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You were explaining why the market value of a debt change in your lecture (Sources of Finance – Debt) and I have few doubts such as:
Example:
10% Debentures 2025 quoted at 80 p.c.[I have changed the market value slightly so that my doubts would be clear]
If the company issues a debenture paying 10% fixed interest for 10 years time where investors taking the debenture will be getting $10 p.a. BUT after some time general interest rates in the economy has changed and now the bank is paying 12% fixed interest so as an investor I should sell my 10% debentures to somebody else in the market so that I can get my hands on 12% interest from the bank but why would somebody buy debenture from me?
Is it true that even though they will get 10% fixed interest if they opt for the company’s debenture but if we sell our existing debenture at a lower market price such as 80 p.c. it would persuade the investor to buy the company’s debenture (not the bank 12%)
The reason for this is they are getting more from our debentures because investors will be receiving 12.5% return if they opt for the company’s debenture over the bank offer.
To calculate whether the investors are receiving higher returns or not they will calculate the interest yield.
Interest Yield = ($10 / $80) x 100 = 12.5%
This formula shows that Investors who want higher returns than 12% bank offer should take the company’s debentures.
BUT if the interest yield shows lower returns such as 10% than bank offer of 12% should be preferred by the investors.
Is that all correct? Thanks for your valuable time 🙂
Once the debentures have been issued, then whoever happens to own them at any time will be getting fixed interest of $10 per year.
If general interest rates go up to 12%, then people will only be prepared to pay 10/12% = $83.33 to buy them from you (so they would be getting a 12% return on what they pay) and you would only be able to sell them for $83.33.
On the other hand, if general interest rates fell to 8%, people will be prepared to pay 10/8% = $125 to buy them from you (so they would be getting an 8% return) and you would therefore be able to sell them for $125.
The MV of the debentures will change from day to day as general interest rates change.
All the above simple illustrations assume that the debt is irredeemable. When it is redeemable the MV is the PV of the future receipts (interest and redemption amount) discounted at the required rate of return. The MV therefore changes with the required rate of return but also with the period remaining until redemption.
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