Cost of debt

Hi Roytir,

I think you are perhaps just a little confused here.

The examiner has in fact done what you are suggesting! … He has calculated the cost of the bond using the IRR.

IT is perhaps a little confusing here to be told to “Ignore Taxation”….Normally the cost of debt, or the cost of the bond in this case, is based on the cash flows AFTER TAX …i.e that the annual interest payable on the bond is tax deductible to the COMPANY. When calculating the return to the bond INVESTOR you ignore taxation because in F9 we ignore Income Tax payable by the investor on the interest received.

Inter-polation is the method normally used to find the IRR …i.e the cost of capital that produces a zero NPV … i.e in this instance Interpolation is used to find the IRR (the cost of bond A or the cost of debt).

Perhaps it is the layout or style of answer which is confusing you ?

Why not study the OT Lecture Notes (chapter 14) on this topic + the relevant OT videos etc., and I am sure you will find the clarity you need!

Hope this helps, Kevin Kelly

Hi Tanleequan,

BY splitting your approach to calculating the cost of bond A (in other words the Bond Holders Required Return) into two separate calculations you are effectively demonstrating a very good understanding of the fundamentals involved here.

In other words, you are assuming that the cost of the bond is made up of two components (1) the annual Interest yield/return and (2) the annual Capital Gain

Thus, your calculations are …. Interest return = 9.47% PA
Capital Gain = 0.52% PA
Total Investor Yield / Return = 9.99%

Conclusion, your estimate of 9.99% is very similar to Examiners answer of 9.83% ….. Accordingly, I would award you full marks provided you stated your assumptions clearly or at least qualified your answer by stating that the “time value of money” (discounting) has been ignored in this instance and ordinarily the inclusion of discounting would lead to a more accurate estimate of the cost of the bond.

It is worth noting that in F9 you have a lot of latitude in your answers …. just make sure your assumptions are clearly stated. Certainly, from the point of view of practical expedience within the exam your answer is derived more quickly!

Well done, Kevin Kelly