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I can’t get my head around the meaning of “cost of capital”, and have difficulty in understanding the logic behind the calculations. To give you an idea about the area I’m stuck on, question 35 from the BPP practice and revision kit (taken from an amended June 2005 exam) has an example.
It relates to goodwill. Basically, the parent company acquired a subsidiary, which included deferred consideration. It states the cost of capital is 8% per annum. The deferred consideration is $108 million, which is paid a year later.
In the answer, it states that the goodwill calculation uses the present value of the deferred consideration. During the year the $8m discount will be charged to the “parent’s” profit or loss as a finance cost.
Firstly, what exactly is “cost of capital”?
Why does paying at a later date reduce the value of consideration.
Why is the reduction 8% of 100 million, not 8% of 108 million?
Thanks for your help.
Cost of capital is effectively an interest.
The fair value of any deferred consideration is calculated by discounting the amounts payable to present value(PV) at acquisition. (i.e, taking into account the time value of money)
PV of deferred consideration is calculated as follows:
$108m * [1 / {(1+0.08)^1} = $100m
The formula is 1 / {(1+r)^n}
where, r is the cost of capital
n is the number of years the consideration is deferredat the end of every year, the discount is to be unwounded; effectively interest on this $100m.
in this qn, it is 8%* 100m = 8m.
this is shown in the income statement as finance cost & also added to the deferred liability.Hope that helps
Hi Najiya,
Thanks for explaining the cost of capital to me. I have to confess, I still don’t understand it!
I understand how to do the calculation above, but I’m still confused by the logic of it. If cost of capital is like an interest charge, and the consideration was deferred for a year, why isn’t the deferred consideration $99,360 (108,000*92%), and the charge $8,640 (108,000*8%)?
If you are able to explain that to me I think I might begin to grasp it. Sorry for being a bit stupid!
PV of deferred consideration is what we should have paid outright, ie, 100,000 (here). If we are not paying it now, then the interest should be charged on this amount…right?
The agreement is to pay 108,000 on a later date. This includes the interest as well. We cannot include the interest in the accounts before it is due. So, we take out the interest from the total amount due.Is that logical?:)
Hi Najiya,
Thanks a lot for explaining it, I think it’s finally sunk in and I understand now!
So if the $108,000 was paid in after 2 years, then the PV would be $92,593, with £8,000 finance charge at the end of y1, and a $7,407 finance charge at end of y2?
u r welcome!
yes…PV is correct.:)
finance charge will be the other way round.
at the end of yr 1 – 8%*92593 =7407
at the end fo yr 2 – 8%*(92593 + 7407) =8000Hi guys,
What figure should be in the statement of financial position as current value of liability as of December 31 (the end of the first year): $92 593 or $(92 593+7404)?
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