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zero coupon bond

I thought A is correct. Since it does not pay any interest , I thought net income is overstated for zero coupon bond. Appreciate any comments on the question.
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Which of the following best describes how issuing zero-coupon bonds affects a company’s financial statements? The company’s:
A. net income is overstated every year until maturity.
B. cash flow from operations decreases for the life of the bond.
C. cash flow from investing decreases during the year of maturity.
D. cash flow from financing increases during the year of issuance.

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Interest paid is not found on the income statement. If you look at answer D, I think you’ll see its obvious: Cash flow from financing is increased by the amount of the bond in the year of issuance. That’s the year they issued the bond, that’s the year they got all the proceeds. The proceeds all went into CF from financing.

zero coupon bond is deep discount bond, thus CFO is underestimated, and CFF should be overestimated. I’d say it’s C. I’m not sure with this answer, please correct me.

Smarshy I would agree with you, i’m thinking too much.

By the way, discount bond underestimates CFO and overestimates CFF, for premium bond, CFO is overstated and CFF is understated, is my logic right?

achogogo Wrote:
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> zero coupon bond is deep discount bond, thus CFO
> is underestimated, and CFF should be
> overestimated. I’d say it’s C. I’m not sure with
> this answer, please correct me.

How can it be C when C only talks about CFI?

true,

achogogo it is actually -

discount bonds - CFO = Overstated CFF = Understatged
premium bonds - CFO = Understated CFF = Overstated

Niraj_a, that’s actually not right.

Archogogo, cash outflows from operations are understated in the case of a discount bond. Cash outflows from financing are overstated.

Niraj_a is right. CFO on a discounted bond is overstated and CFF is understated. I am sure.

I think we are saying the same thing. I am saying cash OUTFLOWS from Operations are understated, which would make cash flows overstated.

I would say it is D .
A. Since the interest is amortized even though it is not paid, it cannot be A.
B. since no interest is paid during bond term, b is wrong
C. wrong since CFI is not affected
D. is right, since the entire proceeds from the bond issue is put in CFF at the time of issue.

YES . D was given as correct answer.

sv102307,

What is exactly happens when it is amortizing?How does it makes net income not overstated? How does it not affect CFO? If possible, could you please explain with simple example on how zero coupon bond transactions are recorded in income/cash flow statements.

Appreciate for your time.

Thanks,
Chinni

Lets take a 3 year Zero Coupon bond with Yield to Maturity of 10%, Face Value of 100 .

Proceeds from issuing the bond = 74.62 (100 / (1.05^6)

Hence CFF is increased by 74.62 in the year of issue.

Interest during the first period = 74.62 * .05 =3.731.

Since no coupon is paid, Liabilityat the end of period 1 = 74.62 + 3.731 =78.353

Interest during the second period is calculated based on the liability at the end of period 1 = 74.8.353 * .05 =3.917.

Since no coupon is paid, Liabilityat the end of period 2 = 82.270.

At the end of 3 years we will have an accumulated interest expense of 25.378 adnd the total liability is now 100.

Since we have recorded interest expense all 3 years the net income is not understated.
Since we have not actually paid any interest there is no impact on the CFO (which is why CFO is said to be understated).

sv102307,

Appreciate for the elaborative explanation. I did not know until now that interest is tracked as accumulated liability on balance sheet.

I guess the interest has to be accounted in income statement to follow accrual accounting. So net income should be less of this interest. Also, any interest expense should be included in CFO. Since cash is not really paid, I am not sure how it is removed from CFO like how it is done for depreciation. I guess there is no way to find if interest expense on income statement is really paid like coupon bonds are just accounted to satisfy accrual concept.

I will read one more time. Appreciate for your valuable time

chinni