Original Issue Discount (OID) on Bonds, Explained
The question
A company issues $400M face value of 5-year bonds with a stated annual cash coupon of 3%. At issuance, the bonds are priced to yield an effective annual rate of 5%, producing initial proceeds (and initial carrying value) of $365.0M. The company uses the effective-interest method for book and tax. Tax rate is 30%. For Year 1, calculate: total interest expense, cash interest paid, OID accretion, the Year-end carrying value, and the cash tax savings from the interest deduction. Round to one decimal.
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Study explanation
- Total interest expense = initial carrying value × effective rate = $365.0M × 5% = $18.3M ($18.25 rounded to one decimal).
- Cash interest paid = face value $400M × 3% = $12.0M.
- OID accretion = total interest − cash interest = $18.3M − $12.0M = $6.3M.
- Year-end carrying value = $365.0M + $6.3M = $371.3M.
- Tax shield: the company deducts the full $18.3M of interest, saving cash taxes of $18.3M × 30% = $5.5M. The cash tax saving exceeds the tax shield that would be obtained if only the $12.0M cash coupon were deductible ($3.6M), demonstrating the cash-flow benefit of OID.
Follow-up pressure:
- If the company were a private entity that used straight-line amortization of the OID for book purposes, compute the book interest expense for Year 1 and explain the deferred tax asset or liability that arises from the difference with the constant-yield tax deduction.
- At maturity, the company must repay $400M in cash. If its cash balance at the end of Year 4 is $300M, walk me through the refinancing risk that OID creates versus a par bond.
- Why might a credit agreement require that the face value of OID bonds be included in total debt rather than the carrying value?
Yield curve: normal vs. inverted
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