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Hi John, the cost of debt used, for the calculation to arrive to the WACC is 5.3%. However, i have seen other questions such as at Coeden (2012), whereby the cost of debt used is the ‘Rf + credit spread’ instead of the bond’s interest at 5.2% .
So, for the Chikepe’s question, why did it not use the government’s rate which is at 2%?
May i know why the difference? i have tried searching for the logic but failed. Thank you.
The question specifically says that the interest is 5.3% (the cost of debt is therefore 5.3% x (1 – 0.2) ).
The 5.3% is higher than the risk free rate of 2% which will be because of the credit spread. But given that we are not told the credit spread but are told the actual rate they are paying, then that is all that is needed.
Hi John,
Thanks a lot for your prompt response.
Now I’d like to refer to the Codene (Dec 2012)’s cost of debt used:
– the redeemable bond is at 5.2%
– the risk free rate is 4% and spread at 60 basis points = 4.6%In my understanding, the cost of debt that should have been used is 5.2% instead of 4.6% (the rate used in the answer sheet is 4.6%), given that in the SOFP, it is clear enough that 5.2% is the interest for the Non Current Liability.
Could you please enlighten me on this? I just think that this is important because wrong rate used means wrong answer.
Firstly we would certainly not use 5.2%. This is the coupon rate and so the actual cost of debt currently is the IRR of the after-tax flows (given that it is redeemable debt).
The important difference from Chikepe is that in Coeden we are told what the credit spread will be (and it matters because the credit rating will change from what it currently is) whereas in Chikepe we are not told anything about the credit spread.
(It is important, but at the same time appreciate that it is not the final answer that matters. If you make a mistake on the way, then provided the marker can follow your workings you only lose the marks for the specific mistake but still get full marks for everything else you do with the wrong figure.)
Hi John,
Thank you for the clear crystal explanation.
And yes, i take note of the last bit as well 🙂
Thanks again !
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