FSA Q

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hyang

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Compared to issuing PAR coupon bonds, a firm that issues premium bonds of equal value will have:
A. lower CFO and higher CFF in the second year after issuance.
B. interest expense that is less in the third year after issuance.
C. lower CFF in the year of issuance.
D. lower net income in the early years after bond issuance.
 
My guess would is B because as the bond liability goes amortizing down towards par, the interest expense decreases.
 
D, higher interest expense from a higher liability bond will result in lower net income.

Why the others are wrong:

A. CFF is only considered at inception and ending of the financing
B. This doesn't happen, liability will always be higher. Premium bond converges to par, par bond is already at par.
C. Higher CFF for the premium bond. You receive more money up front.
 
Hi Thealiman,

y is D as amortisation will reduce interest payment. It should high net income
 
Yes keanhu, it will reduce interest payment, but comparatively to a bond already issued at par, its interest payment will be higher
 
I'm with B because interest expense will be lower in subsequent years for a premium bond. (Session 9 | Reading 39 | LOS b)

However, D also sounds right because higher early year interest expense results lower early year income.
 
Some of these questions are confusing or like me, if you read too much into them, they don't make sense.

I think it is B though. Int exp would be less on a bond which has its premium amortized for 3 yrs, vs. when it was right out of the gate.
 
I def think it is B after re-reading the question...

if they issued par bonds...their int would be constant throughout the life...if it was premium bonds...int exp becomes less as amort becomes more as it converges to par....so 3rd year int exp would be less than 1st year int exp....and vice versa for amort

so definitely think it is B.

what's the answer?
 
I'm with D, for you B guys, remember the question is asking us to compare the premium bond to a par bond, not the difference between years of the premium bond.

Hyang, you have the answer??
 
i hear you...yet another question that is ambiguous...

but look at my last posting....a par bond will have int exp constant, right?...whereas a premium bond will have decreasing int expense as the amort gets higher (off the flat coupon rate)...so int expense for the premium bond will be less in 3 yrs for a premium bond vs a par bond....
 
cfabaino Wrote:
-------------------------------------------------------
> I'm with D, for you B guys, remember the question
> is asking us to compare the premium bond to a par
> bond, not the difference between years of the
> premium bond.
>
> Hyang, you have the answer??


B still makes more sense because

For premium bond - interest exp in third year is less than at issuance
For par bond - all year int exps are the same
 
you're right it will have decreasing int expense, however the interest expense will always be higher than the par bond until maturity....greater int expense at a decreasing rate.
 
actually now that i tihnk about it...wont a premium bond have less int exp...the int exp is the coupon rate minus the amort of premium....so the bond with the premium will actually have a lower int exp vs the one at par....hence the cfo is understate with a premium bond...
 
Sorry guys, I missed your discussion. Stressed out and went to sleep after posting.

B is the correct answer. Yet I can't think of anything wrong with D though - so I guess B is more right than D in this case. Imagine have to get this right in 1.5 min.!!!
 
cfabaino Wrote:
-------------------------------------------------------
> you're right it will have decreasing int expense,
> however the interest expense will always be higher
> than the par bond until maturity....greater int
> expense at a decreasing rate.

I got confused for a while. however I am still with B after checking CFA text.

Please see CFA's FSA book page 471 (exbt 2). It explains well why B is the correct answer.
 
i hear you...im on the same boat...i need to take a break and go to the gym...my head is about to pop.

did you read my post above?....i think D is wrong because with a premium bond...you are paying less int exp than a par bond...remember for a premium bond the coupon pmt is the int exp plus premium amort...versus par bond is coupon equals int exp....so NI would be higher for a premium bond via less int exp...

maybe ur getting confused with a discount bond?...in that case D would be right...
 
FYI - does anyone know what time the big 12 and SEC championship games are next sat?...hopefully they are after 6pm - when this test is over.
 
wow, lesson learned.

but can someone confirm this for me....not that this will change the answer, but to the point of why D is wrong and not just "less right".

(1) If we keep the market rate constant and lower the coupon rate to make it a premium bond then interest expense is higher for a premium bond, than it would be for a discount bond if you raised the coupon ???

(2) Conversely and what this question assumes, if you hold the coupon constant and change the market rate (price) to make it a premium bond, premium bonds interest expense is actually lower than a discount bond when you do the opposite.

this is something i totally overlooked.
 
D is wrong because par bond interest expense is actually higher than premium bond for bond life because premium is amortized whereas par is not.

so premium in fact should have higher net income than par.

Please see CFA's FSA book page 471 (exbt 2). it makes more sense then.
 
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