Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

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
answer
 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.

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.

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