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DDD Co has two loan notes in issue, each with a nominal value of $100 per loan note.
Loan note A will be redeemed at nominal value in 10 years’ time and pays annual interest of 9%. The current ex-interest market price of this loan note is $95.08.
Loan note B will be redeemed at a premium of 5% in four years’ time and pays annual interest of 8%. The pre-tax cost of debt of this loan note is 7%.
Question
3. Which of the following are possible reasons why loan note A and loan note B have different pre-tax costs of debt?Different levels of security
Different periods to redemption
Different redemption prices
1 and 2
1 only
1 and 3
3 onlyThe answer is 1&2. My question is why don’t different redemption prices affect the cost of debt?
I personally think it’s very ambiguous and possibly wrong……
You could say that different redemption prices do affect the cost of debt. When calculating the cost of debt, the redemption price is an important factor. If the debt is redeemable, the amount payable on redemption can distort the cost of debt calculation because it is not tax allowable. The cost of debt is typically calculated as the internal rate of return (IRR) of the after-tax interest and redemption payments on the market value of the debt.
So, if the redemption price is different, it will impact the calculation of the cost of debt.But then again it could be because loan note A and loan note B have different pre-tax costs of debt because they have different periods to redemption (10 years for loan note A and 4 years for loan note B) and different levels of security.
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