What exactly is cash interest?? And how does it compare to interest expense? I’m on SS9 Reading#39 - Analysis of Financing Liablities, reading right now about bonds with warrants vs convertible bonds. If the coupon rate is the same, a convert bond & bond with warrants will have the same cash interest, but a conventional bond will have greater cash interest costs. How does this logically make sense?
At issuance, both left and right terms of the accounting equation A = L + E would increase by the same amount to keep the equation in balance. A, Assets will increase by the amount received in cash. The right term, L+E, would have a different structure for bonds with attached warrants than in the case of conventional bonds. For conventional bonds, the entire increase goes to liabilities (the debt). For bonds with warrants, the actual amount received for warrants is registered as E equity, so Liabilities for bonds with warrants (the book value of the liability) would be lower than in the case of conventional bonds. Since: (i) at the time of issue, the YTM for both type of bonds would be the same (because nobody in the market would buy a bond with a lower YTM) (ii) the liability is lower for a bond with warrants than for a conventional bond (iii) interest is calculated as YTM* book value of debt, then the interest cost/expense will be lower for a bond with warrants than for a conventional bond. It does make sense, because warrants are considered equity hence reducing the book value of the liability, hence reducing interest expense.
Here are links to topics that should help you: http://www.analystforum.com/phorums/read.php?11,648916,648947#msg-648947 http://www.analystforum.com/phorums/read.php?11,776460,780775#msg-780775
Thanks for your response map1. I understand the concept about interest expense being lower for a bond with warrants vs a conventional bond. What I don’t get is the concept of “cash interest.” I’m just not sure what it is & how it relates to interest expense. Cash Interest: convertible bond = bond with warrants < conventional bond
Cash interest used to diffrenciate interest expense from the actual cash paid towars the interest expense. when preparing the cash flow, you only use cash account. So, for bond with warrants, the warrant would reduce the debt value, therefore, the cash interest will be lower than conventional bond interest expense. Why this concept is very imposrtant, is becuase bond with warrants tend to overstate CFO( cash expense is less than interest expense) and understate CFF ( the warrants has been detached from liabilities therefore, less debt) versus conventional bonds.
Value of convertible and bond with warrant has lower value as compare with conventional bond because these instruments have special right as it is not enjoyed by conventional bond holder. as Cash interest = Coupon rate * bond value if the bond value is lower, definitely u will get lower cash interest. hope it helps.
Cash Interest is what you actually paid for interest on debt whereas interest expense it was is actually recorded. Exemple you issue a debt a premium, you cash expense is the coupon rate and interest expense what in recorded on the income statement. And convertible bond and bond with warrant will have same cash interest since, since cash interest= coupon payment and is this two bonds are same coupon rate. Now conventional bond will have greater cash interest because, investor will require a greater compensation(meaning higher coupon rate) for forgoing convertibiliy and warrant feature. Hope this helps.
disct bonds - overstate CFO, understate CFF premia bonds - understate CFO, overstate CFF disct bonds = higher int exp premia bonds = lower int exp premium bonds: coupon > YTM disct bonds: coupon < YTM important rules to ingrain in yo head.