you encounter!