Zero coupon debt

CFA Level I
#1

Overstates 1-CFO 2-Interest Expense a- 1 b- 2 c- both 1&2 d- neither

#2

a) overstate CFO

#3

Don’t ask me how, I just make notes on my mistakes from the mock’s, believe I saw that in mock2… Can anyone explain pls

#4

“When a company issues a zero-coupon bond, cash flow from operations is overstated over the life of the bond. Interest expense is recorded for income statements purposes, but is added back in the statement of cash flows as a non-cash adjustment to cash flow from operations”

#5

Yes, it’s from mock 2. I have the pdf, that explains the CFO being overstated, but I remember the Q had the question about Interest Expense also, and the pdf doesn’t really explain i it does or not.

#6

.

#7

zero Wrote: ------------------------------------------------------- > When a company issues a zero-coupon bond, cash > flow from operations is overstated over the life > of the bond. Interest expense is recorded for > income statements purposes, but is added back in > the statement of cash flows as a non-cash > adjustment to cash flow from operations That is what I have on the mock 2 pdf… but does it or does it not overstated IE?

#8

Thanks CP!

#9

not sure about my answer, so I removed it. what i had written was… no interest expense - and since that is normally deducted while getting to net income - (starting point for CFO) - CFO is overstated. another way to look at the same thing is – CFF is severely understated in case of a zero coupon bond when compared to a par bond. Zero coupon is a deeply discounted bond.

#10

Still can’t figure it out.

#11

Net income usually has a component of Interest expense deducted on a normal financial statement. for a zero coupon bond, that Deduction is not present. so Net income is higher -> means CFO is overstated. Likewise, since this is a deep discount bond, when you compare the amount received from the issue of the bond ( which is a CFF inflow ) to that received for a par bond - you would get much lesser for a zero coupon bond. So CFF Inflow is understated for a zero coupon bond (much like it is for a Discount bond) . does that make things clearer, CFA_2010?

#12

Helped me out!

#13

Thanks a bunch!!! Just looked through the books as well. Sorry feeling tired. Gonna quit for today. Thanks again.

#14

So is the answer C? 1&2 both?

#15
  1. Zero coupon bonds overstate CFO
#16

The interest expense isnt subtracted and then added to CF…its more of an “implicit” cost that should be taken into account if you are trying to compare apples to apples… please tell me if thats inaccurate.

#17

After giving it more and more thought… The answer would be a - Overstates CFO. Regarding IExpense, compared to a Bond issued at par, IE would be less, so it cannot be overstated. Which also makes sense, when in comes to NI, being greater and helping overstate CFO. I hope I am right. Tricky question.

#18

just think about it this way zero coupon ===> coupon < interest instead of deducting interest amount from CFO, you’re deducting coupon amount ====> deducting less then you should ===> overstating CFO

#19

I think the answer is C. CFO is over stated, just as what everyone has explained. but IE is also over stated, because the zero coupon bond needs to amortize its principle UP to the face value. so compared to a par bond, it needs to overstate to amortize the principle.

#20

Remember Zero Coupon Debt is discounted, so when issued CFF will be understated and CFO will be overstated because the interest expenses will INCREASE over the life of the bond until it matures