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Hi Mike!
N issues 20,000 redeemable debentures at their at their $100 par value. The debentures are redeemable at a 5% premium in 4 years time and carry a coupon of 2%. The effective rate on the debenture is 4.58%.
I am having some issues understanding some basic thing. Could you explain what is meant by:
1. “The debentures are redeemable at a 5% premium in 4 years time”
2. “carry a coupon of 2%”
3. “rate on the debenture is 4.58%.”Thanks.
Let’s say these $2,000,000 worth of debentures were issued on 1 January, 2015 and “the debentures are redeemable at a 5% premium in 4 years time”
On 31 December 2018 the company has to repay (redeem) these debentures and has to pay a premium of 5%, so is facing an outlay of cash of $2,100,000 on 31 December, 2018
When these debentures were issued, the terms of issue were that they “carry a coupon of 2%” so, each year, the company that has issued these debentures will have to pay cash by way of debenture interest amounting to 2% x $2,000,000 = $40,000
But clearly, $40,000 is not a true reflection of the true cost of this borrowing because that would leave us with a set of distorted non-comparable financial statements
Debenture interest would appear in 2015 as $40,000, in 2016 $40,000, in 2017 $40,000 but in 2018 $140,000 ($40,000 interest + $100,000 premium) and that cannot be acceptable
If we take the full cost of servicing these debentures, the question tells you that the EFFECTIVE rate (as distinct from the 2% coupon rate) is in fact 4.58%
Does that make it any clearer?
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