# The cost of Capital – Cost of debt (part c)

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1. says

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…

• says

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)

2. says

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…

• says

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.

3. says

Hi mr John.
Can you please explain why the higher the required return the lower the market price?

Thanks.

• says

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.

4. says

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.

• says

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%!!

• says

Thanks. It makes sense to me now. Besides, I should have thought of that you last sentence. God bless.

5. says

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.

• says

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.

6. says

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! 😀

7. says

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?

• says

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)

8. says

Hi John,

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.

Thanks

9. says

Hi!

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.

• says

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

10. says

@johnmoffat
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?

• says

@annchen,
Sorry i think i got it; it’s more what we would need to pay in the future, not what is already paid

11. says

i have been struggling to understand this topic and after this lecture, i cant believe how easy it seems. This lecturer is great. Thanks alot.!!!!!

12. says

your stuff is simply invaluable,splendid and fabulous.users like me will forever be grateful.God bless you

13. says

IM IN LOVE WITH THIS MAN, HE HAS MADE F9 MANAGEABLE FOR ME, THANK GOD FOR MEN LIKE HIM, I WISH HE WAS MY TUTOR.