The real estate group of a manufacturing company needs to finance a large construction project. The CEO wants to use zero coupon bonds, because “they are easy to understand.” The Executive Vice President (EVP) recommends a bond issued with a coupon rate greater than the current market rate of interest. A consultant recommends a bond issued at par. Regarding the financial and cash flow impact, which of the following statements is FALSE? All else equal, if the company follows the: A) EVP’s suggestion, interest expense will decrease over time. B) EVP’s suggestion, both the cash flow from financing and cash flow from operations will be understated compared to that of the par value bond recommended by the consultant. C) CEO’s recommendation, the company will still recognize interest expense. D) CEO’s recommendation, there will be no impact on cash flow from operations. **************************** I think both B and D are false… schweser ans=B any thoughts ?
there is interest expense but no cash flows for zero coupon bonds until maturity.
yes, so thats why cash flow from operations will be overstated … I think its the language of question that confused me again… thanks maratikus
It’s (B). Here’s the logic: First off, this is merely a true false question. So when you answer these questions, make a habit of marking “t” or “f” next to the answers. >>A) EVP’s suggestion, interest expense will decrease over time. The EVP suggested using a higher CPN bond. The CPN rate would be higher than the market yield. Hence, this instrument would sell at a premium. Suppose you issue a 20 year $100,000 semi-annual bond with a 10% coupon. With a market yield of 8%, the PV is $119,792. When calculating your interest, you take 1/2 of the market yield and multiply it by the principal amount. You’re left with $4,791.71 in interest expense. But you’re cash flow is $5,000, so the difference ($208.29) represents premium amortization. Remember this rule about amortization: principal repayment becomes a larger portion of your cash flow, whereas interest becomes smaller. Think of how a mortgage works. >>C) CEO’s recommendation, the company will still recognize interest expense. This is true. On a zero coupon bond, the interest expense represents accretion of the discount from face. Over time, that discount will shrink until the value hits par. >>D) CEO’s recommendation, there will be no impact on cash flow from operations. This is very true. After all, only two cash flows are tied to the use of zero-coupon debt. The inflow from issuance, and the outflow from retirement. But to be even more convincing, simply refer to volume 3, reading 39, page 472, paragraph 3: “The interest on a zero-coupon bond never reduces operating cash flow.” Now, why is (b) wrong? >>B) EVP’s suggestion, both the cash flow from financing and cash flow from operations will be understated compared to that of the par value bond recommended by the consultant. If we use the EVP’s recommendation, which is to issue a premium based bond, we have two things occurring when we make our coupon payment: 1) a large portion will be attributed to interest, and therefore classified under operations, and 2) a smaller portion will be attributed to principal reduction, and hence classified under financing. Refer to the example above that I gave. Under a par value bond scenario, your outflow is categorized under CFO, so a $5,000 payment in a single period would equate to an outflow of $5,000 in CFO (under U.S. GAAP of course). With the premium bond, we have an outflow in CFO of $4,791.71, and CFF outflow of $208.29. So compared with a par bond scenario, CFO is OVERSTATED (due to lesser impact from interest) while CFF is UNDERSTATED (since you’re negating the principal repayment, which does not occur under a par bond scenario). Hope that helps.
wow ! thanks giddy … I comprehended option D as: no impact = CFO is neither overstated or understated… and thats why I thought it was not true… are u a teaching assistant or professor ? you and some other folks on this forum are really good on explaining concepts. Thanks again !!