The gain generated from the difference between the purchase price and the face value of an asset is known as the accretion of a discount.
What Is Accretion (of a Discount)?
The gain an investor makes after purchasing assets at a discount is referred to as an accretion (of a discount). The investor progressively makes money on the difference between the discounted purchase price and the bond’s face value by keeping the bond until it matures.
In corporate finance, accretion is the value that you produce when you merge with or acquire another company. The value of your stockholders’ shares rises, as a result, raising your earnings per share (EPS).
How to Calculate Accretion of a Discount?
When you purchase a bond for a price less than its face value, it is known as accumulation and it puts more money in your pocket.
But how does it work?
Let’s assume you bought a discounted bond for $800 but its face value is $1,000. You keep the bond until the maturity date. When the bond matures, you receive interest on top of the difference between the face value and the discounted price. In other words, if you bought it only for $800, you gained $200. Additionally, you got the interest on the bond’s $1,000 face value.
When a bond reaches maturity, interest is paid out either yearly or all at once. Either the straight-line technique or the constant-yield method can be used to determine the bond’s accretion. Let’s check out the two calculation techniques.
The Straight-Line Approach
Let’s assume that the maturity of your bond is after five years. The bond’s face value was $500 more than what you paid for it.
There are 20 financial periods left till the bond matures because the bond issuer reports its financial standing every quarter. You may observe a $25 addition every quarter until the bond matures (if you divide the discount [$500] by the length of financial periods ). In other words, until the bond’s maturity date, the value of your amount will rise by $25 every three months.
The Constant-Yield Approach
The bond’s value rises as it gets closer to its maturity date using the constant yield approach. This implies that some financial periods, particularly those approaching the conclusion of the bond’s life, will show greater benefits.
The accretion of discount can be calculated using the following formula:
Accretion Amount= Purchase Basis x (YTM/Accrual periods per year) – Coupon Interest.
Using this approach, you must first get the value of yield to maturity (YTM) in order to calculate the accretion of discount. The earnings on a bond that is held to maturity are known as YTM. Keep in mind that the profit’s compounding frequency has a significant impact on YTM.
At the maturity date, both bond accretion computations will result in a profit for you. The constant yield strategy, however, enables the bond issuer to get additional time before they must raise the bond’s value.