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Mr John – it doesn’t make sense to me that when interest rates fall the market value go higher. Arithmetically, this is fine, but why would investors be prepared to pay more (MV of debt) when they will be getting a lower return? Am I getting it wrong here?
For irredeemable debt, the actual return that the investor is getting is the interest the company is paying (the coupon rate) divided by the amount they have to invest (the market value).
If (for example) the company issued debt with interest at 6%, then it means that when the debt was issued 6% must have been a fair rate.
Suppose general interest rates are now 3% – the company will still be paying 6% on nominal but if you want to buy some of the debt from an existing owner (on the stock exchange) they are not going to let you buy it from them at nominal value so that you get 6%. You are going to have to pay them 200 because the interest of 6 a year will be giving you a return of 3%, and you will be prepared to pay 200 because a 3% return is what you could currently get elsewhere.
The same logic obviously apples also to redeemable debt.
If the before-tax cost of debt is 7%, then this is the investors required return. (The IRR of the pre-tax cash flows).
The actual cost of debt will be the IRR of the post-tax cash flows and to calculate this you would need more information (when redeemable. the coupon rate, the market value, and whether redeemable at par or at a premium).
Please advice re below because its a little bit confusing for me.
If i have to calculate the M.V of a redeemable bond what will be the investors req’d rate of return if the exercise tell me that the before-tax cost of debt is 7%p.a. Assume tax rate is 30%.
Would it be 7%x(1-0.30) or 7% without taking in mind tax?
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