Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024
:
Private EquityReal Estate Investing
Hedge Fund InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open

# Original Issue Discount (OID)

Step-by-Step Guide to Understanding the Original Issue Discount (OID)

Last Updated March 24, 2024

## How to Calculate OID

An original issue discount (OID) occurs when debt securities are sold below their redemption price.

If a debt instrument is sold at a discounted price lower than the redemption price – i.e. the par value – an original issue discount (OID) is created.

The original issue discount (OID) is the difference between the redemption price and the discounted offering price of the debt.

The standard reduction from the redemption price (i.e. the “haircut”) is around the 1% to 2% range.

The inclusion of an OID is most often related to making the debt offering more attractive to potential investors.

In such cases, since the bondholder purchased the bonds at a discount price lower than the par value, there is a greater chance of obtaining higher returns.

## OID Formula

The original issue discount is equal to the difference between the stated redemption price and the issuance price.

Original Issue Discount (OID) = Redemption PriceIssuance Price
• Redemption Price: The par value of the bonds, i.e. the amount obligated to be returned on the date of maturity.
• Issuance Price: The offering price that the bonds were sold for on the date of sale.

## Debt OID Calculation Example

Suppose that a company is attempting to raise \$100,000 in the form of debt.

To make the financing more marketable to potential lenders, the company offers to accept \$98,000 in capital rather than the entire \$100,000.

However, on the maturity date, the borrower is still obligated to pay back the full \$100,000 – plus the periodic interest expense, which is based on the stated interest rate and the \$100,000 principal.

• Borrower’s Perspective: The debt is issued at a discount to the par value (e.g. “98”), so the borrower receives \$0.98 for each dollar owed.
• Bondholder’s Perspective: On the other hand, the investor had to provide just \$98k but receives \$100k at maturity with interest payments based on the full principal instead of the actual financing amount.

In this example, given how the debt with a \$100,000 par value was sold for \$98,000, the OID equals \$2,000.

## Why Issue Debt with an OID?

Considering the issuer receives less than the full principal, it is reasonable to ask:

• “Why might a company decide to offer an original issue discount (OID) when raising debt?”

The original issue discount (OID) causes the debt issuance to be more appealing to potential lenders in the market, i.e. it is offered as a “deal sweetener” since the OID offers higher yields with less capital contributed.

The bondholder can then reinvest those leftover funds elsewhere, and the coupon payments are received at higher effective interest rates, increasing the total returns further.

While not always the case, the issuer could face difficulty raising enough capital to meet their total financing needs. The issuer’s credit health could be the reason, or the amount of debt raised could be concerning for risk-averse lenders (e.g. leveraged buyouts, “LBOs”).

###### OIDs and Interest Rate Environment

Companies seeking to raise debt capital in a high-interest rate market could be hesitant, given the risk of being stuck with high-interest expense payments over a long period.

If interest rates were to decline later, the high-interest rate bonds – i.e. priced above market – could soon burden the issuer.

Therefore, the risk is better mitigated by offering low-coupon or zero-coupon bonds with an original issue discount (OID).

## OID Bond Examples: Zero-Coupon and Coupon Bonds

Bonds are often issued at a discount – i.e. their offering price is lower than their par value.

Generally, there are two types of bonds with an OID:

1. Zero-Coupon Bonds: In most cases, bonds that pay zero interest are issued at an OID so that the amount that would have hypothetically been paid out as interest is received at maturity, i.e. the OID in zero-coupon bonds capture the excess of the redemption price over the issuance price.
2. Coupon Bonds: While coupon bonds pay out interest regularly, they can still carry an OID if the coupon is deemed too low relative to comparable investments.

Whether there are no coupons or relatively low coupons paid, the discounted issuance price positively impacts bondholder returns (e.g. yield to maturity)

## How Does an OID Impact the 3-Statements?

For original issue discount (OID) accounting, the OID is amortized across the borrowing term and treated as a form of taxable interest.

The OID must be amortized over the debt term and treated as non-cash interest, just like accounting for financing fees.

The three-statement impact of an OID is described below:

• Income Statement (IS): An annual OID amortization expense is recognized on the income statement for each period in the life of the borrowing (and usually) consolidated within the interest expense line item. The OID amortization reduces pre-tax income and net income in the current period.
• Cash Flow Statement (CFS): On the cash from operations section, the OID amortization is added back since it is a non-cash expense, which increases the ending cash balance (i.e. amortization is tax-deductible).
• Balance Sheet (BS): On the assets side, cash increases, which is offset by the increase in the book value of debt – but the face value of the debt remains constant.

## Original Issue Discount and Taxes (Phantom Tax)

Under U.S. GAAP, the OID amortization expense reduces the pre-tax income on the income statement over the borrowing term.

However, the actual taxes paid are not reduced – thus, there is a difference between the taxes reported for book and tax purposes.

Consequently, deferred tax assets (DTAs) are created from the temporary timing difference associated with the OID, which gradually reverses as the maturity date nears.

For the taxes owed by the bondholder to the IRS, the tax expense due could factor in the so-called “phantom income,” i.e. the difference between the original amount and guaranteed payout at maturity.

The positive gain will not be received until the date of maturity, but the bondholder can still be taxed on the phantom income before then.

## OID Calculator | Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Submitting...

## OID Calculation Example

Suppose that a company decided to issue OID bonds with a stated redemption price of \$1 million (“100”).

If the issuance price was offered at a 2% discount to the redemption price, the bonds were offered for \$980k (“98”).

• Issuance Price = \$1 million × (1 – 2%) = \$980k

The OID is the discount or the difference between the original face value and the price paid for the bond, so the OID amounts to \$20,000.

• Original Issue Discount (OID) = \$1 million – \$980k = \$20k

If we assume the amortization period, i.e. the term of the borrowing – is five years, the OID amortization is \$4k per year.

• OID Amortization Per Year = \$20k ÷ 5 Years = \$4k

In Year 1, the OID is \$20k and is reduced by \$4k in amortization per year, equaling zero by the end of Year 5.

As a general modeling best practice, we recommend wrapping the “MIN” function between the beginning OID balance and the amortization expense to ensure the OID does not decline below zero.

The \$4,000 OID amortization expense is added to the book value of the bonds each period, but recall that the interest expense on the bonds is based on the par value of the bonds.

While not applicable to our modeling exercise, the interest expense would still be based on the \$1 million redemption price, i.e. the face value of debt.

As the bond reaches maturity, the balance of the OID declines to zero, as the book value of the bonds returns to the \$1 million par value.

Step-by-Step Online Course

### Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Inline Feedbacks
Chaitanya
November 23, 2023 7:24 am

Hi,

When issuing bonds with OID, which price goes into the balance sheet initially? Redemption or issuance price?

November 24, 2023 1:31 pm

Hi, Chaitanya,

The B/S initially records the bond at issuance price, and then as the OID is amortized, the B/S is adjusted until it matches the redemption value at maturity.

BB

Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

The Wall Street Prep Quicklesson Series

### 7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.