CFO overstated- bonds issued at discount???

CFA Level I
#1

Hey folks, Is CFO overstaed for bonds issued at a discount because there should be more interest allocated to CFO, as opposed to a bond issued at a premium or at par? I know that for a bond issued at premium, too much is allocated to CFO, since the principal portion of the payment really belongs to CFF, not CFO. But, still don’t get the discounted bonds thing.

#2

For discount bonds it is just the opposite of premium bonds.

#3

probably the easiest way to look at it is from CFF point of view discount bond cff inflow - below par outflow- par - cff is understated therefore cfo overstated premium bond cff inflow- above par outflow- par cff is overstated therefore cfo understated makes sense?

#4

Imagine a zero coupon bond issue at $600 that will mature at $1000 in 5 years. You will book no interest expense because no coupon is being paid at all for the zero. Because you are really paying about 10.5% interest that is not reflected in coupon payments CFO will be overstated. I haven’t looked at this since June so I could be off.

#5

florinpop Wrote: ------------------------------------------------------- > probably the easiest way to look at it is from CFF > point of view > discount bond cff inflow - below par outflow- par > - cff is understated therefore cfo overstated > premium bond cff inflow- above par outflow- par > cff is overstated therefore cfo understated > makes sense? Could you please elaborate a bit more?

#6

mwvt9 Wrote: ------------------------------------------------------- > Imagine a zero coupon bond issue at $600 that will > mature at $1000 in 5 years. You will book no > interest expense because no coupon is being paid > at all for the zero. Because you are really > paying about 10.5% interest that is not reflected > in coupon payments CFO will be overstated. > > I haven’t looked at this since June so I could be > off. I just read my own post and it didn’t make any sense. Because you have issue a zero coupon bond you will not pay out any cash for the theoretical coupon that exisis on the bond. In this case the bond has an interest rate of about 10.5%, but you are paying none of it until the bond matures (at which time you pay it all in a lump sum). From the standpoint of the analyst CFO is overstated.

#7

well my logic - and it may be wrong-is no matter how you issue a bond the overall cash flows will be the same over the life of the bond. that is cfo+cff of a premium bond=cf0+cff of a disount bond=cfo+cff of a par bond. If you believe that is true and it should be because cash flows are cash flows no matter how you consider them - that means that there is an inverse relationship between cff and cfo for me its easier to say if cff is overstated or understated because the cashflows are clear - the inflow is what you issue it at premium, disocunt or par and outflow is always par. Based on that premium bonds will have a cff overstated and cfo understated discount bonds will have a cff understated and cfo overstated par bonds will have the cff accurate and cfo the same What do you think?

1 Like
#8

good explaination…

#9

thanks florinpop…makes sense to me

#10

for premium bond there is principal pmt, thus CFO is overstate, for discount bond there is no principal pmt and thus understate. this works for me.