Zero-coupon bonds and Maturity

CFA Level I FRA
#1

All,

I didn’t get this EOC question at all.

A company needs to raise 10 million euros. If the company chooses to issue zero-coupon bonds, its debt to equity ratio will most likely:

a) rise as the maturity date approaches

b) decline as the maturity date approaches

c) remain constant throughout the life of the bond.

OA is A.

I chose B because I thought that as the maturity date approaches, the bond will be amortized until maturity so that the company doesn’t end up showing expenses of 10 million euros at maturity. Hence, as the bond is amortized, the debt will go down. (i.e. the contra-liability account,“discount on bonds pay,” in case of a discount bond, will increase, or liability account “premium on bond pay”, in case of a premium bond, will decrease. There are no coupon payments required in this one. ) However, the OA is A. I am not sure why. Can someone please help me?

Thanks in advance.

#2

Zero-coupon bonds are issued at a discount, which will be amortized over the life of the bonds. Thus, the liability will start out low (well below par), but will increase to par on the maturity date. Simultaneously, the increase in interest expense caused by the discount amortization will raise the company’s interest expense, lowering its net income, and reducing the increase in its retained earnings. The upshot is that you’re to conclude that debt-to-equity will rise.

However, without any knowledge of the company’s earnings, this is a superficial analysis. If their earnings are sufficiently high, so that the percentage increase in equity is higher than the percentage increase in debt, then their debt-to-equity ratio will, in fact, fall.

I know what they were trying to do with this question, but they failed.

1 Like
#3

Hello S2000magician,

Your responses are really helpful. I am not sure about one thing — When a debt (bond) is issued, the selling price is recorded as Cash (Assets). Now for Liabilities + Owners’ Equity part, a liability equal to the face value is recorded and a contra-account, “discount on bonds pay”, is increased until maturity, aka amortization of interest. Right?

If so, there won’t be any question of increasing the liability until maturity of the bond because the future liability would already have been recorded at the time of issuing the bond. I am still not clear. Can you please help me?

thanks in advance.

#4

You’re reducing the contra account, which increases (net) liabilities.

#5

Oh thanks, S2000magician. I refered to my notes. My mind mixed Premium with Discount bonds. Sorry about this.

thanks

#6

My pleasure.