Bonds

CFA Level I
#1

Hi, Can someone please explain why CFO is understated for discount bonds? In the notes it says it’s to do with coupon being less than interest expense however I don’t understand how the two are related. Coupon is just what is paid to investors in cash and comes out of CFO and interst is just liab at begining of period x interest rate and hits the income statement as interest expense, but I can’t see how the difference in the two leads to CFO being understated?

#2

for the same reason cfo is SEVERLY understanded for a zero coupon bond.

#3

You assume a semi annual coupon when amortizing the bond, but since it is discounted/zero coupon, it is understated compared to a par bond.

#4

First of all, you have it backwards. CFO is overstated for discount bonds. The market is requiring a higher coupon than what they are paying. Therefore, price is at a discount, and yield is higher than coupon. CFO only reflects the coupon, but in economic reality, the amortization of the discount as the bond approaches maturity is in essence more interest being paid. This amortization is reflected in CFF, instead an interest expense in CFO as it should be. CFF is understated.

#5

LOL. i need to revisit financing liabilities

#6

All bonds at discount have understated CFF, overstated CFO. The bottom line is that instead of receiving the face value amount, the issuer receives a lower value when the bond is issued. Simply put, the CFI inflow is understated. CFO will be overstated by the exactly same amount as the understatement in CFI.

#7

map1, you mean CFF, not CFI.

#8

CFF, right

#9

http://www.analystforum.com/phorums/read.php?11,668506,669937#msg-669937 Here is a link to a previous discussion on CFF and CFO, over/under statement

#10

wyantjs Wrote: ------------------------------------------------------- > First of all, you have it backwards. CFO is > overstated for discount bonds. YES, FOR DISCOUNT BONDS, THE INTEREST EXPENSE IS > COUPON EXPENSE [TO COMPENSATE INVESTOR FOR FACT THAT COUPON % ID < YTM %), SO SINCE WE KNOW THE CFO IS GETTING HIT WITH THE COUPON RATE (NOT THE INTEREST EXPENSE AMMOUNT), THE CFO IS OVERSTATED. IT IS TOUGH TO DESCRIBE, JUST RECALL THIS RULE DISCOUNT: UFOO --> UNDERSTATES CFF AND OVERSTATES CFO PREMIUM: OFUO --> OVERSTATES CFF AND UNDERSTATES CFO