Bonds issued at a discount

CFA Level I
#1

Can anyone explain the option A. Thanks in advance. Which of the following statements about bonds issued at a discount is FALSE? A) Cash flow from operations will be overstated and cash flow from financing will be understated. B) The original liability will be higher than the bond’s par value. C) Interest expense will have an upward trend for each period. D) Interest expense will equal the cash paid plus the amortization of the discount. Your answer: B was correct! Bonds issued at a discount will have an original liability that is lower than the bond’s par value.

#2

The cash received when the bond is sold is classified as CFF. This is the “original liability”. Since it is issued at a discount, the cash received is less than the par value of the bond. So CFF is understated, because you are receiving less than the par value. The interest expense paid is what is deducted from CFO. Interest expense is based on the book value of the bond at the beginning of the period. Because the bond is a discount bond, book value will be < par, so interest expense is < what it should be. Therefore you are deducting less from CFO each payment, meaning CFO will be overstated. The difference between the coupon payment and the interest expense is added back on to the book value each year, which will increase the book value of the discount bond each year. It will eventually return to par value at the end.

1 Like
#3

perfect! thanks LongOnCFA

#4

what I don’t understand is why is the interest expense in an upward trend for discount bonds?

#5

Because you are “borrowing” the interest that is otherwise owed.

#6

'coz eventually the book value of discount bonds increase towards Par. Interest expense is market rate @ issuance * Current book value. For discount bonds, that book value increases every coupon payment period by an amount = [market rate @ issuance * Book Value] - Coupon Payment

#7

Will amortization stop when the BV reaches the PV? Will this BV ~ PV condition occur at Maturity or they can become equal before maturity dates? I am pretty confused, can’t visualize this… - Dinesh S

#8

BV = Par at maturity not before. At issuance the BV