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Pre-funded Coupon and Zero-Coupon Bonds: Cost of Capital Analysis

In: Encyclopedia of Finance

Author

Listed:
  • Suresh Srivastava

    (University of Alaska Anchorage)

  • Ken Hung

    (Texas A&M International University)

Abstract

Pre-funded coupon bonds have been developed and sold by investment bankers in place of zero-coupon bonds to raise funds for companies facing cash flow problems. Additional bonds are issued and proceeds are deposited in an escrow account to finance the coupon payment. Our analysis indicates that a pre-funded coupon bond is equivalent to a zero-coupon bond only if the return from the escrow account is the same as the yield to maturity of the pre-funded issue. In reality, the escrow return is lower than the bond yield. As a result, the firm provides interest subsidy through issuing additional bonds which leads to higher leverage, greater risk and loss of value compared to a zero-coupon issue.

Suggested Citation

  • Suresh Srivastava & Ken Hung, 2022. "Pre-funded Coupon and Zero-Coupon Bonds: Cost of Capital Analysis," Springer Books, in: Cheng-Few Lee & Alice C. Lee (ed.), Encyclopedia of Finance, edition 0, chapter 4, pages 541-553, Springer.
    • Handle: RePEc:spr:sprchp:978-3-030-91231-4_4
    DOI: 10.1007/978-3-030-91231-4_4
    as

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