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Dear Mr Mike,
Could you kindly help me on below question?
On the 1 Januay 20×1 Penfold purchased a debt instrument for its fair value of $500.000. It had a principal amount of $550.000 and was due to mature in five years. The debt instrument carries fixed interest of 6% paid annually in arrears and has an effective interest rate of 8%. It is held at amortised cost.
At what amount will the debt instrument be shown in the statement of financials position of Penfold as the 31 December 20×2?
Answer 514.560
Working
01.01.20×1
500.000+40000 (8% Interest) -33000 (6% on 550000)=50700031.12.20×1
507000 + 40560 -33000 = 514560
I dont understand why the effective rate has been calculated on 550.000 and not 500000.
Does the principal amount include the premium paid at maturity?
If so, isnt the premium included into the effective rate? 8%.My answer was 520800 as I calculated the fixed rate on 500.000.
Thanks
Gabriella
“500.000+40000 (8% Interest)”
You can see from this extract from your post that the effective rate (8%) is calculated on the $500,000
You’re getting confused!
The coupon rate (6%) is applied to the face value of the debt instrument ($550,000)
Dear Mike,
Yes I think I have made a bit of confusion, sorry about that.
So, Am I right if I say that the effective rate must be used for the fair value of the debt instrument and the coupon rate is used for the principal/face value of the debt instrument?Thanks again for your help.
Best Regards
Gabriella
Dear Mike,
Thanks for your reply, this is clear now.
However, I still have some doubts in relation to the financial instrument.Is it correct to say that the FV of the loan needs to be calculated if the Market Rate is different from the effective rate?
Still a bit confused. what is the market rate? and why and when it should be different from the effective rate?
Example 1
4% $1000 loan 3 years. Market rate 10%
Calculation of fair value of the loan
1000*0.751= 751
40*0.909=36.36
40*0.826=33.04
40*0.751=30.04
Total 850.44Then the interest 4% (effective rate) will be using to calculate the interest on 850.44
Example 2
2%$1000 + 200 premium loan 3 years. Market rate 10%
1200*0.751=901.2
20*0.909=18.18
20*0826= 16.52
20*0.751=15.02Total fair value 950.92
I hope I was able to make the statement clear enough
Thanks for your help
Gabriella
“Is it correct to say that the FV of the loan needs to be calculated if the Market Rate is different from the effective rate?”
Yes
“Still a bit confused. what is the market rate? and why and when it should be different from the effective rate?”
It’s the face rate or coupon rate. It’s the rate of interest that the borrower has agreed to pay. But in this type of instrument there is often a premium t be paid on the final redemption
So, when adding all the interest and the value of the premium together, the examiner will say something like “A similar instrument without the final premium would need an interest rate of (say) 8%”
Why?
Because it reduces the amounts payable in the immediate future (the 6% interest) and defers the true liability until redemption date
No. The 850.44 will be unwound at the rate of 10%. So …
850.44 + 10% unwinding = 935.48
935.48 – 40 interest paid = 895.48
895.48 + 10% unwinding = 985.03
985.03 – 40 interest paid = 945.03
945.03 + 10% unwinding = 1,039.53
1,039.53 – 40 interest paid = 999.53 = 1,000.00
Similarly:
950.92 will be unwound at the rate of 10%. So …
950.92 + 10% unwinding = 1,046.01
1,046.01 – 20 interest paid = 1,026.01
1,026.01 + 10% unwinding = 1,128.61
1,128.61 – 20 interest paid = 1,108.61
1,108.61 + 10% unwinding = 1,219.47
1,219.47 – 20 interest paid = 1,199.47 = 1,200.00
OK?
Dear Mike,
It is not only ok… it is perfect!
Now it is clear.
Thanks a lotGabriella
Hi Mike,
I have another question with regard the financial instrument…
Let say that we have a discount on issue or cost of issue. Should we subtract both of them from the principal amount as per below example?For example.
2%$1000
Cost of issue 100
Loan 3 years. Market rate 10%Calculation of fair value
1000-(100) =900
900*0.751=675.9
20*0.909=18.18
20*0826= 16.52
20*0.751=15.02Fair value = 725.62
The same apply for discount
Thanks and Best Regards
Gabriella
“900*0.751=675.9”
No, you’re going to have to pay $1,000 in 3 years’ time so this line should be “1,000*0.751=$751.31”
Here we go again!
Present value of the flows associated with the loan are:
20 x .909 = 18.18
20 x .826 = 16.53
20 x .751 = 15.03
1,000 x .751 = 751.31So, a present value of 801.05
801.05 will be unwound at the rate of 10%. So …
801.05 + 10% unwinding = 881.16
881.16 – 20 interest paid = 861.16
861.16 + 10% unwinding = 947.28
947.28 – 20 interest paid = 927.28
927.28 + 10% unwinding = 1,020.00
1,020.00 – 20 interest paid = 1,000.00
OK?
As for a discount on issue … how does that work? We borrow $1,000 but the lender says “You only owe me $900”
If that’s what happens, the above figures become …
Present value of the flows associated with the loan are:
20 x .909 = 18.18
20 x .826 = 16.53
20 x .751 = 15.03
900 x .751 = 676.18So, a present value of 725.90
725.90 will be unwound at the rate of 10%. So …
725.90 + 10% unwinding = 798.49
798.49 – 20 interest paid = 778.49
778.49 + 10% unwinding = 856.35
856.35 – 20 interest paid = 836.35
836.35 + 10% unwinding = 919.99
919.99 – 20 interest paid = 900.00
But why would a lender say that?
If you know anyone that would lend me money on those terms, please let me know!
Dear Mike,
For example 1, how do we treat the cost of issue?
Where should it be deducted from? from the Fair value of 801.05?Thanks
Gabriella
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