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The effective interest rate is determined by the market interest rate at the time of issuance of the bond. In this case, the firm issued a bond with a coupon rate of 5.00% when the market interest rate was 5.50% on bonds of comparable risk and terms.
When a bond is issued, it pays periodic coupon payments to the bondholders. The coupon rate is the fixed percentage of the bond’s face value that is paid as interest over the life of the bond. In this case, the coupon rate is 5.00% of the face value.
However, as the market interest rate changes over time, the bond’s value in the secondary market can also change. If the market interest rate rises, the bond’s value may decrease because new bonds with higher coupon rates become available. Conversely, if the market interest rate falls, the bond’s value may increase because new bonds with lower coupon rates become less attractive.
In this scenario, one year later, the market interest rate increases to 6.00%. Since the market interest rate has risen above the coupon rate of the bond, the bond’s value in the secondary market would likely decrease. As a result, the effective interest rate would be higher than the coupon rate.
The effective interest rate is the discount rate that equates the present value of the coupon payments and face value to their selling price. In this case, since the market interest rate at the time of issuance was 5.50%, which is higher than the coupon rate of 5.00%, the effective interest rate is 5.50%.
Therefore, the correct answer is B. 5.50%.