Can someone clearly explain this concept of "Why issuance of Discount bonds will lead to an understatement of CFF and an overstatement of CFO & the premium bonds have the reverse effect ? Thanks in advance.
On a Discount we have 1) Market rate> Coupon Rate 2) The coupon amount(cash Interest) is the sum that is pay to the user at the end of each period not the Interest amount(Interest Expense). 3) Cash Interest paid by the coupon is < to Intesrest expense Charged for the repayment of the debt 3) Since Cash interest is
First: Bonds are issued at discount if… coupon on bonds is less than market rate. Second : Coupon payments are shown as -ve in CFO…Low coupon payments mean less -ve…eventually higher CFO Third: For CFF… think of a combined cash flow statement of multiple years… these years include year of issuance of bond and year of retirement… Fourth: Lets assume … a bond is issued at par value of $1000…In our cash flow statement, there will be two impacts of this issuance on CFF…first will be +ve(inflow) of $1000 at time of issuance… second will be -ve(outflow) of $1000 at retirement(redemption). Fifth : The net effect is 0 in CFF section of Cash Flow Statement. Sixth : However, if bond is issued at a discounted price of $900… we will have inflow of $900… but outflow of $1000 at retirement. Thus net outflow of $100. Seventh: Net cash outflow reduces CFF. Thus CFF is understated because of issuance of discount bond.
Is the coupon rate = interest payment as part of CFO and is the interest= Pv of bond * mkt interest at the beginning = to the interest of CFF?? I don’t get this. what is part of CFO and part of CFF??? for a premium or discount bond?
Bond issued at discount: - The face value of the bond is $1,000 but (FV=$1000) - it has been issued at a discount price of $930 (PV=$930) – the Book Value. The difference between the face value and the book value is a loss that will be amortized until maturity, - has a coupon of 6% (that is a 3% period payment = PMT = $30) and - 4 years to maturity (N=8 – coupon payments semiannually). Input the above in your calculator to determine the I/Y: N=8, PV=-$930, PMT=$30, FV=$1000 = > I/Y=4.0415%, that’s an bond yield to maturity of 8.083% The IE per each period is calculated by multiplying the book value of the debt by the I/Y: The first interest expense is calculated as: IE=$930*4.0415%= $37.59 The first coupon payment is PMT=$30 The difference between the IE and the PMT ($7.59) is the amortization of the loss f $70 (from the issue of the bond at discount) = > the BV of the debt will now be $930+$7.59 = $937.59, and the loss of $70 would have been amortized to $62.41. The $937.59 be used to calculate the IE for the second period, IE2=$937.59*4.0415%= $37.89. At maturity, the entire loss would have been amortized ad the book value of the debt increased to the face value of the bond. The company received $930, will pay $1000 at maturity => this is an understatement of the CFF Since IE = 37.59 is a CFO (under GAAP), but the actual payment is only PMT=$30, the CFO outflow is only $30, the CFO outflow is lower so the CFO remaining to the company is higher, an overstatement of the CFO. Bond issued at premium: - The face value of the bond is $1,000 but (FV=$1000) - it has been issued at a discount price of $1030 (PV=$1030) – the Book Value. The difference between the face value and the book value is a gain that will be amortized until maturity, - has a coupon of 9% (that is a 4.5% period payment = PMT = $45) and - 4 years to maturity (N=8 – coupon payments semiannually). Input the above in your calculator to determine the I/Y: N=8, PV=-$1030, PMT=$45, FV=$1000 = > I/Y=4.0534%, that’s an bond yield to maturity of 8.1069% The IE per each period is calculated by multiplying the book value of the debt by the I/Y: The first interest expense is calculated as: IE=$1030*4. 0534%= $41.75 The first coupon payment is PMT=$45 The difference between the IE and the PMT ($3.25) is the amortization of the gain f $30 (from the issue of the bond at premium) = > the BV of the debt will now be $1030-$3.25 = $1026.75, and the gain of $30 would have been amortized to $26.75. The $1026.75 be used to calculate the IE for the second period, IE2=$1026.75*4. 0534%= $41.62. At maturity, the entire gain would have been amortized ad the book value of the debt decreased to the face value of the bond. The company received $1030, will pay $1000 at maturity => this is an overstatement of the CFF Since IE = $41.75 is a CFO (under GAAP), but the actual payment is PMT=$45, the CFO outflow is $45, the CFO outflow is higher so the CFO remaining to the company is lower (a larger amount deducted), this results in an understatement of the CFO.