I’m sure there has been a post on this before, although I can’t seem to find it during my cursory search. Can someone please explain to me why bonds offered at a discount have overstated CFO, and understated CFF while premium bonds have overstated CFF and understated CFO. This concept has yet to crystalize for me with Secret Sauce readings. The CFAI curriculum neglects to mention this in as much detail as I’d like. Many thanks
Think of part of the interest expense of a discounted bond being in the form of the coupon, and part being in the form of the discount on the principal. The latter is non-cash interest expense that still counts towards Ops.
Cash flow from financing CFF would be overstated under a premium because there is more cash inflows relative to PAR and discounted bonds therefor it would be an overstatement. As for CFO NByz is right. An example would be a zero coupon bond. Pays no coupon which is a cash outflow from ops. CFO would be higher overstates relative to premiums where they will pay coupon which hence lowering your CFO (understated) Hope this helps.
Discount: CFO : Overstated CFF : Understated Premium CFO: Understated CFF: Overstated Zero-coupon - just like a discount, but more severe.
Let me see if I can further simplify this for you… think of CFF, negative cash flows for a zero will comprise of int+principal so more negative than for regular bond, which includes just principal component. For the sake of understanding, take Zero cpn as discount bond as esco pointed… Now, for a Regular Bond, when amortizing, we incur interest expense (CFO) and principal reduction (CFF) through out its life right? lets call these are CFOb and CFFb. For a zero cpn, as we dont incur interest expense (zero cpn) at all and all the amortizing expense will effect principal – CFFd. So cash out flow for financing, CFFd, is more or is more negative (int+principal) than CFFb (just principal). In summary, CFOd (zero) > CFOb (some neg) – CFO is overstated for a discount. Simliarly CFFd (more neg) << CFOb (less neg) – CFF is understated for a discount bond. hth…
It’s hard to picture CFF as negative. The amount the bond is sold for, it’s price, is a cash inflow for financing. I think it would help immensely for me if the pieces of the cash flow process are broken down. Coupon Payments are an operating cash out flow. - CFO When the bond is created Principle recieved is a CFF inflow, while the face value payoff at maturity is a CFF outflow Amortizing expenses are not considered a cash flow. Do these have ANY affect on this discussion? Also some terms I am having confusion with. Is Interest Expense the same thing as Interest Payment. Interest Payment is the coupon, interest expense is the PV of the bond X market rate - coupon. This is negative for a premium, positive for a discount, to amortize each closer to par. The Sauce is very vauge about these terms in my opinion.