Schweser mock - CFO question

discount, investment, question, net

Can anyone explain the logic here:

Acme Corp. wants to issue debt with proceeds net of issuance costs of $75 million. Acme reports under U.S. GAAP. Acme’s investment banker estimates that issuance costs and market yield will both be the same whether Acme issues premium or discount bonds to raise the $75 million. If Acme chooses to issue the premium bonds rather than the discount bonds, it will report:

A) lower net income during the bonds’ life.
B) higher interest expense during the bonds’ life.
C) lower operating cash flow during the bonds’ life.

They say that the higher cupons increase cash interest costs=>lower CFO (which I agree).
What I don't understand is why B is not correct as well....In other words, what's the difference between the cupon payments and the interest expense?

Thx

dotamasta

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发表于 2011-7-13 16:23 | 只看该作者

draz Wrote:
-------------------------------------------------------
> Can anyone explain the logic here:
>
> Acme Corp. wants to issue debt with proceeds net
> of issuance costs of $75 million. Acme reports
> under U.S. GAAP. Acme’s investment banker
> estimates that issuance costs and market yield
> will both be the same whether Acme issues premium
> or discount bonds to raise the $75 million. If
> Acme chooses to issue the premium bonds rather
> than the discount bonds, it will report:
>
> A) lower net income during the bonds’
> life.
> B) higher interest expense during the bonds’
> life.
> C) lower operating cash flow during the bonds’
> life.
>
> They say that the higher cupons increase cash
> interest costs=>lower CFO (which I agree).
> What I don't understand is why B is not correct as
> well....In other words, what's the difference
> between the cupon payments and the interest
> expense?
>
> Thx

Say you issue a 10 year annual coupon bond for $100. Coupon - 10%
If market rate is 11% - Discount bond. Proceeds = 94
Market rate is 9% - Premium bond. Proceeds = 106
Coupon Payment in either case = $10 (10% of 100)
Interest Expense in Discount bond = 11% of 94 = $10.34 (Higher than coupon)
Interest Expense in Premium bond = 9% of 106 = $9.54 (Lower than coupon)

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MythosHF

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发表于 2011-7-13 16:23 | 只看该作者

Interest expense is YTM times the carrying value of the bond while the cash interest cost is simply the actual coupon payments. Interest expense is an accounting figure (income statement) designed to estimate the cost of borrowing the market price amount at the YTM rate. A premium bond with the same principal value and with a higher coupon payment may have a higher interest expense, but this is the fault of the question for not specifying two key points: what feature of the bond is actually changing to produce a premium or discount; are coupon rates and maturities both dynamic?

It is possible that the coupon rate could remain the same while a changing maturity schedule could induce a premium or discount, but then the net interest expense differential would be a wash. If the maturity is assumed to remain the same, then coupon rates must be changing and would necessarily cause a higher interest expense. The question states that “market yield” remains static and I’ve never seen that term define a coupon rate, so I’m assuming this is either current yield or YTM and both terms indicate a changing coupon rate given the choice of a variable issue price.

Please correct me if I’m wrong… the wording of this question is a mind f*** as it seems to go either way.

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