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Low Redemption yield

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Low Redemption yield

  • This topic has 3 replies, 2 voices, and was last updated 6 years ago by John Moffat.
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    Posts
  • January 25, 2017 at 7:25 pm #369568
    Candy
    Member
    • Topics: 135
    • Replies: 79
    • ☆☆☆

    In debt lectures you discuss the above.

    I am confused as to why anyone would buy debentures at a higher value than the nominal $100 if they will lose?

    Please explain the benefits of such a purchase

    Thank you

    January 26, 2017 at 6:49 am #369604
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 51532
    • ☆☆☆☆☆

    And they do you say they will lose?

    Suppose banks are paying interest of 5% but the debentures are paying interest of 10% per year. People will be prepared to pay much more than nominal value because the interest paid is so much higher.

    January 26, 2017 at 10:56 am #369701
    Candy
    Member
    • Topics: 135
    • Replies: 79
    • ☆☆☆

    Ok,

    Maybe I am misunderstanding:

    If bank offers only 3% but debentures offer 5% repaid in 3 years $130

    Max they would receive in interest would be £15 and then they will receive £100 at the end of 3 years maximum of only £115 to the £130 they paid in.

    In the exam should we just assume it will always be better than banks etc?

    Otherwise I do not see the benefit of accepting debenture at higher value than nominal.

    January 26, 2017 at 1:44 pm #369740
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 51532
    • ☆☆☆☆☆

    In your example, if the debentures were to be repaid at par (i.e. $100) then the current market value could not possibly be $130.

    If you have watched the lectures, then you will know that the market value is the present value of the future receipts (interest and redemption) discounted at their required rate of return (which will be the same as the redemption yield).

    They required rate of return is likely to be slightly more than the 3% offered by the bank, because debentures carry a little more risk than deposits at the bank.

    If however, for your example, the market value is certainly likely to be more than $100 because the PV of $5 per year interest and $100 repayment, when discounted at 3% is certainly going to be more than $100.

    I suggest that you watch the lectures again – especially those on the valuation of debt.

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