I can’t remember the exact question from Schweser, but it’s basically this. If a firm issues a bond at a discount to par, what would be the CFO effect, versus whether they had issued the bar at par. CFO overstated or understated? Why?
discount bond: coupon lower than market rate coupon pmts < interest expense coupon pmts are CFO, i.e. CFO is overstated (b/c coupon pmts are less than par, and you’re therefore deducting less from CFO than you should be, so this overstates CFO)
Discount to par So CFF will be understated when compared to a Par bond Par Bond: Cash received would have been 1000$ Cash 1000 Bond Payable 1000 For a Discount Bond: Cash Received is 900 e.g. So Cash 900 Bond Discount 100 Bond Payable 1000 The Cash is the Cash Flow Financing Inflow… So CFF is understated for a Discount Bond. Since total Cash flow in both cases must be the same… (CFO would be overstated for a Discount bond). I hope I got that right… (Or do I have to hit the books again???) feeling a dreaded sense of deja-vu creeping all over me…
lola Wrote: ------------------------------------------------------- > discount bond: coupon lower than market rate > coupon pmts < interest expense > coupon pmts are CFO, i.e. CFO is overstated (b/c > coupon pmts are less than par, and you’re > therefore deducting less from CFO than you should > be, so this overstates CFO) I agree with your reasoning, but is that necessarily the case? Interest expense = initial proceeds * market rate at issuance Coupon payment = coupon % * par value The market rate is higher, but the initial proceeds on a discount bond are lower.
Rest assured cpk… you are right. Think about a zero-coupon bond; since there is no coupon payment —> no CFO —> CFO overstated. All cash paid is principal —> higher CFF outflow —> CFF understated.
Dimes - The reasoning is this… Coupon payments are lower… thus CFO is overstated. Principal payments are higher, thus CFF is understated. Don’t think about interest expense when contemplating CF… interest expense is accounting income. Agree?
Yep I agree. The zero-coupon idea is a good way to think about it. I’m still a little bothered by what I wrote above, but I’m sure there is a sound mathematical reason for why that is not the case.