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September 4, 2017 at 9:30 pm
In Example 8, since debentures are redeemed at premium of 10% at the end of 5 years, wont there be an expense of $2 each year (which in itself is not a cash flow) but it will reduce the tax expense by 2*30% = 0.6 each year .
Why is this not taken into account for calculating cost of capital?
August 5, 2017 at 2:45 pm
Thanks again for such wonderful lectures.
For the sake of my confusion, for Example 8 when we are calculating cost of debt to the company, wouldn’t it make more sense that the cash flow in Time0 (issue of debt) a positive 85, while the payment of interest and redemption from Time1-5 negative 6 p.a. and negative 110 at Time5?
John Moffat says
August 5, 2017 at 5:13 pm
If you want to do that then fine – the IRR will still be the same. (All the signs will be reversed, but and NPV of +0 is the same as and NPV of -0).
The reason why we tend to show the flows the way we do is that we are used to having the flows this way when calculating the IRR of projects. Reversing the signs can make it more confusing for some people.
July 10, 2017 at 2:51 pm
Sir in the any question for redeemable debt if it is asked find cost of bebt , do we need to find investors required rate of return or cost to company?
July 10, 2017 at 3:27 pm
If you are asked to find the cost of debt then that is the cost to the company.
February 19, 2017 at 3:00 pm
Amazing lectures thank you!
I want to clarify something regarding example 8.
I understand the use of IRR in determining the interest rate – choosing two different percentages and hence you used 10 and 15.
What I don’t understand is why did you not use a DF of 7% ( 6 the debentures rate /85 the ex int) as you did in example 7 to calculate the Re (return on investment).
I thought the DF % to use is usually the same % as the rate of investors return.
February 19, 2017 at 3:45 pm
In example 7, the debt is irredeemable and then we can use coupon rate/market value
In example 8, the dent is redeemable and then we have to calculate the IRR.
(You could calculate the IRR for example 7 if you wanted, but not only would it obviously take longer, but the answer would only be approximate whereas here it is exact.)
February 19, 2017 at 8:20 pm
That makes perfect sense. Thank you for the super fast reply 🙂
February 20, 2017 at 6:46 am
You are welcome 🙂
November 15, 2016 at 3:36 pm
As we studied that the cost of bank loan is “Interest * (1 – t)” because there is no premium or discount when redeemed at the end of the loan.
In Kaplan book, it is mentioned:
“Where the debt is redeemable at its current MV, the position of the investor is the same as a holder of irredeemable debt.”
Does both of the statements have the same meaning?
Can you please explain by numbers i.e., how come the return is same for redeemable and irredeemable debts?
Thanks as always,
November 15, 2016 at 5:03 pm
If you want numbers, then you must ask in the Ask the Tutor Forum and not as a comment on a lecture.
The two statements do mean the same. The cost of the debt is obviously the interest that has to be paid, and in the case of redeemable debt repayable at a premium, then the premium makes the overall cost higher.
If there is no premium, then the cost is only that of the interest.
November 17, 2016 at 10:18 am
You did not say anything about discount. Is there any debt that is redeemed at discount ? What will be the effect of the discount on the overall cost ?
November 17, 2016 at 4:05 pm
No – debt is either redeemed at par (nominal value) or at a premium.
November 5, 2016 at 3:32 pm
Thank you for such lectures.
I have TWO questions:
1. I was proofing that the NPV is ZERO at 11.86%.
MV = -85
Interest =(6*5)/((1+0.1186)^5) = 17
Repayment =110/((1+0.1186)^5) = 63
NPV = -5
Can you please comment on the above calculation as I am getting -5 as NPV.
2. Why the investors require the IRR rate (where NPV is ZERO)? As an investory they should require positive NPV which will result in gain for them. Please comment.
November 6, 2016 at 6:42 am
Question # 1 solved. I should have expanded the interest payments and discount them individually.
Question # 2 remains. Why the investors require the IRR rate (where NPV is ZERO)? As an investor, they should require a positive NPV which will result in gain for them. Please comment.
November 6, 2016 at 7:51 am
Have you watched the earlier lectures on the valuation of debt?
It is the investors who determine the market value of debt – they get the return they require by fixing the market value at the PV of the future receipts. All we are doing here is ‘working backwards’ to find out what that required return is.
noor mohamed hassan says
May 15, 2016 at 6:40 pm
excellent lecture, but the only problem i have is how to get the market values of equity and debt. Thank you.
May 16, 2016 at 7:54 am
If you are asked to calculate the cost of capital, then you will be given the market values (as traded securities they will be quoted on the stock exchange and so in practice it is simply a question of looking in the newspapers to find the market value).
As to how the market values are determined in the first place, this is cover in chapters 15 and 16 of the lecture notes and the lectures that of with them.
May 8, 2016 at 2:55 pm
Hello John Sir, thank u very much for those wonderful lectures as always.
I have a question regarding the chosen % for D.F to calculate the IRR. For Kd you took 10% and 15%, and for Company’s cost you took 5% and 10%.
I took 10% and 15% to ease calculations (because we already got annuity and discount values from previous calculation for Kd), but got 9.77% instead of 9.81%, it’s for sure answers will vary as it’s not linear. My question is does the examiner cater for this and allow a margin of error.
May 8, 2016 at 3:28 pm
It is no problem – using two guesses only ever gives an approximate answer (but leave it to two decimal places just so the marker can see from your workings that you know what you are doing.
(However, if you calculated at 10% first, you should have realised that since the NPV is negative then the IRR had to be lower than 10%. It would have therefore been better to make your second guess at lower than 10%.)
If you were asked to calculate an IRR in section A, then you will be told which guesses to use.
May 10, 2016 at 4:17 pm
ok thank you 🙂
May 10, 2016 at 5:03 pm
December 18, 2015 at 2:09 pm
First of all I would like to thank you for your brilliant lectures. They are clear and concise.
I have a question in relation to Example 8 part b – Cost to the company.
As per explanation of example 8 the symbols on cash flows are the following:
Time 0 M.V – Negative Cash flow
Time 1- 5 Interest – Positive Cash flow
Time 5. Repayment – Positive Cash flow
From a cash flow perspective, as this is the cost to the Company, should the cash flows have the opposite symbol? That is:
Time 0 M.V – Positive Cash Flow – Co. receives the money
Time 1 – 5 – Negative Cash Flow – Co. is paying interest
Time 5: Negative Cash Flow – Co. is repaying Debt finance.
Thank you in advance for your kind response.
December 18, 2015 at 3:19 pm
It doesn’t make any difference at all – an NPV of +0 is the same as an NPV of -0 🙂
Do it whichever way round you want. However the reason we usually to it in the same way round as the lecture is because that is the way round that we are used to setting up the flows when we are calculating the IRR when we are investing in a project.
January 4, 2016 at 12:53 pm
Yes, your answer makes a lot of sense.
That´s great. Thank you John and Happy 2016!
January 4, 2016 at 5:26 pm
You are welcome, and happy new year to you also 🙂
December 9, 2015 at 6:16 pm
Why isn’t the cost of debt for irredeemable debentures simply: the expected return to investors* (1-rate of tax)???
December 9, 2015 at 7:37 pm
If you listen carefully to the lecture then you will find that I actually say that!!!!!
December 9, 2015 at 7:59 pm
i am sorry i meant redeemable!!
December 10, 2015 at 7:23 am
Because only the interest is tax allowable – not the repayment.
December 5, 2015 at 9:56 am
I am getting confused. In example 8 why would the NPV would be 0 if the present value of the receipts is the market value i.e. 85c. I just don’t understand.
And is this a general rule whether we are talking about shares or debt borrowing that the market value of the share or security is the present value of the expected receipts which are dividends in the case of shares and interest in the case of debt borrowing.
October 11, 2015 at 12:11 pm
In Solution to Example 7, why are we diving the Cost of debt with the Current Market Price of 90. Dont we assume that the company always issued it at USD 100 at the time of raising the debt and the cost of capital will always be kd (1-t) for every year till it redeems it, Unless of course there is a redemption at a premium.
Can you kindly clarify.
October 11, 2015 at 12:30 pm
As I explain in the lecture, if it is quoted at 90 p.c. then it means the market value is $90 for every $100 nominal.
Therefore the interest each year (given a coupon rate of 8%) is $8 per year.
Therefore the return to investors (Kd) is 8/90 = 8.88%, and the cost to the company is Kd(1-T).
The price at which the debt was issued is completely irrelevant.
Here the debt will never be redeemed – the question specifically says that it is irredeemable.
If the debt is redeemable (which is more common in the exam) then the approach is different – we have to calculate the IRR and the cost of debt does not equal Kd(1-T), but this is dealt with in example 8.
I do suggest that you watch the lecture again.
July 24, 2015 at 8:48 am
Thank you for lectures
How did you get 10% ( you have discounted annuity and repayment at 10%) ?
July 24, 2015 at 9:22 am
I assume that you mean the 10% that I used as part of my calculation of the IRR to get the cost of debt.
When calculating the IRR you make two guesses. I chose 10% as one of the guesses but any two rates will do. Using different guesses does give slightly different answers (because the relationship is not linear) but still gets full marks in the exam.
I do suggest that you watch the earlier lectures on investment appraisal where the IRR calculation is explained in detail.
July 24, 2015 at 9:37 am
Thank You Mr. John
You are great teacher
July 24, 2015 at 9:46 am
Thank you 🙂
May 21, 2015 at 11:03 am
Thank you sir this information is very useful..
May 21, 2015 at 9:31 am
is it possible to find cost of debt for a redeemable bond if interest payment is made semi- annually and in arrears.if so how can i determine coupon payment ?
May 21, 2015 at 10:39 am
It is (but in F9 we always assume that the interest is paid annually).
The coupon rate every six months is simply half of the annual rate (in real life 🙂 ).
So if they are 8% bonds, then the interest (on 100 nominal) would be $4 every six months.
You then discount at the investors required return, and it is the discounting which is more messy. If the required return were (for example) 10% p.a., then you would have to calculate the discount factors using the formula. So for 6 months it would be (1/1.1)^(1/2); for 18 months it would be (1/1.1)^(3/2). and so on.
This is the reason why in F9 the interest is always assumed to be paid annually (and in P4 as well 🙂 )
March 24, 2015 at 6:58 pm
hello sir I am confused regarding the redeemables, you say that the required rate of return to the investors is 11.6% because @ this percent the NPV is 0 etc…..However what I don’t understand is why would investors want a higher rate of return if this makes their cash flows worth less? for example at 10% they would’ve made $6 but at 11.6% they don’t make anything? Perhaps I don’t understand the concept can you please clarify…
Thanks in advance
March 24, 2015 at 8:56 pm
The market value is fixed by the investors and depends on the return that they require. If they want a higher return then they will fix the market value lower, if the want a lower return then they will fix the marker value higher.
Since we know the market value they have placed on their investment we are simply working backwards to find out what return it is that they are wanting.
I assume that you have already watched the lectures on the valuation of securities, but if not then you should and then it will make sense. (The lectures really should be watched in order to make full use of them)
November 20, 2014 at 1:10 pm
Dear Sir, could you clarify this for me?
When calculating the cost of debt (redeemable) we should always use the current ex int market value of the bond if given else we assume nominal value of $100 right?
I have been working some past papers and i noticed this while checking the answers.
For 12/10 question NNN Co the current ex int market price of $103.50 was used.
For 6/11 AQR Co the nominal value was used, and for BKB Co (12/12) the calculated market value of bond $105 was used…
November 20, 2014 at 3:51 pm
We always use the market value and it is always given in one way or another.
In AQR the nominal value was used simply because if we issue at par then its immediate market value is the issue price – i.e. nominal.
In BKB we were needed to calculate the market value first, but then the market value was used to calculate the cost of debt.
It is always market value – there is no confusion.
May 5, 2014 at 7:55 pm
Hi mr John.
Can you please explain why the higher the required return the lower the market price?
November 20, 2014 at 3:52 pm
Because the market value is the present value of future receipts discounted at the required return. If you discount at a higher rate, then the present value (and therefore market value) will be lower.
April 8, 2014 at 12:39 am
Please, I’m confused about the inflow and outflow in the cost of debt calculation. You put the MV as an outflow while the interest paid and the repayment value as inflow. While this please because if the current MV is inflow and the interest paid and the redemption paid are outflows, the result for IRR will be different. I hope you get what I mean. e.g df@5% will give a negative NPV of 19.42 and df@10% will give a positive NPV of 0.77. Then, IRR = 5.19% totally different from 9.81%. Please, explain which one is correct because I think 5.19% is logical looking from company’s view. Thanks.
April 8, 2014 at 6:05 am
It does not matter which way round the flows are. If the flows are reversed then the sign of the NPV will be the opposite. However, we are after a NPV of zero – minus zero and plus zero are the same!!
I have no idea how you arrived at 5.19% – just looking at the figures should make you realise that 5.19% is impossible. Since the NPV at 10% is almost zero, the IRR must be very close to 10%!!
April 8, 2014 at 7:58 am
Thanks. It makes sense to me now. Besides, I should have thought of that you last sentence. God bless.
April 5, 2014 at 10:31 am
Dear Professor John
some thing I just want to confirm, can we write the abbreviation for terms which we use it often in the exam , i.e. in Example 9 ( $2.50 cum div & 92 ex int )
by the way, does “cum div” mean included div, and “ex int” mean excluded interest ?
sorry for asking such kind of simple question, but it’s really confused students who’s native language is not English like me… if we can use the abbreviation during the exam, could u show us some clue please ?
Thanks for your brilliant lecture, I learned a lot here.
April 5, 2014 at 10:34 am
Yes – cum div means that they are about to pay the dividend (and so the price includes the dividend). Ex div means that they have just paid the dividend (and so the price excludes the dividend).
The same applies to cum and ex int.
In the exam you always assume ex div / ex int unless you are told differently.
April 6, 2014 at 11:00 am
March 5, 2014 at 8:34 am
I love how you explain the logic behind every little calculation that we have to do! It saves me from having to cram them up! Kudos Sir! You are amazing! 😀
March 5, 2014 at 8:53 am
January 7, 2014 at 5:14 pm
could someone please help me. I don’t understand the concept of “90 over 100 nominal”
what does this mean? furthermore i don’t understand the logic between the investors borrowing from the Business, or is it the Business selling debt? if its the Business selling debt, are they selling the debt which is worth 100 i.e nominal for 90?
January 8, 2014 at 5:00 am
The market value is what investors are prepared to pay to buy debt on the stock exchange.
To explain the relevance, suppose a company has in issue some 9% bonds with a nominal value of $100, which are trading at a market value of $90.
This means that investors are currently requiring a return of 10% (9/90). If they wanted a different return they they would pay a different price.
So…..this in turn means that if the company wanted to raise more debt finance, then they would have to offer a return of 10% (otherwise nobody would be prepared to invest)
November 5, 2013 at 8:16 pm
I’m practising June 2009 past paper, titled ‘KFP Co’ using Kaplan exam kit.
I’m calculating cost of debt and I’m bit confused with which discount factor to use. The question says its 7% redeemable bond in 7 years and under other relevant information it gives an average return on the market 10.5%.
In the answer they have used 10% and 5%, but my understanding is that if it’s 7% interest then I would use 7% discount factor (which gave me positive NPV) and then I used 10% (giving me negative NPV). I get an IRR= 8.65% but the answer in kit gives an IRR = 6%, please can anyone look at this question and tell me where I’m going wrong.
November 5, 2013 at 8:52 pm
Sorted it out, thanks!
October 30, 2013 at 5:02 pm
Can you please explain why you took $8/$90 in Example 7? I was bit confused because it says 8% Irredeemable debentures quoted at 90 c.
October 30, 2013 at 7:08 pm
8% means that the interest is 8 per year (because the nominal value is 100)
However the market value is £90 for 100 nominal, and so the return to the investor is 8/90
December 4, 2012 at 10:46 am
Please allow me the following question: while i understand that we compute the investors return using the market rate, from the company’s perspective, in order to compute the cost, i would use the nominal, since this is the amount actually received. I don’t see where the market price of the debenture would influence the company’s cost. Therefore the net yield would be (1-tax (%)) x interest / nominal. Could you please advise?
December 4, 2012 at 10:48 am
Sorry i think i got it; it’s more what we would need to pay in the future, not what is already paid
October 4, 2012 at 5:41 pm
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May 13, 2012 at 11:48 pm
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March 27, 2012 at 6:48 am
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Saad Bin Aziz says
December 8, 2011 at 8:55 pm
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