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3. Bonds are often sold to raise money for water resources project investments. Each bond is a promise to pay a specified amount of
3. Bonds are often sold to raise money for water resources project investments. Each bond is a promise to pay a specified amount of interest, usually semiannually, and to pay the face value of the bond at some specified future date. The selling price of a bond may differ from its face value. Since the interest payments are specified in advance, the current market interest rates dictate the purchase price of the bond. Consider a bond having a face value of $10,000, paying $500 annually for 10 years. The bond or "coupon" interest rate based on its face value is 500/10,000, or 5%. If the bond is purchased for $10,000, the actual interest rate paid to the owner will equal the bond or "coupon" rate. But suppose that one can invest money in similar quality (equal risk) bonds or notes and receive 10% interest. As long as this is possible, the $10,000, 5% bond will not sell in a competitive market. In order to sell it, its purchase price has to be such that the actual interest rate paid to the owner will be 10%. In this case, show that the purchase price will be $6927. The interest paid by some bonds, especially municipal bonds, may be exempt from state and federal income taxes. If an investor is in the 30% income tax bracket, for example, a 5% municipal tax-exempt bond is equivalent to about a 7% taxable bond. This tax exemption helps reduce local taxes needed to pay the interest on municipal bonds, as well as providing attractive investment opportunities to individuals in high tax brackets.
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