CFA Practice Question

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CFA Practice Question

Jorgensen Products has just issued $25,000,000 in 4.50% annual coupon bonds at a market yield of 4.80%. The bonds have a maturity of 8 years. What adjustments would an analyst make to the CFO at the end of the first year?
A. Increase by 51,543
B. Decrease by 51,543
C. Decrease by 488,681
Explanation: Proceeds of bond issue: PMT = 1,125,000; I/Y = 4.80; FV = 25,000,000; N = 8; CPT PV = 24,511,316

Jorgensen will recognize this as a liability. Its annual interest will be 0.048 x 24,511,316 = 1,176,543.

Jorgensen records a CFO of -1,125,000 based on the coupon payment. The analyst would reduce the CFO by 51,543 to reflect the higher interest cost (= 1,176,543 - 1,125,000). Thus, CFO would be reduced by 51,543.

User Contributed Comments 12

User Comment
danlan The value of bond increases and CFO will be reduced.
danlan It's the bond price change from year 0 to year 1.
danlan Since interest expense > coupon, CFO decreases.
CoffeeGirl cause bond interest expense > coupon payment (CFO outflow)
Analyst must deduct the difference from CFO

so, if bond interest expenses < coupon payment (bond at premium ) analyst must add the difference to CFO
IslamKaddoumi check this out:
- This bond is issued at discount, it is value should be $24,511,316.
- Interest payment is 4.5%*$25,000,000 = $1,125,000.
- Interest expense reported on Income statement using the "effective interest rate method is $1,176,543.
- Diff. between $1,176,543 - $1,125,000 = $51,543 is the amortized value of the bond.
- since this bond is issued at discount, it is amortized value "non-cash" should be added back to net income to reconcile of CFO.

So I belive the answer should be an increase of $51,543.

any comments?
chantal I agree with Islamkaddoumi, since interest expense for accounting purposes ( 1 176 000) is superior to actual interest payment 1125000$) the portion of the expense not paid during the period which represents amortisation of discounts should be ADDED back to operating net income to obtain Cash Flows From Operations... this is consistent with notes
charlie both chantal and Islamkaddoumi talked about increase of CFF, but the question asks the change in CFO which should be the opposite!
jpducros IslmKaddoumi; For the issuer of a bond; Coupon payment is an outflow of Cash; and this outflow is classified in CFO. Natural outflow as you mentioned is coupon payment = -1125; while given the change in yield, correct outflow should be -1176; you then have to decrease CFO to reach the correct one. Hope it helps.
PeterL That doesn't help. Amortization of the bond's discount will be positive and will be recorded in CFO.
scottm8571 Bottom line here, since you paid out less cash than interest expense on the income statement, you have to add back the difference.

Bond discount amortization (higher interest expense than cash outlay)= add back

bond premium amortization (lower interest expense than cash outlay) = subtract difference
enetis The way I thought about it was since coupon Pmt was a cash outflow (negative #) you basically need to make it an even more neg # by reducing the CFO by 51,543, hence a larger "hypothetical" cash outflow (even though the diff is non cash and just amort).
something CFO should decrease, as it's the added amortization should effectively increase the outflow in CFO. Net effect should be increase in outflow , therefore negative.
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