Financing Liability

Hey guys, I’ve been touching up on my FSA and i’ve hit a small roadblock regarding discount/premium bonds and their impact on CFO and CFF. The issuance of of discount bonds will lead to an understatement of CFF and overstatement of CFO, and the issuance of premium bonds will have the opposite effect. I’ve read the section were it discusses these points and I somewhat understand it when i go over it but after a few days i totally forget the reasoning. Anyone want to clear this up for me since its driving me crazy. Any help will be appreciated.

Ok, take your TI BA II Plus calculator and follow along with this example: 100,000 face value bond with 20 years to maturity, 10% coupon, semiannual interest. Scenario 1: Market Rate = 10% Your present value will be exactly $100,000 since the market rate equals the coupon rate. Each coupon payment is entirely interest. Let’s use this as our baseline scenario. So to summarize: —CFO = -$5,000 (this is a semi-annual figure; also we’re looking from the standpoint of the issuer) Scenario 2: Market Rate = 8% Since the market rate is below the coupon rate, your bond will sell at a premium. Plug the numbers in the TI calculator (P/Y=2, N=40, I/Y=8, PMT=5,000, FV=100,000) and you get a PV of $119,793. Now, press [2nd] and [PV] to go to the amortization schedule. Set P1=1, P2=1, and press the down arrow key until you see the principal payment of $208.29, and interest payment of $4,791.71. Your loan balance is $119,793. Multiply that by one-half of the market rate (8%/2). That equals $4,791.71, which is your interest. This is reported in CFO, which results in overstatement of CFO compared to the base scenario. But what is the net effect on cash flows? Nothing. Why? Because the $208.29 will be an outflow in CFF, since you’re in essence paying down the premium on the bond. And as time goes by, the interest portion of the coupon payment will decrease because your principal balance will also decrease. The principal portion will increase–this property is always true with amortization (just like how a mortgage or car loan works). Try it out by pulling up the amortization worksheet and setting P1=2 and P2=2. Scenario 3: Market Rate = 12% Market rates above the coupon rate imply a discount bond. We now change I/Y to 12 and compute PV. The result is $84,953.70. Again, go to the amortization worksheet and set P1=1 and P2=1. Notice how the interest is 5,097.22 and principal is -$97.22. What does it mean with the principal portion is negative? Take 6% (12%/2) of the outstanding loan balance (PV=84.953.70) and you get $5,097.22. This is our interest expense. We report this in CFO, which thereby understates CFO compared to our base scenario. But what about the -$97.22? Remember, no matter how you slice it, our coupon, and net cash flow, will always be $5,000, as that represents the coupon payment the issuer has to make. So if the CFO reports an “outflow” of $5097.22, how is this amount offset so that we have net $5,000 outflow? We add 97.22 CFF; in other words, the 97.22 represents a CFF inflow. Remember, with discount bonds, the discount portion shrinks to zero when we hit maturity. So basically, an increasing liability on the balance sheet, as awkward as it sounds, represents a financing inflow–even though we’re not even receiving 97.22 in cash from the investor! This is why the authors believe that all these cash flows should simply be lumped into CFF to avoid any exaggeration or confusion of cash flows. Once again, pull up the amortization worksheet on your calculator. Notice how, as you move forward every period, the loan balance actually increases. All of this analysis employs what’s known as the effective interest method. When in doubt, just try it out–on your calculator, of course ;).