Understanding Original Issue Discount (OID)

What is an OID?

An Original Issue Discount (OID) refers to a feature of debt financing where the issuance price is less than the stated redemption price. In simpler terms, OID occurs when debt securities are sold below their redemption price, which is the par value.

How to Calculate OID

An OID is created when debt instruments are sold at a discounted price lower than their redemption price. The formula for calculating OID is:

OID = Redemption Price − Issuance 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.

Example of OID Calculation

Suppose a company wants to raise $100,000 in debt. To make the financing more appealing, the company offers to accept $98,000 in capital. However, on maturity, the borrower still has to pay back the full $100,000 plus periodic interest based on the stated interest rate and the $100,000 principal.

Borrower’s Perspective: The debt is issued at a discount (e.g., “98”), so the borrower receives $0.98 for each dollar owed.

Bondholder’s Perspective: The investor provides $98k but receives $100k at maturity with interest payments based on the full principal.

In this example, the OID is $2,000 ($100,000 - $98,000).

Why Issue Debt with an OID?

Companies issue debt with an OID to make the offering more attractive to potential investors by offering higher yields with less capital contributed. This strategy is often used when:

The issuer faces difficulty raising capital due to credit health concerns or the amount of debt raised.

The market has high-interest rates, and the issuer wants to mitigate the risk of high-interest expense payments over a long period.

OIDs and Interest Rate Environment

In a high-interest rate environment, companies might offer low-coupon or zero-coupon bonds with an OID to avoid being burdened with high-interest payments if rates decline later.

Types of Bonds with OID

Zero-Coupon Bonds: Bonds that pay zero interest are issued at an OID, capturing the excess of the redemption price over the issuance price.

Coupon Bonds: These can still carry an OID if the coupon is too low relative to comparable investments.

Impact of OID on Financial Statements

The OID is amortized over the borrowing term and treated as a non-cash interest expense:

Income Statement (IS): An annual OID amortization expense is recognized, reducing pre-tax income and net income.

Cash Flow Statement (CFS): The OID amortization is added back as it is a non-cash expense, increasing the ending cash balance.

Balance Sheet (BS): Cash increases on the assets side, offset by the increase in the book value of debt.

OID and Taxes (Phantom Tax)

Under U.S. GAAP, the OID amortization reduces pre-tax income, but actual taxes paid are not reduced, creating deferred tax assets (DTAs). Bondholders can be taxed on "phantom income," the difference between the original amount and guaranteed payout at maturity, even if the positive gain is not received until maturity.

Example: OID Calculation and Amortization

Assume a company issues bonds with a stated redemption price of $1 million at a 2% discount, resulting in an issuance price of $980k. The OID is $20,000 ($1 million - $980k). If the borrowing term is five years, the annual OID amortization is $4k ($20k ÷ 5 years).

Disclaimer

The information provided here is for educational purposes only and should not be considered financial advice. Always consult with a qualified financial advisor before making investment decisions.