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A company has 7% loan notes in issue which are redeemable in seven years’ time at a 5% premium to their
nominal value of $100 per loan note. The before-tax cost of debt of the company is 9% and the after-tax cost
of debt of the company is 6%.
What is the current market value of each loan note?
A $92.67
B $108.90
C $89.93
D $103.14The correct answer is (A)
I got (D) since I got confused whether we were supposed to use the before tax cost of debt or after tax cost of debt, Ive already watched all of your lectures and im able to solve most of the questions but I got a slight confusion in this as I might’ve forgotten some rule.Thankyou
It is the investors who determine the market value and so we discount the expected receipts at the investors required rate of return (which is the same as the before-tax cost of debt – it is only the company who gets the tax relief).
So when do we use the after tax cost of debt for the calculation ? like how will the examiner ask if he wants us to use the after tax cost of debt.
Thanks
We use the after tax cost of debt in calculating the weighted average cost of capital. The only affect of the tax is to reduce the cost to the company because the company saves tax on the interest payments.
Okay Sir and lastly, I just saw a question in the specimen exam of the bpp kit where they ask ” Assuming the conversion value after seven years is $126·15, what is the current market value of the 8%
loan notes ” and in the OTQ paragraph about the company, they’ve mentioned “Par Co has a cost of debt of
9% per year ” .So in the exam when they tell us something like this do we assume its the before tax cost of debt and use it in the calculation for the market value or we take it as an after tax cost of debt and use the normal interest rate of the loan note ( 8% in this case, for example. )
Thanks
We always discount at the before tax cost of debt – we would never ever discount at the coupon rate of 8% (that would be meaningless!).
Since there is no mention of tax in the question you assume there is no tax and therefore the before tax cost of debt is the same as the after tax cost of debt.
You can easily check from the answer that they have discounted at 9%, which is correct.
Sir I came across a WACC mcq. I can’t really get the right answer for the questions. Although it looks easy but I’m stuck on the MV of the debt and its cost.
It says: 50c ordinary shares at $12m
8% $1 preference shares at $6m
12.5% loan notes 20×6 at $8m
Loan notes are redeemable at nominal value in 20×6. Current market prices are –
50c ordinary shares at 250c
8% $1 preference shares at 92c
12.5% loan notes 20×6 at $100
Corporation tax at 30%
Cost of the company’s equity capital is 18%. We are required to calculate the WACC
Kindly can you show me how to do each step and then put it altogether in the formula. I got my answer wrong when I did it and when I checke for the answer at the back, it showed all of the values put together in the formula without any workings which got me more confused.The cost of preference shares is 8/92 = 8.70%
Since the MV of the loan notes is $100 which is the same as the nominal value and the amount payable on redemption, then cost of debt is 12.5 x 0.7 / 100 = 8.75%
The total MV of equity + pref + loan notes = (24 x 2.50) + (6 x 0.92) +8 = 73.52M
Therefore the WACC = (60/73.52 x 18%) + (5.52/73.52 x 8.70%) + (8/73.52 x 8.75%)
(I am of course assuming that you had copied everything in the question correctly 🙂 )
Assume that theloan notes have recently been issued specifically to fund the
considered. It has been suggested at a project appraisal meeting that because
company’s expansion programme under which a number of projects are being
these projects are to be financed by the loan notes,the cutoff rate for project
acceptance should be the after-tax interest rate on the loan notes rather than the
WACC. Discuss this suggestionThere is no point in asking me to discuss something here!!
Unless you have been set this as a homework question you must have an answer in the same book in which you found the question, so ask about anything you do not understand in the question.
If you have been set this as homework, then we do not do your homework for you 🙂
Everything needed to answer this is explained in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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