At the beginning of the yr, 2 companies issued debt with the same mkt rate, maturity date, and total face value. One company issued coupon-bearing bonds at par and the other company issued zero-coupon bonds. All other factors being equal for that yr, compared with the company that issued par bonds, the company that issued zero-coupon debt will most likely overstate: A. CFO by not interest expense B. Interest expense but not CFO C. Both CFO and interest expense D Neither CFO nor interest expense
I’ll go with A. CFO gets overstated since all the outflows get shifted to CFF. Int exp is actually understated since there is no int exp in a zero coupon bond.
A. CFO *But* not interest Expense
yea that’s what I said, but the explanation kinda confused me. It says interest expense is recorded for income statement purposes, but is added back in the statement of cash flows as a non-cash adjustment to cash flow from operations. Does that coincide with A? lol For a 0 coupon bond, is interest expense less or more compared to a par bond?
No it doesn’t because that how you calc out CFO using the indirect method under GAAP Interest - Cash outflow so it needed to get added back to calc CFO Compared to a PAR bond? I made this example up… PAR INITIAL LIAB = 1000 MR = 10% INT. EXPENSE = $100 Zero Coupon Liab. - (800) MR = 10% INT EXPENSE = $80 but increasing each year. I would think less initially?
That’s what I was thinking, same mkt rate but multiplied by a small amount. So A is correct ya think?
yea I would have picked A as well. (The same reasoning as beingthatguy) Just an extension on the same concept: when comparing a company that issued par bonds with a company that issued premium bonds then the company with premium bonds: CFO would be the same and interest expense would be less?
CFO would be less for the premium bonds. Why? Because they are shelling out more cash to pay for the extra interest. Interest expense would be higher for the premium bond.
interest expense is lower for prem. bonds
A. Without even having to read the others.
A, this only applies at inception since interest rate expense will rise on the zero-coupon bond over time til maturity…
But compared to a PAR bond, a zero coupon will pay out less interest expense, correct?
beingthatguy Wrote: ------------------------------------------------------- > interest expense is lower for prem. bonds Interest expense = principle x market rate. Doesn’t that make interest expense larger for premium bonds?
Isura, is does but in the CFAI FSA book they assume that you issue a higher coupon bond for a lower market interest rate (rather than for the same market interest rate as what you issued the discount bond at). This results in lower interest expense. Kind of dumb.
this thread has confused mroe than most. revising this section.
TheAliMan Wrote: ------------------------------------------------------- > Isura, is does but in the CFAI FSA book they > assume that you issue a higher coupon bond for a > lower market interest rate (rather than for the > same market interest rate as what you issued the > discount bond at). This results in lower interest > expense. Kind of dumb. I wonder how they’re going to portray this on the exam. Do we make the automatic assumption that the premium bond was issued at lower market rates?
That’s ridiculous. So if interest expense on Premium bonds is lower, what will the effect of that be on CFO? I assumed CFO would be understand (lower than CFO for par bonds) but given what’s just been said about interest expense being LOWER for premium bonds, how will the CFO compare for par bonds?
though interest expense is lower or higher - there would be an Amortization of Bond Premium (which would be -ve) in case of premium bonds - and an Amortization of Bond Discount (which would be +ve) for Discount bonds. That number is subtracted for Bond Premium / added for Bond Discount cases while calculating the Net Income. So when you go to calculate the CFO - the number would be backed out (added for bond prem, subtracted for bond discount). so you will not see any difference because of that. Liability of Bond * Market Interest Rate = Interest Expense. Face Value * Coupon Rate = Coupon (Interest Expense Diff. Coupon) = Amortization Amount.