Could someone please advise me on the following question (taken from passmaster)? Two years ago a firm issued three bonds with 10-year maturities. All three had the same par and all traded at the same yield-to-maturity when they were issued. But, one was issued at a premium, one at par, and one at a discount. Which bond will have the largest interest expense for the second year post issuance? a) bond issued at par b) bond issued at a premium c) bond issued at a discount d) the recorded interest expense will be the same for all three Explanations (as taken from passmaster): Choice “b” is correct. Interest expense is based on the yield-to-maturity times the net book value of the bond (bond payable adjusted for premium or discount). As the net book value of the premium bond is the largest, its interest expense will be the largest. Choices “a”, “c”, and “d” are all incorrect. See above comments. However, my understanding was that bond issued at a discount will have the highest int. exp. This is because the cash coupon is lower than interest expense, which results in Interest Exp = Coupon + Discount In the numerical example provided in Schweser Book # 3, p.210, it is clear that the interest expense for a discount bound is higher than the one for a premium bond. Am I missing something here?
1.first of all i think if you want to make things easier than you go with the fact that interest expense is always book value *yield 2.the interest expense for cfo calculation is the cash payment even though some might be interest and some principal therefore the premium bond will pay the most so it has the highest interest expense 3.We also know that for premium bonds CFO is understated which means that cfo outflow is overstated, which in our case is the interest expense
Also for a discount bond the interest expense should be lower, just a part is actual interest expense ( cfo) and the other part is amortization of discount (cff)
Interest expense is market rates at the time of issuance * current book value. Since all three had same ytm…i.e market rate at issuance. the one with higher book will have the highest int. exp. The reason why the bond was issued at premium is because its coupon was higher than the market rate @ issuance, while for the discount bond coupon rate was less than the market rate. The difference between the coupon payment and interest expense is used to ammortize the premium or discount on the bond. work through an example par = $1,000 ytm = 5% annual coupon maturity: 3 years Coupon: Bond 1=6%, Bond 2=5% & Bond 3=4% Bond1: Begining Book Value = ? Year 1: Interest expense=? Coupon Payment=? Interest expense - Coupon payment=? use this number to adjust the ending book value of the bond Ending book value=? Do it for all bonds for all three years. I bet that will clear things up. It helped me
I’m wondering is schweser has incorrect info here. This is directly from a practice exam I’m taking on qbank: * When a company issues bonds at a premium, the coupon payment is “too big” (which reduces CFO) and thus interest expense is reduced by the amount of the amortization of the premium. I’m glad I saw this thread, so I know this is incorrect.
No, I think that statement is right, Moto. The comp issued a bond with a coupon rate higher than the market rate so people are willing to pay a premium for it. Since the CR is higher than they should have gotten, they are paying more interest. The premium is amortized over the life of the bond reducing the interest expense.
Thanks trek. So, interest expense is reduced over the life of the bond to amortize the premium, but it is still more interest expense overall than would be paid on a discount bond. Is that correct?
This might be one of those places where common sense trumps studying. Suppose that you issue two bonds - a discount bond at 50 and a premium bond at 150 with the same YTM. If you issue ten bonds of each, you have $500 in your pocket from the discount bond and $1500 in your pocket from the premium bond. Which is going to cost you more interest to borrow $500 or $1500? One way to think of a premium bond is that it is a par bond + amortizing bond.
I dunno I guess I don’t think deep enough for these questions, my thinking was just higher coupon rate, more interest paid. Question done. Not the most in depth analysis, but I got the question right
If we are talking about what gets booked to the interest expense account- the discount bond will have higher interest expense Upon issuance: (discount bond) Cash (100,000 x 95%) 95,000 Discount on Bonds Payable 5,000 Bonds Payable 100,000 Interest payment Interest Expense 12,500 Discount on Bonds Payable 2,500 Cash 10,000 Upon issuance: (Premiuim bond) Cash (100,000 x 105%) 105,000 Premium on Bonds Payable 5,000 Bonds Payable 100,000 Interest Payment Interest Expense 7,500 Premium on Bonds Payable 2,500 Cash 10,000
trek7000 Wrote: ------------------------------------------------------- > I dunno I guess I don’t think deep enough for > these questions, my thinking was just higher > coupon rate, more interest paid. Question done. > Not the most in depth analysis, but I got the > question right Or even a correct analysis. Since the interest expense on a premium bond is less than its coupon payment, you could construct a par bond with lower coupon payments but higher interest expense.
masynya, what is confusing is that in the question we have bonds with different coupon rates and the same effective market rate. In Schweser Book # 3, p.210 the scenario is with bonds that have the same coupon rate but the market interest rates are different (that is when the interest expense on the discount bond > interest expense on the premium bond)
Did they really do that in Schweser? They worked out interest expense on discount, par, and premium bonds with different market rates?! I’ll bet that’s nice and confusing for everyone…
It is the same way of presenting it in the CFAI book also- Book3 Page 515. The example is a bond with coupon rate of 10%, premium case when market rate=8% and discount rate when the market rate is 12% As so you have interest expense: Premium
Thanks everyone for the explanations! I think I got it now!!!
In discount bond, the interest exp > coupon payment. So, when asked which of the 3 has higher interest payment, wouldn’t Discount bond be the answer? No matter how i look at it, your book value x i.r. at issuance will be higher with discount bonds…
What’s the book value of each of the bonds? Would it make sense to you to go into the corporate boardroom and say “Well we could issue a bond at 75 or we could issue a bond at 125. so we would get either 75 M or 125 M but our interest expense would be higher for the 75 M”? If you buy a 45,000 car, is your interest expense higher or lower than a $25,000 car?
joey, i understand your concept and it makes perfect sense. But when I was lookin thru the Schweser example, the discount bond x higher market rate = higher expense. This also makes sense because the higher rate gives out higher interest exp. Unless this interest expense is referring to something else…
Read above what the problem is with the Schweser examples. It’s a different interest rate for each bond.
omg. I see it now. Schweser used same coupon % but different ytm. Wtf, Schweser’s gonna screw me on this one