Internal Revenue Bulletin: 2004-40 |
October 4, 2004 |
| 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.
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