I’m just trying to clarify why: 1) For premium bonds, CFF is overstated and CFO understated? and 2) For discount bonds, CFF is understated and CFO overstated? Say, company X issues bonds at a premium (market rate is 10%, yet its coupons pay 12%), it therefore receives more than $100k as proceeds. Clearly, its annual interest expense (assuming annual bonds) will be less than $120, its cash coupon payment. Lets start with CFO, why would it be understated? It pays $120 in cash, but its stated interest expense will be something lower (lets say $97, too lazy to calculate that). Why would that make CFO understated? Then why is CFF overstated? What is its periodic CFF anyway? Discuss and clarify please. Thanks
What you need to understand is “COMPARED TO WHAT”? Premium Bond: Receives 110K as proceeds, which is more than what the Par bond 100K would have received. This cash inflow is the CFF. So CFF is overstated . So CFF for a Premium Bond is Overstated compared to the Par Bond. Now look at the interest expense part. For the Par bond – it is say 50$ coupon per 1000$ par per half year. For the Premium Bond it would be less than the 50$ coupon. So the CFO is understated with respect to the Par Bond. Similarly do the analysis for the Discount bond with respect to the Par bond. CP
Dreary, here is a link to a more detailed explanation with an exampe of the CFF and CFO for bonds at premium or discount. Hope it helps: http://www.analystforum.com/phorums/read.php?11,668506,669937#msg-669937
Thanks cpk123 and map1 for the help. cpk123’s answer is an interesting twist on the problem, in which he is looking at how premium bonds and discount bonds differ from par bonds in terms of cash flows, hence comparing as overstated and understated. This should give the correct answer, and in a quick way, I must say. But it doesn’t help in seeing the details. The way it is explained by map1 is more to the point, but he lost me here: > The IE (what you record) will always be > ACTUAL cash flow (the coupon) so > the CFO is higher than it would have been otherwise => higher net CFO, CFO is > overstated. So, if I book $12k on interest when actual coupon cash payment is only $10k (discount bond), NI will be reduced by $12k instead of $10k, so it will be understated, not overstated! Lets say Sales =$100k, and assume no other expenses other than interest expense. In this case, NI will be $100k -$12k = $88k. CFO is equal to NI in this case. If we had deducted $10k then NI and CFO will be $90k. Therefore, CFO as reported ($88k) is $2k below what it should have been, $90k (i.e, it is understated). Still can’t see it 
The IE that you have on your income statement would be higher than the actual coupon (the actual outflow from operations), so in fact your actual net CFO (inflow minus outflow) is higher (because of a smaller actual outflow). The question is about the CFO, not NI.
It may help to think of it this way: for a premium bond, the coupon is equal to IE and ammortization, therefore only the IE portion SHOULD be reflected in CFO (the ammortization portion SHOULD be in CFF, so CFF is overstated)
Map1, I think the main point is still missing, and although I appreciate your explanation please bear with me to comment on what you said: > The IE that you have on your income statement would be higher than the actual coupon > (the actual outflow from operations), so in fact your actual net CFO (inflow minus outflow) is > higher (because of a smaller actual outflow). The question is about the CFO, not NI." 1. By definition, CFO is what you call net CFO, so there is no need to say net CFO. 2. What’s missing from all the explanation I’ve seen so far is the statement you will find as a footnote on page 470 of Reading 39. Here is what it says: “Under the indirect method, NI is adjusted by the change in bond disount/premium to derive CFO. Thus for teh first year, the cash flow statemnet will show an addback of $1612 in the premium case, and a deduction of $1612 in the discount case”. It is not adjusted by the interest or coupon payment, but by the CHANGE in bond premium/discount. This is the crux of the matter, thanks.
I agree that there is no need to call it net CFO, as long as you refer to the CFO as being the net result of inflows and outflows. Ok, bear with me; let’s get it from square 1, with full consideration given to CPK123 on the remark that when considering over/underestimation of CFF/CFO you compare these with the CFF/CFO of a par bond: A bond issued at a premium: CFF The price is greater than the face value. Price charged on the selling of the bond is a CFF inflow Returning the face value of the bond, at maturity, is a CFF outflow. The inflow is greater than the outflow, so you have a gain, a surplus from CFF. Compared to a bond issued at par, this gain is a surplus to what the CFF would have been, this is an overstatement of CFF in a premium bond compared to a par bond. CFO For a bond issued at a premium, the coupon rate > YTM. The coupon payment is a CFO outflow. Compared with a bond issued at par, when the coupon rate = YTM, in the case of the premium bond you pay more than the YTM, more than it would be the case for a par bond. This is why a premium bond understates your CFO (your CFO position is lower than it should have been, if you had issued the bond at par). A bond issued at a discount: CFF The price is smaller than the face value. Price charged on the selling of the bond is a CFF inflow Returning the face value of the bond, at maturity, is a CFF outflow. The inflow is smaller than the outflow, so you have a built in loss (a loss that is amortized along the life of the bond with the difference between what you actually pay – the coupon, and what you deduct, the YTM). Compared to a bond issued at par, this loss lowers what the CFF would have been; this is an understatement of CFF in a discount bond compared to a par bond. CFO For a bond issued at a discount, the coupon rate < YTM. The coupon payment is a CFO outflow. Compared with a bond issued at par, when the coupon rate = YTM, in the case of the discount bond you pay less than the YTM, less than it would be the case for a par bond. This is why a discount bond overstates your CFO (your CFO position is higher than it should have been, if you had issued the bond at par). NI is adjusted by the change in the bond discount/premium to address misclassifications of outflows between CFO and CFF. These misclassifications come from reporting the coupon payment, rather than the interest expense, as CFO outflow. For a bond issued at premium, the actual periodic cash outflow in the form of the coupon is higher than the YTM. The coupon is in fact partly interest expense, and partly repayment of principal, the Coupon (treated as CFO outflow) in fact includes some CFF outflow in it (the repayment portion). You end up deducting therefore more CFO and less CFF and you should have had, if you would have considered interest expense as CFO outflow and prepayment as CFF outflow. They balance each other by exactly the same amount, so the amount is the same. In the case of the premium bond, the $1612 represents the difference between the coupon payment (CFO that includes some CFF) and the interest expense (Exhibit 1 on lower page 467) for the first year. This is to reflect the misclassification of $1612 as CFO, so add it back to NI to get the real CFO. For a bond issued at discount, the actual periodic cash outflow in the form of the coupon is lower than the YTM, the difference amortizing your loss as it is included in the Bond Discount account (which is a liability counter account). Since your coupon is lower than the interest expense, the Coupon (treated as CFO outflow) is lower than it should have been (in fact the interest expense). You end up deducting therefore less CFO (because the part that you amortize is also interest expense). Again, CFO and CFF balance each other by exactly the same amount. In the case of the discount bond, the $1452 represents the difference between the interest expense and the coupon payment (Exhibit 1 on mid page 468) for the first year. This is to reflect the misclassification of $1452 , so deduct it from NI to get the real CFO.
thanks map1, I think we have nailed it! A small correction, you should comapre to market rate, not YTM.
yeap, it is the current market rate that allocates payments between principal and interest.