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i am clear about the theoritical implication of both….but cant figure out the real diffrence btween coupon rate and require return kd….to me.both are the return to investor..??!!!!!
If a bond is bought and sold by the investor at par the return to the investor is equal to the coupon rate.
If the bond is bought or redeemed at at a amount that is not par – the return will have two components, the gain or loss calculated as the difference between purchase price and redemption and the coupon yield. Coupon yield is different from the coupon rate, it’s the interest paid during the year divided by the market value of the bond.
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Recap:
Kd denotes the required return of the INVESTOR
Kdat denotes the required return of the COMPANY, and so is after taxThe investors required return has two components (1) the Interest received pa = the Coupon Rate pa x $100 and (2) the Capital Gain pa = Redemption proceeds minus the Purchase Price (current Market Price PU) / no. of years to redemption of the loan note.
The usual approach in the exam is to calculate the required return in annual % terns (i.eKd) using the IRR method
Alternatively, you could calculate the average returnpa (1) relate the coupon interest received to the purchase price paid (current MP pu) + (2) relate theTotal Capital Gain to the purchase price paid / no. of years left to redemption of the loan note. (3) Add the two components together and you have the total investors required return pa…. so you can see that the coupon rate only takes account of part of the total investors required return.
The accepted convention for calculating the Kd is to use IRR which takes account of all the relevant cash flows pertaining to the bond + it has the added advantage of taking account of the time value of money, which the alternative method I have described above does not.
Regards, Kevin Kelly
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