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Dear Professor,
please help me to find the solution for following test question.
A company has 6% bonds in issue which are redeemable in 5 years time at a premium of 10% to their nominal value of 100 USD per bond. The before-tax cost of debt of the company is 10% and the after-tax cost of debt to the company is 7%.
What is the current MV of each loan note ?
My solution:
PV of coupons = 100*6%*(1-30%)*4.1(for 5 years annuity for 7%)= 24,6 USD
PV of par with premiunm= 110 * 0,713 = 78.43 USDTotal = 95,65 USD
What the mistake is in this answer?
I assume that my mistake is in choosing discount factor whether 7% or 10% and related tax (should or shouldn’t be) for coupon payment.
Please explain the approach in which cases should I use after-tax cost of debt and in which before tax cost of debt while calculating the market value of bond and how to handle the tax rate ?Thank you in advance!
Kind Regards,
BohdanIt is investors who determine the market value of the debt by discounting the interest they will receive by the return that they require.
Company tax is of no relevance to the investor – they receive interest of the full 6 per year, and they require a return of 10%.Tax is only relevant when calculating the cost of debt to the company.
I really do suggest that you watch the free lectures – they are a complete course for F9 and cover everything needed to pass the exams well (including stressing the point above).
Dear Professor,
thank you for your clarifications. Now it is very clear for me.
Kind Regards,
Bohdan
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