Internal Revenue Bulletin:  2004-40 

October 4, 2004 

APPENDIX

Examples
Issue Price $8.97 Expected Yield 8.455%
Expected Cash Flows:        
Year 0 (8.97)      
Year 1 5.00      
Year 2 2.50      
Year 3 1.50      
Year 4 1.00      
Year 5 0.50      
         
If pays as expected:        
End AIP Payments Beg. AIP OID  
4.73 5.00 8.97 .76  
2.63 2.50 4.73 .40  
1.35 1.50 2.63 .22  
0.46 1.00 1.35 .11  
0 0.50 0.46 .04  
      1.53  
Actual Yield 8.455%  
If pays faster than expected:
End AIP Payments Beg. AIP OID  
1.89 5.00 8.97 (1.11)  
1.05 1.00 2.86 (0.35)  
0.54 0.60 1.50 (0.19)  
0.18 0.40 0.72 (0.09)  
0 0.20 0.23 (0.03)  
      (1.77)  
Actual Yield -12.397%  
Holder’s OID Income under Current Rules (w/Negative OID prohibition):
Year 1 0      
Year 2 0      
Year 3 0      
Year 4 0      
Year 5 0      
1.77 loss at maturity        
         
Holder’s OID income under Proposal allowing Negative OID:
Year 1 (2.08)loss      
Year 2 0.16      
Year 3 0.09      
Year 4 0.05      
Year 5 0.02      
Overall income (1.77)        
ALTERNATIVE METHOD EXAMPLE
Examples:        
Investment/Issue Price $8.97 Expected Yield 8.455%
Total expected return: $10.50    
Example 1        
         
Expected Cash Flows:
Year 0 (8.97)      
Year 1 5.00      
Year 2 2.50      
Year 3 1.50      
Year 4 1.00      
Year 5 0.50      
(Offset amounts in bold.)
         
Year 1        
payments for year/total expected payments = 5/10.5 = .47
ratio multiplied by investment = .47(8.97) = 4.27
         
Year 2        
2.5/10.5 = .23        
.23(8.97) = 2.14
         
Year 3        
1.5/10.5 = .143        
.143(8.97) = 1.28
         
Year 4        
1/10.5 = .095        
.095(8.97) = .85
         
Year 5        
.5/10.5 = .047        
.047(8.97) = .43        
         
[4.27 + 2.14 + 1.28 + .85 + .43 = 8.97]
         
Example 2        
         
If the expected return is not updated, the holder won’t recover its investment.
Actual Cash Flows:        
Year 0 (8.97)      
Year 1 5.00      
Year 2 1.00      
Year 3 0.60      
Year 4 0.40      
Year 5 0.20      
Year 1        
5/10.5 = .48        
.48(8.97) = 4.27
         
Year 2        
1/10.5 = .095        
.095(8.97) = .85
         
Year 3        
.6/10.5 = .06        
.06(8.97) = .51
         
Year 4        
.4/10.5 = .04        
.04(8.97) = .34        
         
Year 5        
.2/10.5 = .02        
.02(8.97) = .17
         
[4.27 + .85 + .51 + .34 + .17 = 6.14]
         
Example 3        
         
If you update the expected return after year 1:
Actual Cash Flows:        
Year 0 (8.97)      
Year 1 5.00      
Year 2 1.00      
Year 3 0.60      
Year 4 0.40      
Year 5 0.20      
Year 1        
5/10.5 = .48        
.48(8.97) = 4.27
         
After year 1, total expected return is 7.20 (5+1+.6+.4+.2):
         
Year 2        
1/7.2 = .14        
.14(8.97) = 1.25
         
Year 3        
.6/7.2 = .08        
.08(8.97) = .75
         
Year 4        
.4/7.2 = .06        
.06(8.97) = .50
         
Year 5        
.2/7.2 = .03        
.03(8.97) = .25
         
[4.27 + 1.25 + .75 + .50 + .25 = 7.02]

If the holder recalculates Year 1, using the new total expected return ((5/7.2)(8.97)) = 6.23), and takes into account the difference between that amount (6.23) and the amount calculated using the original expected return (4.27), which equals 1.96, the holder will recover its total investment.


More Internal Revenue Bulletins