Accounting for Financial Modeling

Deferred Taxes due to OID & OIP

 Deferred Taxes

Amortization due to OID is not a tax deductible expense (reduces tax expense on income statement,
but not cash taxes paid)

However, when bond is redeemed at the end of bond’s maturity, the OID is tax deductible (loss on
extinguishment of debt)

The temporary difference between tax expense and cash taxes paid - leads to deferred tax assets
(less taxes will be paid in the future)

The opposite is true for OIP - leads to deferred tax liability (more taxes will be paid in the future)
 Example
Period Year 1 Year 2 Year 3 Year 4
Cash flow when bond sold and at maturity 1100 (1,000.0)
Coupon payments at 10% (100.0) (100.0) (100.0) (100.0)
Total cash flow 1100 (100.0) (100.0) (100.0) (1,100.0)

Implicit discount rate (IRR of total cash flows) 7.0%

1. Suppose that a company sold a bond with a face Bond opening balance 1,100.0 1,077.5 1,053.4 1,027.6
value of 1,000 for 1,100 (OIP is 100) at the beginning Bond opening balance x Implicit discount rate 77.5 75.9 74.2 72.4
of year 1; OIP amortization (22.5) (24.1) (25.8) (27.6)
Bond closing balance BS 1,077.5 1,053.4 1,027.6 1,000.0

2. The coupon rate is 10% payable annually (based on Cash interest expense 100.0 100.0 100.0 100.0
OIP amortization (22.5) (24.1) (25.8) (27.6)
the bond’s face value);
Interest expense IS 77.5 75.9 74.2 72.4

EBIT 250.0 250.0 250.0 250.0

3. Bond’s maturity is 4 years; Interest expense 77.5 75.9 74.2 72.4
EBT 172.5 174.1 175.8 177.6
4. Assume EBIT of 250 per year and income tax rate of Tax expense @25% 175.0 43.1 43.5 43.9 44.4
Net income IS 129.4 130.6 131.8 133.2
25%;
EBIT 250.0 250.0 250.0 250.0
Cash interest expense 100.0 100.0 100.0 100.0
5. Show the impact of interest expense on the income Gain on debt extinguishment 100.0
statement and balance sheet. EBT 150.0 150.0 150.0 250.0
Cash tax paid @25% 175.0 37.5 37.5 37.5 62.5
Net income 112.5 112.5 112.5 187.5

DTL opening balance 5.6 11.7 18.1

Tax expense @25% 175.0 43.1 43.5 43.9 44.4
Cash tax paid @25% 175.0 37.5 37.5 37.5 62.5
DTL closing balance BS 5.6 11.7 18.1 0.0