Zero Coupon Bond, Convertible bond, Bond with warrant, Redeemable Preferred Stock

Zero Coupon Bond
Also know as pure discount instrument.

For an extreme case of a discounted bond issue, the coupon rate is 0, so the entire interest expense goes towards amortization of the bond discount.

The carrying value of the bond grows towards par over the life of the bond. Recognized interest expense for each period by applying discount rate to book value (i.e. effective interest method or PV amortization method)

Convertible Bond:
The conversion option is ignored in accounts upon issuance and the bond is booked in the same way as non-convertibles. Option is undetachable and the interest expense of the convertible is lower {due to the conversion option the firm gives to bondholders, which is not reflected in liabilities}.

Upon conversion, reclassified from debt to equity in balance sheet.

Bond with warrant:
Option is detachable and as a sweetener , proceeds from issuance of bonds should be split into 1) pure bond valued treated as debt 2) options is treated as equity.

GAAP requires the issuer to calculate the fair value and report the warrant separately in stockholders’ equity. Accounting for bonds with warrants is closer to economic reality than that of convertible bonds.

How should an analyst treat convertibles:
· If current stock price < conversion price, treat like an ordinary bond (debt).
· If current stock price > conversion price, treat like equity.
· If current stock price is close to the conversion price, choose the more conservative treatment.

Alternatively, use option-adjusted yield as the true cost of debt.

Redeemable preferred stock:
Often recorded as a separate item between equity and debt.

Analyst should
· treated as debt and its dividends as interest payments for purpose of analysis.