Zero Coupon Bond Cash Flows

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CFABLACKBELT

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Nomad Company issued $1,000,000 face value 2-year zero coupon bonds on December 31, 20X2 to yield 8% interest. Bond proceeds were $857,339. In 20X3 Nomad recorded interest expense of $68,587. In 20X4 Nomad recorded interest expense of $74,074 and paid out $1,000,000 to redeem the bonds.
Based on these transactions only, Nomad’s Statement of Cash Flows would show cash flow from operations (CFO) of:
A) -$68,587 in 20X3 and -$74,074 in 20X4.
B) -$142,661 in 20X4.
C) -$1,000,000 in 20X4.
D) zero in all years.
 
is it D? because CFO is unaffected by interest on zero coupon bond
 
I would understand that they only ask about real cash flows and not about any adjustments? In case of asjustments I would add back to net profit interest expenses in both years to eliminate impact of non-cash items.
What do you think?
 
I think the question is confusing. Anyway, I agree with tgrycner. You subtract interest expense to get to net income. When interest expense is a cash expense, it does not affect CFO (at least under US GAAP). However, when interest expense is a non-cash expense (e.g., for a zero-coupon bond), you need to add it back to reconciliate net income and CFO. So it should be +$68,587 in 20X3 and +$74,074 in 20X4 - which is the opposite of A, B and C do not look right, so D (though I must confess I am still not clear about what the question is asking!).
 
D would be the correct choice. Zero coupon bonds don’t make interest payments. The analyst would adjust the CFO (downward) because otherwise, it’ll be overstated when comparing this company to others that issue coupon debt.
 
Why should analyst adjust CFO downward? Hasn’t it already been “adjusted”? I mean net income already includes interest expense?
If lwebb01 says that D is correct you say there is no adjustment am I right?
The analyst should just not eliminate interest expense from CFO in order to make FS of that company comparable to those companies that issue not pure discount bonds?
But anyway the interest expense in case of interest bearing bonds may differ from the real cash flow so is CFO much more comparable if we don’t eliminate interest expense?
 
I’m pretty sure D is correct. Since zero coupon bonds do not make interest payments there is no cash flow and accordingly CFO should not be affected.
Coupon rate rather than interest expense is used to calculate CFO - that’s what leads to CFO and CFF being over or under stated when bonds issued at a premium or discount.
Look at Study Session 9: Reading 39: LOS B&C
 
Yeah, I understand that interest expense does not usually equal real cash outflow and therefore must be adjusted.
But you make an adjustment to CFO and how it all affects CFF?
 
It is a non cash interest expense which is used to ammortize the discount on the Balance sheet. As maturity approaches the B/S value gets closer to face value.
At maturity the whole amount $100,000 is payed and is treated as a repayment of principle. In practice therefore the whole amount is adjusted from CFF. The answer I would therefore say, is D.
As analysts we know that the interest expense as recorded is inherent in the repayment of our principle amount. We know therefore that CFO is overstated by the amount of interest in 03 and 04 and CFF understated by that much, but im pretty sure that’s not what the question is asking. The question is simply asking how this would be recorded in the books and NOT how as analysts we view the result (under and over statements) or adjust accordingly.
Hisham
 
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