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Know that amortization reflects the economic fact that a security sold at a premium must decline to its maturity or redemption price. The principle is similar to the use of depreciation that prices property to its lowest redeemable price when it is no longer useful.
Compute the par value, cost and maturity of the bonds purchased. Assume $1,000,000 par amount, $1,250,000 cost and 10 years to maturity. Subtract the premium from the par (or maturity) amount. The amount to be amortized is $250,000.
Create the entire straight-line amortization for the 10 years to maturity. Divide the $250,000 by the 10 years to maturity. Each year, $25,000 will be amortized. Create more detail. Divide the $25,000 by 12 months and reduce the cost basis by $2,083 per
month. The point is that you are recognizing the gradual reduction of the premium to reflect the bond's terminal value.
Recompute the straight-line amortization to the call and its premium price. With a 5-year call redemption and a premium of $1,200,000, the annual amortization is $40,000 per year. The appropriate choice between amortization of the call price is simple. The investor must amortize the bond to the highest yield whether it is the call or maturity date.
Know there are several forms of amortization. You could, at the time of purchase, compute the ending value of the bond as a 9-, 8-, 7-. 1-year bond to maturity. This is called "scientific" or "constant yield" amortization. Use this technique, and amortization will occur more slowly in the early years and faster at the end.