Straight Bonds

[jb207]

With amoritization of bond discounts, cash flow from operations (CFO) is overstated and cashflow from financing activities (CFF) is understated and vice versa for premium bonds. Could someone explain this to me? I'm thinking (for bond discounts) that CFO is overstated because of the higher interest expense and CFF is understated because of the initial 'low' financing inflow or PV. Am I on the right track in this thinking?

 

[hiredguns1]

jb, I think the source of your confusion lies in how interest expense is calculated, b/c everything else you've posted is accurate.

Let's consider the most extreme discount bond: a zero-coupon bond.

CFO is overstated b/c interest expense is understated, but why?

interest expense = book value of debt (i.e. its PV, which is lower) * interest rate

So b/c the book value is substantially lower than if the bond paid any sort of coupon, the expense is lower, and the impact is that CFO is overstated.

I found it helpful to work through several examples of discount bonds, market-rate and premium bonds to see how interest expense was calculated, how the carrying-value of the bonds changed, etc.

I hope I've remembered this correctly, feel free to chime in here folks...

 

[jb207]

thanks hiredguns...

so for a zero-coupon bond (low PV) CFO is overstated because of the low expense, which means a higher net income and higher cash flow???

so, CFF (financing cash inflow - or $$ received at issuance) would be understated because of the low PV.

Thanks for the input, knowing how interest expense is calculated helps!

 

[jb207]

Okay...the CFO is overstated for a zero-coupon bond or discount bond because they either don't pay a coupon or pay a very small coupon to the bondholder...which would make CFO higher.

Anyone feel free to correct me on this...