How to Calculate the Premium on Bonds Payable
The premium on a bond payable represents the extra cash value of a bond that pays an interest rate that is higher than current market rates. Bonds are a series of fixed cash flows based on a fixed interest rate. Therefore, a bond that pays an annual rate of 5 percent becomes more valuable if current interest rates fall to 3 percent, due to the fact that its cash flows will be higher than cash flows created by a 3 percent bond.
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Instructions
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1
Build a table of the bond's cash flows. For a $500,000 face value, five-year bond that pays 5 percent annually, the cash flows will look like this:
$25,000
$25,000
$25,000
$25,000
$525,000
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2
Write down 1.03 next to each of these numbers, to represent the new annual interest rate of 3 percent.
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3
Raise each 1.03 by the power that corresponds to each year of the cash flows. For example, the first year will be 1.03^1 = 1.03. The fifth and final year will be 1.03^5=1.159. Write each factor down and the table will look like this:
$25,000 1.03 1.03
$25,000 1.03 1.061
$25,000 1.03 1.093
$25,000 1.03 1.126
$525,000 1.03 1.159
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4
Divide each cash flow number by its corresponding factor, and write the numbers down in a column on the right side of the table like this:
24,272
23,563
22,873
22,202
452,977
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5
Add up the column of numbers to get 545,887.
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6
Subtract the bond's face value of 500,000 from 545,887 to get 45,887. This is the premium on the bond payable.
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