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example, when a bond is prepayable, the market price incorporates
the likelihood that the bond will be prepaid. A comparison of
the adjusted issue prices of petitioner’s debt instruments and
the market prices indicates that petitioner’s instruments were
traded at a discount as of January 1, 1985. The difference
between the adjusted issue price and the market price is the
market discount. The discount reflects the present value
difference between petitioner’s contractual interest rate for
each debt instrument and the market rate for comparable debt on
January 1, 1985. From petitioner’s perspective, the amount of
the discount is the present value of the additional interest cost
that the debtor would have to incur to borrow the amount of the
existing debt at market rates.
Professor Schaefer calculated the fair market value of the
favorable financing inherent in each of the 30 debt instruments
as of January 1, 1985, as the difference between the adjusted
issue price per $100 of principal and the January 1, 1985, market
price per $100 of principal, multiplied by the unpaid principal
balance divided by $100.11 Professor Schaefer’s report provided
the January 1, 1985, market price, adjusted issue price, and
unpaid principal balance for the 30 debt instruments as follows:
11 FMV = (adjusted issue price per $100 - market price per
$100) x (unpaid principal balance / $100).
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