State the circumstances under which it would be advantageous to lenders and to borrowers from the issue of: (i) Debentures with a floating rate of interest. (ii)...

      

State the circumstances under which it would be advantageous to lenders and to borrowers from the issue of:
(i) Debentures with a floating rate of interest.
(ii) Zero-coupon bonds. (Ignore taxation)

  

Answers


Kavungya
i) Debenture with floating interest rate
- A debenture whose interest rate is variable and pegged to charges in interest rate on
Treasury bill e.g. a debenture/bond may have a 3% premium above interest rate on
Treasury bill such that:-
- If interest rate on treasury bill is 7%, interest rate on the bond is 7% + 3% = 10%
- If interest rate on Treasury bill rises to 8.5%, the interest rate on the bond
rises to 8.5% + 3% = 11.5%.
- Such a bond is advantageous when market interest rates are volatile.
- If market interest rate falls the borrower pays lower interest charges and when it rises, the
lender receives more interest income.
- Since the coupon rate is matched to market interest rate, the intrinsic value of the bond is
usually stable and easy to determine.

ii) Zero coupon bonds
- The bonds do not pay periodic interest hence the words “zero coupon” bond.
They are issued at a discount and mature at par.
- Therefore, interest is accumulated and accounted for in the redemption value of the bond.
- The lender is not locked into low fixed interest rate while the borrower does not have
fixed financial obligations of paying fixed interest charges.
- The liquidity of the borrower is not affected until the redemption date.
Kavungya answered the question on May 5, 2022 at 14:00


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