Discount bond when issued having more CFO and less CFF

CFA Level I FRA
#1

I have this in my notes but I am not sure exactly why a discount bond will have more cash flow from operations and less from financing It says that less cash is paid until maturity So a premium bond is just the opposite?

#2

A bond issued at a discount pays a lower coupon rate than its YTM. If it had been issued at par, its coupon rate would equal its YTM; i.e., it’s coupon rate would have to be higher than it is.

Because coupon payments are CFO outflows, a bond issued at a discount will have a smaller CFO outflow than a bond issued at par: its coupon rate will be too low; hence its CFO will be higher than it would have been had the bond had a higher coupon.

Because the bond was issued at a discount, the cash inflow from financing is lower than if the bond had been issued at par.

Yes, a bond isseud at a premium will cause the opposite effect: CFF is higher (in the year it’s issued) and CFO is lower (throughout its life).

#3

Thanks the CFF part was easy to understand

I didn’t get the CFO part though. So I get that coupon payments are CFO outflows and a discount bond has lower coupon rate compared to YTM. Thus since the coupon payments are smaller, it makes think that the CFO should be less. Could you please explain what you mean by this: “its coupon rate will be too low; hence its CFO will be higher than it would have been had the bond had a higher coupon.”?

#4

Coupon is a deduction from CFO when you’re deducting less, the balance is more.

#5

I think a numerical example might helps.

Consider the following:

  1. $1,000 4% annual pay coupon bond with YTM of 5% (@ issuance)
  2. $1,000 5% annual pay coupon bond with YTM of 5% (@issuance)

For case 1, the bond is a discount bond as coupon rate is smaller than the bond’s YTM @ issuance.

For case 2, the bond is a par bond as coupon rate is equal to the bond’s YTM @ issuance.

As the issuer of the bond, coupon is paid to the holder of the bond, and this periodic payment result in a cash outflow (under Cash Flow from Operating Activities).

Let’s consider case 1- 4% coupon will means the issuer will pay 4% of $1,000 to the bond holders annually. This means $40 will be paid to bond holders.

Now let’s consider case 2- 5% coupon means issuer will, on an annual basis, paid out 5% of $1,000 ( which = $50) to the bond holders.

Everything being equal, let us compare the CFO figures for both case 1 and case 2. Since coupon payment is cash OUTFLOW ; a firm which issue a discount bond ( as in Case 1) will have lesser cash outflow ( amount = 50-40) than firm which issue a par bond ( as in Case 2). This will translate into higherCFO for the former and lower CFO for the latter.

Hope the above helps a bit :slight_smile:

#6

Makes sense. Thanks.

#7

Good job, Ernest!

#8

Higher coupon will lead to more cash flows from operations and the lower YTM also will lead to lower financing costs. This combination of mechanism will lead to what you have asked. So the nature of cash flows will decide the net amt paid or recieved.

Thanks…