1. Understand the difference between a stated cash interest rate in a debt contract and an effective interest rate negotiated by the debtor and creditor.
2. Compute the price of a term bond when the stated cash interest rate is different from the effective interest rate.
3. Determine the amount of interest to be compounded each period when the stated cash interest rate is different from effective interest rate.
4. Prepare all journal entries for a term bond when the stated cash interest rate is different from the effective interest rate.
The total present value of the cash flows promised by this bond at an annual 6 percent rate for four years is
$173,256 (cash interest) plus $792,090 (face value) or $965,346. Smith will receive this amount on January
1, Year One and pays back $50,000 per year for four years followed by a single payment of $1 million.
Mathematically, that is equivalent to earning a 6 percent rate of interest each year for four years.