Kd – IRR

This topic contains 9 replies, has 3 voices, and was last updated by Avatar of johnmoffat John Moffat 1 year, 4 months ago. This post has been viewed 150 times

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    dazhong0703
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    Eg
    T0 purchase price (125)
    T1-10 interest after tax 15(1-.25)
    T10 redemption value 100

    Usually we need to try DF5%, and DF10%, to determine IRR
    But I see some suggested solution is: [15(1-.25)+(100-125)/10]/[(100+125)/2] = 7.8%

    I think the logic is: (interest gain + principal gain)/(average of principal)

    Can I use this method to get IRR straight away in the exam, pls? It is obviously much faster. Thank you.


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    nandinigirish
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    Hi sorry, I could get same answer of your = 7.8%


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    John Moffat
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    That method would give an approximation and you would be given some credit, but the correct way is to calculate the IRR properly (which only takes a minute if you are fast with your calculator!)


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    dazhong0703
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    If using Kd = Rf + (Rm-Rf) x Bd, there is no need to multiply (1-t) for Kd, isn’t it? Thanks.


    Avatar of johnmoffat
    John Moffat
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    That is correct :-)


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    dazhong0703
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    Again I have seen two views, today I did a question: Kd(post tax) = (Rf + spread) x 0.7
    [Tax rate = 0.3]


    Avatar of johnmoffat
    John Moffat
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    What do you mean ‘Again, I have seen two views’!?

    If you think about it, Kd post tax is obviously 70% of Kd pre-tax – I don’t exactly see that there are two views.

    Anyway, Kd is the return to investors and is always pre-tax. We are only interested in post-tax if we are looking at the cost to the company.


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    dazhong0703
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    Because the day before yesterday, I saw a question when calculating WACC, the ans straight away uses Kd = Rd + (Rm-Rf) x Bd, never multiply (1-t);
    Then yesterday I saw another question the ans given for Kd(post tax) is as above.
    I see from GTG revision card, Kd = (Rd + spread)(1-t), so I think it was my former lecturer’s mistake by not multiplying (1-t).


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    dazhong0703
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    Since debt has a credit spread, why did MM assume debt risk free? When degear/regear, we also assume debt risk free? The cause of debt crisis is interest too high!
    Thank you.


    Avatar of johnmoffat
    John Moffat
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    Your GTG revision card is wrong if it says that.
    Kd is the return to investors. It is the cost to the company that is Kd (1-t).
    (Try looking at the formula for WACC on the formula sheet!!!!)

    M&M ignored the risk of bankruptcy. If there is no risk of bankruptcy then the income is fixed and is therefore risk free. (That is one of the reason that M&M does not work perfectly in real life – in real life the risk of bankruptcy does exist.)

    The formula for calculating the asset beta is really a M&M formula and that is why we assume for that formula that debt is risk free.

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