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Why is the discount on the issue of debentures considered as an incremental interest expense?

Question:

Why is the discount on the issue of debentures considered as an incremental interest expense?

Debentures:

Debentures are unsecured debt instruments issued by institutions to the investors for a specified period and a specific rate of interest for the generation of capital for their operations. Any asset does not back them, and its security is dependent on the creditworthiness and integrity of the issuer. Some debentures are convertible, such that they can be changed to equity shares while others are non-convertible.

Answer and Explanation:

When debentures are issued at a discount, the debenture holder pays a price that is lower than its nominal value. If, for example, a debenture that has a nominal amount of $100 is issued at a discount of 10%, the issuer would receive $90. Issuing the debenture at a discount would, therefore, raise the actual rate of interest payable because, taking an example, if 12% debentures of $100 are issued at 10% discount, the issuer would have to pay $12 for a loan of $90. Hence, the actual interest rate would be 12/90 * 100, which would be 13.33%. Therefore, the interest expense is viewed as incremental because it constitutes of the total amount of interest paid and the discount that was written off.


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Sources of Long-Term Financing

from Business 100: Intro to Business

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