honeycfa

A zero coupon bond, compared to a bond issued at par, will result in higher:

A) interest expense.

B) cash flows from financing (CFF).

C) cash flows from operations (CFO).

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The zero-coupon bond will have higher cash flows from operations, as the cash interest expense in this case is zero and no cash is paid until maturity. Candidates should remember that any bond issued at a discount will have more cash flow from operations and less cash flow from financing.

honeycfa

Which of the following statements is FALSE? When a bond is issued at a discount:

A) the interest expense will be equal to the coupon payment plus the amortization of the discount.

B) cash flows from financing will be increased by the par value of the bond issue.

C) the interest expense will increase over time.

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Upon issuance, cash flow from financing will be increased by the amount of the proceeds.

honeycfa

A $1,000 bond is issued with an 8% semiannual coupon rate and 5 years to maturity when market interest rates are 10%. What is the initial liability?

A) 923.

B) 855.

C) 1023.

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FV = 1000; PMT = 80/2; N = 5 × 2; I/Y = 10/2; solve for PV = 923.

honeycfa

A company sells a long-term, zero-coupon bond. The company’s cash flow from operations in subsequent years, compared to what it would have been if the company had issued debt at par for the same proceeds, will be:

A) understated.

B) properly stated.

C) overstated.

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Cash flow from operations (CFO) is systematically “overstated” when a zero-coupon bond is issued because the interest on a zero-coupon bond never reduces operating cash flow. The amortization of the bond discount at maturity is charged to financing cash flow when, in fact, it should be charged against CFO. Thus, CFO will be overstated.

honeycfa

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) zero in all years.

C) -$142,661 in 20X4.

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All of the cash flows for zero coupon bonds are included in cash flow from financing activities and none in cash flow from operations.

honeycfa

The real estate group of a manufacturing company needs to finance a large construction project. The CEO wants to use zero coupon bonds, because “they are easy to understand.” The Executive Vice President (EVP) recommends a bond issued with a coupon rate greater than the current market rate of interest. A consultant recommends a bond issued at par. Regarding the financial and cash flow impact, which of the following statements is least accurate? All else equal, if the company follows the:

A) CEO's recommendation, there will be no impact on cash flow from operations.

B) EVP's suggestion, both the cash flow from financing and cash flow from operations will be understated compared to that of the par value bond recommended by the consultant.

C) EVP's suggestion, interest expense will decrease over time.

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If the company issues a premium bond (defined as coupon rate greater than the current market rate), the cash flow from financing will be overstated and cash flow from operations will be understated compared to the par value bond recommended by the consultant.

The other statements are true. With the premium bond, interest expense decreases over time because the carrying value of the bond decreases as the unamortized premium decreases by the difference between the coupon payment and the interest expense (market rate times carrying value.) All cash flows for a zero-coupon bond are financing cash flows, but the bond still has interest expense (used to amortize the unamortized discount account).

honeycfa

An analyst is considering a bond with the following characteristics:

• Face value = $10.0 million
• Annual coupon = 5.6%
• Market yield at issuance = 6.5%
• 5 year maturity

At issuance the bond will:

A) provide cash flow from investing of approximately $9.626 million.

B) increase total assets by $9.626 million.

C) increase total liabilities by $10.0 million.

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First we must determine the present value of the bond. FV = 10,000,000; PMT = 560,000; I/Y = 6.5; N = 5; CPT → PV = 9,625,989, or approximately $9.626 million. At issuance, the university will receive cash flow from financing of $9.626 million.

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Using the effective interest method, the interest expense in year 3 and the total interest paid over the bond life are approximately:

Year 3 Interest Expense

Total Interest

A) $560,000 $2.80 million

B) $634,506 $3.17 million

C) $560,000 $3.17 million

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• Interest expense in any given year is calculated by multiplying the market interest rate (at time of issuance) by the bond carrying value. For example, in year 1, interest expense = 9,625,989 × 0.065 = 625,689. Since the coupon payment = 10,000,000 × 0.056 = 560,000, the interest expense is “too high” by 65,689, and the carrying value of the bond is increased (through a decrease in the unamortized bond discount account) to $9,691,678. In year 2, using a similar calculation, the carrying value of the bond increases to $9,761,637. Thus, the interest expense in year 3 = 9,761,637 × 0.065 = 634,506, or approximately $0.635 million.

   

• Total interest expense is equal to the amount paid by the issuer less the amount received from the bondholder.

Amount paid by issuer = face value + total coupon payments
= 10,000,000 + (0.056 × 10,000,000 × 5) = 12,800,000
Total interest paid over the life = 12,800,000 – 9,625, 989 = 3,174,011, or approximately $3.2 million.

honeycfa

On December 31, 2004, Newberg, Inc. issued 5,000 $1,000 face value seven percent bonds to yield six percent. The bonds pay interest semi-annually and are due December 31, 2011. On its December 31, 2005, income statement, Newburg should report interest expense of:

A) $300,000.

B) $350,000.

C) $316,448.

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Newberg, upon issuance of the bonds, recorded bonds payable of (N = (2 × 7) = 14, PMT = $175,000, I/Y = (6/2) = 3, FV = $5,000,000) $5,282,402. Interest paid June 30, 2005, was ($5,282,402 × (0.06 / 2) =) $158,472. The coupon payment was $175,000, reducing bonds payable to ($5,282,402 – ($175,000 - $158,472) =) $5,265,874. Interest paid December 31, 2005, was ($5,265,874 × (0.06 / 2) =) $157,976. Total interest paid in 2005 was ($158,472 + $157,976 =) $316,448.

honeycfa

Assume a city issues a $5 million bond to build a new arena. The bond pays 8 percent semiannual interest and will mature in 10 years. Current interest rates are 9%. Interest expense in the second semiannual period is closest to:

A) $106,550.

B) $210,830.

C) $80,000.

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Step 1: Compute the present value of the bond: Since the current interest rate is above the coupon rate the bond will be issued at a discount.

FV = $5,000,000; N = 20; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,674,802

Step 2: Compute the interest expense at the end of the first period.

= (0.045)(4,674,802) = $210,366

Step 3: Compute the interest expense at the end of the second period.

= (new balance sheet liability)(current interest rate)

= $4,674,802 + $10,366 = $4,685,168 new balance sheet liability

(0.045)(4,685,168) = $210,833

honeycfa

A bond is issued with the following data:

• $10 million face value.
• 9% coupon rate.
• 8% market rate.
• 3-year bond with semiannual payments.

Assuming market rates do not change, what will the bond's market value be one year from now and what is the total interest expense over the life of the bond?

Value in 1-Year

Total Interest Expense

A) 10,181,495  2,962,107

B) 11,099,495  2,437,893

C) 10,181,495   2,437,893

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To determine the bond's market value one year from now: FV = 10,000,000; N = 4; I = 4; PMT = 450,000; CPT → PV = $10,181,495.

To determine the total interest expense:

1. FV = 10,000,000; N = 6; I = 4; PMT = 450,000; CPT → PV = $10,262,107. This is the price the purchaser of the bond will pay to the issuer of the bond. From the issuer's point of view this is the amount the issuer will receive from the bondholder.
2. Total interest expense over the life of the bond is equal to the difference between the amount paid by the issuer and the amount received from the bondholder.

[(6)(450,000) + 10,000,000] – 10,262,107 = 2,437,893