Two years ago a firm issued three bonds with 10-year maturities. All three had the same par and all traded at the same yield-to-maturity when they were issued. But, one was issued at a premium, one at par, and one at a discount. Which bond will have the largest interest expense for the second year post issuance?
i believe bonds issued at a premium pay the highest coupon rates therefore CFO will be lower for bonds issued at a premium. Interest expense is largest with the premium please correct me if i am wrong
Bonds issued at a premium would have LOWER interest expense than a discount bond or par bond, so CFO would be understated for the life of the bond. YTM premium bond < YTM par bond < YTM for discount bond Interest expense = BV of the bond * mkt rate of interest
BV of the bond above should be “Balance Sheet liabilty” of the bond, but you get the picture
Yes this is quite confusing because the book states that CFO would be understated for bonds issued at a premium yet they have a lower interest expense which should overstate CFO.
Since interest expense is a function of book value and has nothing to do with the coupon rate, won’t the bond issued with the highest book value (i.e., the premium bond) have the highest interest expense over its life?
budfox427 Wrote: ------------------------------------------------------- > Bonds issued at a premium would have LOWER > interest expense than a discount bond or par bond, > so CFO would be understated for the life of the > bond. > > YTM premium bond < YTM par bond < YTM for discount > bond > > Interest expense = BV of the bond * mkt rate of > interest No. Suppose that I sell a bond for 130 and I sell a bond for 30 both of which mature in 10 years and have the same ytm. If I sell 1000 of these bonds, I borrow $130,000 for the first bond and $30,000 for the second bond. So with the first bond I buy an Aston Martin and with the second I buy a Jeep. Is my interest expense in the second year greater for the Aston Martin or for the Jeep? (Ans: Aston Martin).
so the answer is discount bond right?
No. The discount bond buys the Jeep. The premium bond buys the Aston Martin. BTW - I know that the example in Schweser for this is deeply messed by calculating interest expense at different market rates for each of these bonds. Key here is “same ytm”.
gotcha now. since the premium has the biggest book value, it will have the biggest interest expense as well. thnx guys…i hope i pass
ugh, same YTMs. Thanks joey.