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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
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.
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.
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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