Zero-Coupon Bonds and the Three Statements, Explained

The question

A company issues $150M face of zero-coupon bonds maturing in 4 years. The bonds are issued to yield 7% annually. Compute the issue proceeds, the Year 1 interest expense, and the carrying value at the end of Year 1. Then, describe the impact on the cash flow statement for Year 1, assuming the interest is fully tax-deductible and the tax rate is 25%.

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Study explanation

  • Issue proceeds (PV at 7% for 4 years) = $150M / (1.07)^4 = $150M / 1.3108 = $114.4M (approximately).
  • Year 1 interest expense = $114.4M × 7% = $8.0M (rounded).
  • Carrying value end of Year 1 = $114.4M + $8.0M = $122.4M.
  • Cash flow statement: There is no cash interest payment, so operating cash flow is higher than if the bond were coupon-bearing. The company gets a tax deduction for the accrued interest, saving $8.0M × 25% = $2.0M in cash taxes, which is a cash inflow to operations. Financing activities show the $114.4M inflow from issuance. At maturity, the company will have a $150M financing outflow.

Follow-up pressure:

  • If the company used straight-line amortization of the discount for book purposes, calculate the book interest expense for Year 1 and the deferred tax asset created (tax rate 25%).
  • What types of investors buy zero-coupon bonds, and why might an issuer choose this structure over a coupon bond in an LBO?
  • Suppose the company's EBITDA is $30M. Calculate the total leverage (using face value) and the interest coverage ratio based on accrual interest for Year 1. Comment on the divergence.

Yield curve: normal vs. inverted

3M2Y5Y10Y30Y
NormalInverted
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