# Mock Q on Financing Liabilities

When compared to a par bond, a similar discount bond will have higher CFO/Interest Expense 1.yes/no 2.yes/yes 3.no/yes 4.no/no Interest expense will be higher for discount bond. But, CFO will be same due to same coupon amount reduction. So, My guess is No. 3. Can someone please confirm. For some reason I believe the answer was no. 2. Thanks

I’d say #3 as well. Can’t you get the PDF that explains what the answer is?

it is B disct bonds overstate CFO and the interest exp is higher b/c for disct bonds the int exp > coupon boom

I agree with daj, it should be B

Its 1. Think zero coupon bond with 5% market rate. interest will be 5% off book (which is discounted), much lower than 5% off of face (which it would be if on par). CFO will have no negative effects from interest, all interest will go to ammortize discount. So CFO will be higher.

i agree with countingdays, that should be the way it is. however, most people are getting this concept confused because the example in the book compares a discount bond with a market rate of 12% v. a full coupon bond with a market rate of 8%, so of course in that case the discount bond’s interest expense is higher. if you compare bonds with the same market value then interest expense for a discount bond would definitely be lower.

daj224 Wrote: ------------------------------------------------------- > it is B > > > disct bonds overstate CFO and the interest exp is > higher b/c for disct bonds the int exp > coupon > > > > boom Daj - Why would a Discount bond overstate wrt to a par value bond. Discount bond takes Coupon value from CFO and so does a par value bond. Where is the overstatement wrt to a par value bond ??

answer is 1 i believe, CFO will be overstated for a discount bond and the interest expense will be less than that of a par bond, whose coupon=interest expense. The discount bond will be recorded on the books at a discount from par, and the YTM at the time will be applied to caclulate interest expense for a given year. Because the initial liability is less than the par bond, the interest expense will be less. Definitely Yes/No is the answer.

A, assuming “Comparable” means then bonds were issued at the same time under the same market rates.

The market rate will be higher for a discount bond though (I think you have to assume that by “similar” they mean same coupon–at least thats my assumption). Assume that the coupon for both bonds is 10%, and face value is \$1000. Now for the discount bond, assume that the YTM is 12%. Interest Expense for the par bond will be 10%*1000 = 100 for the discount bond (assuming 1 yr to maturity), price = \$982.14 * 12% = \$117.86 As such, int expense is higher for the discount bond. This was just a simple example, but you can try others on your own and will see that this holds.

Where is this question from? Which mock/sample exam?

the market rate should not be different for different bonds. the market rate is whatever the interest rate is currently in the marketplace, therefore you cannot change the market rate. the only thing a company can change when issuing a bond is the coupon rate. if tomorrow a company decides to issue a bond, then they cannot choose at what market rate to issue the bond

Correct. Both bonsd will have the same YTM, and different coupons.

willis, you should be thinking about this question as the par bon carrying both a YTM and coupon rate of 10% and a discount bond carrying a coupon rate less than 10% and a YTM of 10%. Obviously we could come up with a number of ways/scenarios that this could work out, but for this question, consider the bonds to be the same in every regard except the coupon rate. When you take that into account you will clearly see that the answer is A.

mib20 Wrote: ------------------------------------------------------- > answer is 1 i believe, CFO will be overstated for > a discount bond and the interest expense will be > less than that of a par bond, whose > coupon=interest expense. The discount bond will > be recorded on the books at a discount from par, > and the YTM at the time will be applied to > caclulate interest expense for a given year. > Because the initial liability is less than the par > bond, the interest expense will be less. > Definitely Yes/No is the answer. I hate these questions… I agree with you that the discount bond will be recorded on the books at a discount from par, however, interest expense is calculated using the YTM as you have stated which would increase interest expense: here is an example… Par = \$100 Coupon = 6% (Annual) Market Rate = 7% Face Value = \$92.98 Interest expense if coupon = YTM: \$100*.06 = \$6.00 Interest expense at discount: \$92.98*.07 = \$6.51 Which shows that interest expense would be higher. However, the coupon is \$6.00 in both cases, all of which which gets allocated to CFO (this would not be the case for a bond offered at a premium however). So I would agree with thunderanalyst in the first place in that the answer is 3. Let me know if I am way off…I definately hope not.

Ok, then the answer is A

mib20 Wrote: ------------------------------------------------------- > willis, you should be thinking about this question > as the par bon carrying both a YTM and coupon rate > of 10% and a discount bond carrying a coupon rate > less than 10% and a YTM of 10%. Obviously we > could come up with a number of ways/scenarios that > this could work out, but for this question, > consider the bonds to be the same in every regard > except the coupon rate. When you take that into > account you will clearly see that the answer is A. yes, I agree. Thanks for the clarification. I thought I put FSA to bed, but then I continued looking at AF:)

Disregard my last post…I was thinking of it the same way as Willis

let me make it easy for you guys…consider a par bond priced at \$100 with a 10% coupon. This means that the YTM is also 10% on this bond. Now let’s consider the same bond, but this time with a coupon rate of 9%. Let’s also say that both of these bonds have 3 years to maturity and pay their coupons annually. Clearly the par bond will price at \$100. The 9% coupon bond will carry a price of \$97.51. On the par bond, the interest will be simply 10% * \$100 = \$10. On the discount bond, the interest expense wil be 10%*\$97.51 = \$9.71. Clearly the discoun bond carries less of an interest expense than a similar par bond. Because the issuer actually on paid \$9.00 and recorded an interest expense of \$9.71, the liability will amortize upward by .71 and in year 2, the interest expense will be 10%*98.22 = \$9.82 and so forth.

Makes total sense. I was thinking same coupon for both bonds -->leading to different market rates, which is not possible. MIB you are the man !! thanks