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 a reward on redemption. This reward on redemption is 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. In addition there might be an element included to reflect any risk that the sum borrowed will not be repaid.
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.
The reward could 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.