FCFF: Adding back non-cash charges to NI

CFA Level II
#1

Schweser Notes (Page 143, Book 3) states that to calculate FCFF, the amortization of a bond discount should be added back to net income and the accretion of the bond premium should be subtracted from net income.

What’s confusing me here is the book doesn’t state whether it’s from the issuer’s perspective or from the investor’s. I have come to the conclusion that this should be from the perspective of the issuing firm based on the following reasoning:

  1. If the firm issues a bond at a coupon rate lower than the market rate, it’ll be sold at a discount.
  2. Subsequently, the firm recognizes the coupon payment (actual cash outflow) PLUS the amortization of the discount as the interest expense in the income statement.
  3. Since the net income has been reduced by the amortization amount, you should add back this non-cash charge to net income to calculate FCFF.
  4. It’ll be reverse for the investing firm: i.e., subtract amortization of discount and add back accretion of premium.

Can anybody confirm if this is correct?

#2

I agree with you.

Discounts are amortized over the life of the bond and treated as additional interest expense…

Premiums are also amortized and credit interest expense.

The balance sheet accounts Discount on Bonds payable and Premium on Bonds payable must both be reduced to zero through interest expense.

It must be from the perspective of the issuer.

#3

It is from issuer prospective. The investor does not realize it as he just gets paid with coupon amount.

  1. In case of discount, as Liability Increases, so is the interest expense (amortization) with each passing year, It has to be added back to NI in FCFF calculations. (Additional Taxes)

  2. In case of premium, as Liability decreases, so is the interest expense (accretion) with each passing year, It has to be substracted from NI in FCFF calculations. (Tax saving)

Hope, It clarifies.

#4

maybe i am missing what you are saying. the point of view is from the company that has the debt on its balance sheet. it makes no difference whether t is an investment (asset) or the issuer(liability). In either case you could have a premium or a discount and in either case you would have to amortize…and in either case you would have to adjust cash flows.

maybe i am wrong or missunderstand your question

#5

Thanks Capt and Krishna for your replies. That was very helpful.

Thecodont - you’re correct that either way you have to amortize and adjust cash flows, but then the point of my question is: the direction of the adjustment differs depending on whether it’s the issuer or the investor. i.e., in one case, you subtract amortization of discount and in the other you add it back.

#6

i see

#7

Can someone simplify this pls?

#8

Level 2 generally looks at the investor perspective, i.e. asset side. The question/vignette usually gives a narrative regarding the securities. John Smith CFA is managing a portfolio of 3 bonds… He is the investor right? No confusion for me.

#9

it is pretty easy an investor gains if an asset purchased subsuquently increase in value (fixed income specialists) no cash changes hands though, or a very risky issuer raised money (debt) but need to repay more (market valued his debt lower than he 20% eff rate vs his stated 7%).