Original issue discount
| Original issue discount |
|---|
| See also |
Original issue discount (OID) is a form of interest on bonds or other debt instruments that is offered at a rate lower than the coupon rate. It is the difference between the face value of a bond and the amount the issuer pays to the bondholder. OID is typically seen when a bond is issued at a discount, where the interest rate is lower than the market rate of interest. This can occur when the bond is issued at a lower price than its face value, or when the issuer is offering a lower interest rate than the current market rate. OID can also be seen when a bond is issued at a premium, where the interest rate is higher than the market rate of interest. In this situation, the issuer will pay the bondholder an amount higher than the face value of the bond.
Example of Original issue discount
Original issue discount (OID) can take many forms, depending on the bond issuer and the market conditions when the bond is issued. For example, if a bond is issued at a discount, the OID would be the difference between the face value of the bond and the price at which it is sold. If a bond is issued at a premium, the OID would be the difference between the amount paid by the bondholder and the face value of the bond. Additionally, if the interest rate on the bond is lower than the current market rate of interest, the OID would be the difference between the interest rate on the bond and the current market rate of interest.
Formula of Original issue discount
The formula for calculating the original issue discount (OID) of a bond is: OID = Face Value - Issue Price. This formula takes the face value of the bond, subtracts the issue price of the bond, and the result is the original issue discount.
For example, if a bond has a face value of $1,000 and an issue price of $900, then the OID for the bond would be $100. This can also be expressed as a percentage of the face value of the bond, which in this case would be 10%, or 10 cents per dollar of face value.
When to use Original issue discount
Original issue discount can be used when an issuer wants to borrow money at a lower rate than the current market rate or when an issuer wants to raise additional capital at a lower cost. In both cases, the issuer will offer the bond at a lower rate than the market rate, resulting in a discount to the face value of the bond. This discount is the original issue discount, and it is the difference between the face value of the bond and the amount the issuer pays to the bondholder.
Types of Original issue discount
Original issue discount can take several forms, depending on the type of bond or debt instrument being issued.
- Zero-coupon bonds: These are bonds that are issued without a coupon payment. They are sold at a deep discount from face value and the entire interest payment is made at maturity.
- Stripped bonds: These bonds have had their coupon payments removed and are sold at a discount from face value. The coupon payments can be sold separately as zero-coupon bonds.
- Deeply discounted bonds: These bonds are issued with a coupon rate that is lower than the current market rate of interest. They are sold at a discount from face value, with the difference representing the OID.
- Premium bonds: These bonds are issued with a coupon rate that is higher than the current market rate of interest. They are sold at a premium from face value, with the difference representing the OID.
Steps of Original issue discount
Original issue discount (OID) involves the following steps:
- The issuer of the bond will set the face value of the bond. This is the amount that the bondholder will receive when the bond matures.
- The issuer will then set the coupon rate, which is the interest rate that the bondholder will receive for holding the bond.
- The issuer will then determine the market rate of interest. This is the rate of return that is currently available for similar bonds.
- The issuer will then set the offering price of the bond. This is the price that the issuer will pay the bondholder for purchasing the bond.
- The original issue discount (OID) is then calculated as the difference between the face value of the bond and the offering price.
In summary, OID is calculated by finding the difference between the face value of the bond and the offering price, and its calculation is a part of the bond issuance process.
Advantages of Original issue discount
Original issue discount (OID) has several advantages for both issuers and investors.
- For issuers, OID offers a lower rate of interest, which reduces their overall costs of borrowing. This can be especially beneficial for issuers who are in need of capital but cannot afford to pay the current market rate of interest.
- For investors, OID provides a higher return on their investment. Since OID bonds are issued at a discount, investors can earn a higher rate of return on their investment compared to bonds with a more standard coupon rate.
- Additionally, OID can be used as a tax-advantaged investment. Since the interest earned on OID bonds is taxed at a lower rate than other forms of debt, investors can benefit from the tax savings.
Limitations of Original issue discount
Original issue discount has several limitations, including:
- The tax treatment of OID can be complex, as the IRS requires additional reporting and documentation.
- OID may not be available in all cases, as some companies may not be able to offer it.
- OID can be difficult to compare to other investment options, as the interest rate is not fixed and may change over time.
- OID can be difficult to value, as the amount of the discount can vary from one issue to another.
There are several other approaches to OID which are worth considering. These include:
- Yield-to-Maturity: This approach takes into account the current market rate of the bond and the amount of interest the bondholder will receive during the life of the bond.
- Present Value of Interest: This method takes into account the current market rate of interest, the amount of interest the bondholder will receive during the life of the bond, and the present value of the bond.
- Duration: This approach takes into account the time value of money, and the length of time the bondholder will hold the bond.
- OAS Spread: This approach uses the option-adjusted spread (OAS) to determine the OID of the bond.
In summary, there are a number of different approaches to OID which involve taking into account different factors such as the current market rate of the bond, the amount of interest the bondholder will receive, the time value of money, and the option-adjusted spread.
Suggested literature
- Huang, Y. F. (2016). An EPQ model under cash discount and permissible delay in payments derived without derivatives. Yugoslav Journal of Operations Research, 17(2),
- Reider, R., Heyler, P.B. (2003). Managing Cash Flow: An Operational Focus Wiley J. & Sons (47-50),
- Rachlin R., (1997). Return on investment Manual. Tools and Applications for Managing Financial Results. Sharpe Professional. M.E. Sharpe,
- Bienias Gilbertson C., Lehman M. W.,(2009) Century 21 Accounting: General Journal South-western.
