Cash flow effects of bond premium/discount amortization
Date: August 26, 2008 11:04PM
Can someone explain how the amortization of a bond premium causes cash flow from operations to be understated, and cash flow from financing to be overstated?
I understand that a part of the amortization is affecting the balance sheet carrying value, which should be considered a CFF cash flow.
Date: August 27, 2008 12:14AM
Interest Expense on the IS = (Debt on BS) * (Interest rate when issued)
This number is supposedly the "true" interest expense
When a bond is issued at a premium, the coupon payment is higher than interest expense (This is because the coupon payment contains part interest expense and part principal repayment)
The coupon payment is subtracted when calculating CFO. If instead of subtracting coupon payment you had subtracted interest expense (the "true" measure) CFO would be higher.
Since CFO(coupon payment, actual) < CFO (if calculated using "true" interest expense)
CFF is overstated because it doesn't account for the principal repayment that is part of the coupon payment.
CFO is said to be understated
Hope that helps, please pardon the excessive use of quotations.
Date: August 27, 2008 01:06AM
First : Investors buy bonds on premium if.... coupon rate is higher than market rate.
Second : Therefore, a firm can pay high coupon and get bond issued at premium.
Third : A firm doing this... will get higher cash flow[i.e. more inflows] from financing...... (as cash received from issuance of bonds is CFF).
Fourth : The firm will pay higher coupon to bond investors. Coupon payment is outflow in CFO. A higher outflow will reduce the CFO. Thus CFO is understated.