Question: A wide array of bonds and other types of financial instruments can be purchased from parties seeking
money. A zero-coupon bond is one that is popular because of its ease. The face value of a zero-coupon bond is
paid to the investor after a specified period of time but no other cash payment is made. There is no stated cash interest. Money is received when the bond is issued and money is paid at the end of the term but no other payments
are ever made. Why does any investor choose to purchase a zero-coupon bond if no interest is paid?
Answer: No investor would buy a note or bond that did not pay interest. That makes no economic sense. Because
zero-coupon bonds are widely issued, some form of interest must be included. These bonds are sold at a discount
below face value with the difference serving as interest. If a bond is issued for $37,000 and the company
eventually repays the face value of $40,000, the additional $3,000 is interest on the debt. That is the charge paid
for the use of the money that was borrowed. The price reduction below face value can be so significant that zero-
coupon bonds are sometimes referred to as deep discount bonds.
To illustrate, assume that on January 1, Year One, a company offers a $20,000 two-year zero-coupon bond to the
public. A single payment of $20,000 will be made to the bondholder on December 31, Year Two. According to
the contract, no other cash is to be paid. An investor who wishes to make a 7 percent annual interest rate can mathematically compute the amount to pay to earn exactly that interest. The debtor must then decide whether to
accept this offer.
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