CFM11100 - Understanding corporate finance: raising finance: the cost of borrowing: discounts and premiums

Borrowing at a discount or premium

Instead of paying interest to a lender, a company could negotiate to pay an additional amount on redemption. This is known as a premium. The company will need to negotiate the amount it will pay to reward the lender. If no interest is payable then the calculation of the amount to be paid at the end of the term of the debt might be based on the interest that the lender might have received if the loan had been at interest. The size of the premium would also reflect any risk that the sum borrowed will not be repaid.

Where the premium represents the lender’s reward for the loan of the money, it would typically fall be characterised as interest for tax purposes.

Example

In the example at CFM11090, the company wanted to borrow £10,000 at 10% per annum for 3 years. The compound interest on the borrowing was £13,310. The company might instead offer to repay £13,350 at the end of 3 years on borrowings of £10,000. There is a premium of £3,350.

Original issue discount

As an alternative the company could issue a bond, either with no interest return or at a less than market price. An investor would not be willing to pay the full principal amount to take up this issue, so the issue would have to be made at a discount to the redemption price.

As such, the reward to the lender would instead be a discount on issue. A similar calculation would be made as above but the documentation would show that the bond has a face value of say £13,350. The face value is the price on the bond, that is, it will promise to repay £13,350. The issue price, the amount the lender or subscriber pays to buy the bond from the issuing company, will be £10,000. The bond has then been issued at a discount of £3,350. The company has its £10,000 and the lender will get its reward, the £3,350, on redemption.

Sometimes the yield on a security on issue is fine-tuned by issue at a discount or premium. For instance a company might enter into a facility under which it could issue 5-year notes at rate of interest of 5%, at various dates, or even a single future date. The issue price would be adjusted down or up from the redemption price to reflect prevailing rates at the time of issue.