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Hi,
Sorry for the long question,
A company has outstanding $660,000 of 8% bonds on which interest is payable annually on 31 December. The debt is due for redemption at par on 1 January 20×6. The market price of the bonds at 28 December 20×2 was $95. Ignoring any questions on personal taxation, what do you estimate to be the current cost of debt ?
The given answer
Year CF $ DF PV $
Market value 28.12.×2 0 ($95) 1 ($95)
Interest 31.12.×3 1 8 0.909 7.3
Interest 31.12.×4 2 8 0.826 6.6
Interest 31.12.×5 3 8 0.751 6.0
Redemption 31.12.×5 3 100 0.751 75.1
———-
NPV 0
The IRR (Kd)= 10%Question
The MV used in the above calculation is $95 (Cum interest MV) shouldn’t it be ex – interest MV $87 ($95-$8) ?
Do we use the Ex-int or Cum- interest MV when calculating IRR for redeemable bonds ?Kindly clarify
We do use the ex-interest value when calculating the IRR.
However the reason here is that the market value will already be ex-interest. Bonds (and shares) go ex-interest (or ex-div) a short time before the payment is due. I someone was to sell their bonds shortly before the payment date it is too late for the company to change the details in their records and so the payment will still go to whoever was owning the bonds before the sale. So the market value will go ex-int.
Although this is what happens in real life (and the reason that the answer in your book is correct) I do not recall this ever having been a problem in the exam. In the exam we always assume prices are ex-int (or ex-div) unless specifically told otherwise.
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