I understand that in calculating for the “free cash flow to the firm,” I need to add the following for the non-cash charge:
But why do we subtract “amortization of long-term bonds premiums?” if someone could explain the fundamentals behind that, it would be much appreciated.
Because that is also non cash charge. Only actual coupon payments are cash flows and hence available to form.
premiums and discounts are just for balance sheet reporting
Recall that the amortization of a bond premium or discount decreases (premium) or increases (discount) interest expense. Thus, you subtract the amortization of a bond premium and add the amortization of a bond discount to get to cash flow.
In the first year of amortisation of the premium, would you say the same thing? I can’t fathom why we would subtract it. Agreed that interest expense reduces as we go down the line from issue date, but how can you say for sure that reduced interest expense led to inflated net income and the need to subtract amortisation of premium. Please explain it with an example. Much appreciated.
You may be complicating the picture a bit here. I’m not saying that net income is inflated. All I’m saying is that the amortization of the bond premium/discount doesn’t involve cash (similar to depreciation), so we need to make an adjustment to net income to arrive at cash flow (as with depreciation). Would you say that net income is deflated because we had depreciation expense on the income statement (in years 2 – n)?
Hopefully this helps…
If a company issues a $1,000 par bond for $1,100 (premium), they will amortized the difference ($100) over some period. This will result in an lower Interest Expense on the Income Statement (leading to higher net income) than the actual coupon payment (outflow on the Cash Flow Statement). This is because the interest rate embedded in the bond is higher than market rates (which is why it was sold at a premium). When looking at the accounting behind it, you will see the Interest Expense on the Income Statement reflects the lower market value rate, and the cash outflow from the coupon payment on the Cash Flow statement reflects the higher embedded interest rate (the difference being the premium). So when you reconcile Net Income and Operating Cash flow, you will have to deduct the premium (non-cash charge) from Net Income because it was higher (reference sentence 2).
I attached a link to help sort out the accounting behind it.