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IIBF JAIIB AFB BUSINESS MATHEMATICS AND FINANCE | DEBT AND BONDS

IIBF JAIIB AFB BUSINESS MATHEMATICS AND FINANCE | DEBT AND BONDS

In this article, we will be reading the meaning and definition of debt, some features of debt, a little bit about loans, and then about bonds. You will also see how YTM i.e yield-to-maturity is calculated. 

DEBT 

A sum of money that is due under a certain agreement is termed a debt. In the language of laymen, we can say it means a claim for money. 

The most popular kind of debt includes personal loans, credit card debt, auto loans, and mortgages. Under loan terms, one is required to pay the loan amount that has been borrowed by a given date, which can range from single to several years. 

This debt might also stipulate the payment of interest that could be annual or semiannual as compensation to the lender for taking risk of granting the money as a loan. It is most commonly used to pay for large purchases which under normal circumstances couldn’t be made.

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FEATURES OF DEBT

Debt comes in a myriad of forms, which are simply combinations of a small number of its characteristics. After you understand the characteristics of debt, you can make sense of any of its types and compare them too. 

The features or characteristics of debt are discussed below: 

  • The objective of buying funds
  • Anticipated repayment Source
  • Term and duration
  • Cost
  • Mitigation of Risk

OBJECTIVE OF BUYING FUNDS

The loans that are taken by the businesses are usually intended to be used as working capital, to buy assets, or to invest in real estate. By default, the term of the loan should be near to the asset that would be purchased with the loan amount.

ANTICIPATED REPAYMENT SOURCE

When lenders lend money, they look forward to the cash flows that the borrowers’ business will generate in the normal course. While Asset-based lenders look forward to getting the specific assets liquidated to get their repayments. 

TERM & DURATION

Loans are also characterized by their term and duration. 

Loans having a maturity period of < 1-year fall under the category of short-term loans

Loans that have a maturity period of > 1-year fall under the category of long-term loans.

COST

The cost of debt is generally expressed in percentage. When you see an advertisement, in which a bank or financial institution is offering you a loan, then the rate that is being offered is the nominal rate but that isn’t the only cost one would be born. There are different fees and discounts that add to the total cost of a loan. 

This cost of the loan includes the following factors: 

  1. Risk
  2. Regulation
  3. Administration costs

COST OF FUNDS

Banks are highly regulated institutions that have access to deposits that are available at low cost. Asset-based lenders usually have higher admin costs which lead them to charge higher rates of interest only on amounts that are lent. Sometimes they also include the element of risk premium.

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MITIGATION OF RISK

Different lenders will seek to manage – or mitigate – risk in different ways:

A variety of lenders mitigates or reduces their risk by using different methods. There are collaterals, securities, and guarantees that are used to take the fall if there is any default by the creditor. 

Small business owners are usually required to provide personal guarantees when taking business loans. In some cases, third-party guarantees are also taken to Finance small business loans.

TYPES OF DEBT

Debt has been categorized into four main categories which are briefly discussed below:

 

Secured Debt: A debt that is attached to collateral is known as secured debt. Generally, one is required to provide collateral having a value greater than the loan they want. 

This collateral could be in the form of vehicles, boats, houses, investments, and securities that are pledged and created a lien on.

Unsecured Debt: The debt which does not require any security as collateral is termed as unsecured debt. Before providing any unsecured debt creditworthiness and capacity to repay is assessed.

Revolving Debt: A line of credit or an amount which a borrower can access is known as revolving debt. Under this type of credit, one can usually use the funds up to a certain amount, then pay it back and re-borrow the amount again. 

Credit card debt is the most common form of revolving debt.

Mortgages: A debt that is provided for purchasing a real estate property (house or Condo) is known as a mortgage. It is secured against the property itself. But because they are so unique, they have their own debt classification.

Corporate Debt: The funds that are available to be borrowed for the companies, are termed as corporate debt. Bonds and commercial papers fall under this category.

ADVANTAGES & DISADVANTAGES OF DEBT

When loans are given to the companies, a lot of attention is paid to the loan amount.  When a company has a large amount of debt, there are chances that if the company’s sales fall, then it would not be able to pay the interest on the borrowed amount. 

But when your company has no debt, it might be missing out on the chances to expand the business.

Getting a debt from a financial institution provides a company an opportunity to complete some of its projects. 

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BOND

Bond is a type of debt instrument which has allowed companies to generate funds by offering repayment to investors. Individuals and institutional investment firms can easily purchase Bonds that carry a definite interest rate or a coupon rate.

Example: If GHI Ltd. needs Rs.1 Crore to finance new equipment, then it can issue 1,000 bonds having a face value of Rs.10,000 each.

The holders of bonds will get the repayment of the face value and future date, which is called the maturity date. This repayment is in addition to the interest payments that the company makes throughout the years until their maturity.

Their working is similar to that of loans, with the exception that the company is the borrower and the investors are lenders.

Bonds

They are a part of debt capital which mainly consists of bonds and debentures. Here, the holders of debt capital instead of receiving the share in the ownership become the creditors of the company who have a right to certain guaranteed payments till the majority of the bonds. Underwritten are the features of bonds:

  • It is a debt that is raised by the bond issuer. 
  • The bond issuer pays a fixed percentage of interest to the purchases of the Bond. 
  • It has various terms associated with it such as face value, maturity, redemption value, market value, and coupon rate. 
  • The face value and redemption value are usually fixed from the beginning but they still might differ. 
  • The market value of a bond may keep on changing.

So, now you know what is debt and what is a bond and how they are both different. In the next article, we will be bringing you an article on Bond Valuation (YTM calculation). So, be with us and wait for the next article to be out.

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