Question:
ABC Company receives $10 million for bonds carrying a coupon rate of 9%.
XYZ Company receives $10 million for bonds carrying a coupon rate of 11%.
Given that market interest rates at issuance for both the bonds stood at 10.5% and that both the bonds have a 10-year term to maturity, which of the following is least likely?
A) In Year 2, the book value of the bonds is higher on ABC’s financial statements compared to XYZ’s financial statements.
B) ABC records a higher outflow from operating activities each year.
C) The par value of ABC’s bonds is greater than that of XYZ’s bonds.
Solution:
The correct answer is mentioned as B
I understand that statement B is false as ABC pays lesser interest every year and so there is lesser CFO for ABC as compared to XYZ. But, I feel statement A and B is are also wrong.
We can see that ABC has issued a discount bond and XYZ has issued a premium bond.
B-> The book value will be increasing for ABC every year (but it would be still less than $10 million in Y2) and book value will be decreasing for XYZ every year (but it would be still greater than 10 million in Y2)
C-> Isn’t par value mean Face Value? So, why is it going to be different from ABC and XYZ?
Can someone let me know if I’m mistaken anywhere?
Option A is correct in this way, see ABC is a discount bond and XYZ is a premium bond. So, in year 2 When we will show book value of ABC than via pull to par affect that book value will be more than 10 million while book value of XYZ will be less than 10 million due to pull to par affect. Therefore A is right.
I had a doubt, I know B is wrong but I am confused here that how come cash out flow is more in XYZ because if it is premium bond than Coupon will be adjusted to premium amount right? while in ABC int is coupon+ amt. of discount. how outflow is more in XYZ?
The CFO will be higher in XYZ because the XYZ pays a higher interest and we will consider only the coupon payment for CFO
The CFO will be lower in ABC because the ABC pays a lower interest and we will consider only the coupon payment for CFO
Also Kunal, can you clarify as to how the par value of ABC’s bonds is greater than that of XYZ’s bonds?
ABC is discount bond and they received 10 million that shows its par value is more than 10 million. while XYZ is premium bond and they received 10 million too that means its par value must be less than 10 million. By this logic ABC’s par value is greater than XYZ’s par value.