Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins.

Equity is more risky for investors because dividends fluctuate with profits whereas the interest income from debt is constant. The more dividends fluctuate, the greater the beta and the greater the required return and therefore the greater the cost of equity to the company.

In addition the payment of interest on debt is tax allowable to the company whereas dividends are not tax allowable, which makes the cost of debt even lower.

When calculating IRR of a redeemable debt we assume that interest return is allowed for the income tax, whereas the redemption of the debt – is not allowed in the full sum.

But the cash flows can be changed: the debt issuer can pay less as interest and include much in the redemption (is it possible?)

So do not we need to take the exsess = redemption – market_or_nominal_value for the tax allowance also?

Your first two sentences are both correct (for the calculation of the cost of debt).

However, regardless of what coupon rate to offer on the debt and what premium to offer on redemption, the tax rules remain the same and the calculation of the cost of debt follows the same rules.

(The return required by the investors is the IRR of the pre-tax flows, and that will be the same however the interest and redemption are structured. However the cost to the company is the IRR of the post-tax flows, and that will be different.)

Thanks for your feedback. I just want to have a final clarification.

Lets say for example 10, I will revise the original question to give cost of debt instead of market price first. The question will give me 6M 10% debenture that are redeemable in 6 years time at a premium of 10%. It gives me the risk free rate at 7% and credit spread 3.7% (which mean the cost of debt to company is 10.7% * 0.7 = 7.5% as in original question). Annuity for 6 years at 10.7% = 4.267

With this revised question, as you said, I will have to take pre-tax cash flow discounted at pre-tax cost of debt of 10.7% to find market price of debt = 10 * 4.267 + 110/1.107^6 = 102.4

The new market price is different from original market price of 105 in original question. I am not sure if it is because of rounding, or whether my understanding is incorrect here? If I have taken after-tax cash flow discounted at after tax cost of debt, then I should get 105 as in original question. Hope you can help clarify my doubt

The problem is that with redeemable debentures the cost of debt is not Kd(1-t) (which is what you have assumed). That is only the case with irredeemable debentures. I explain this in the lectures.

For example 10, what will happen if we are not given the ex-int price of the debenture, but we are given the risk free rate 11% and credit spread of the company at 1.5% instead?

We will have to calculate the market value of the debenture in such case. However I dont know if we have to use pre-tax cash flow discounted at pre-tax cost of debt or we have to use after-tax cash flow discounted at after-tax cost of debt. According to your previous lecture, we must use after-tax cash flow for redeemable debt.

The cost of debt is calculated using the after-tax flows.

However the market value of debt is determined by the investors and therefore is the pre-tax flows discounted at their required return, which is the pre-tax cost of debt. The investors are not affected by company tax – only the company is affected.

Thanks for your quick reply. I would like to clarify on this a bit. When we are calculating the cost of debt using after-tax cash flows, we are effectively using the market value of the debt (ex-interest price) given in the question as well? Then why does the reverse is not correct, using after-tax cash flow to calculate market value of debt?

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ceevs92 says

are we given formula sheets in the exam?

John Moffat says

Yes. A copy of the sheet given in exam is printed in our free lecture notes.

confideans says

Can you please clarify why the cost of equity is higher than the cost of debt?

confideans says

Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins.

are there other reasons?

John Moffat says

Equity is more risky for investors because dividends fluctuate with profits whereas the interest income from debt is constant. The more dividends fluctuate, the greater the beta and the greater the required return and therefore the greater the cost of equity to the company.

In addition the payment of interest on debt is tax allowable to the company whereas dividends are not tax allowable, which makes the cost of debt even lower.

Elena says

When calculating IRR of a redeemable debt we assume that interest return is allowed for the income tax, whereas the redemption of the debt – is not allowed in the full sum.

But the cash flows can be changed: the debt issuer can pay less as interest and include much in the redemption (is it possible?)

So do not we need to take the

exsess = redemption – market_or_nominal_value

for the tax allowance also?

John Moffat says

Your first two sentences are both correct (for the calculation of the cost of debt).

However, regardless of what coupon rate to offer on the debt and what premium to offer on redemption, the tax rules remain the same and the calculation of the cost of debt follows the same rules.

(The return required by the investors is the IRR of the pre-tax flows, and that will be the same however the interest and redemption are structured. However the cost to the company is the IRR of the post-tax flows, and that will be different.)

duybachhpvn says

Thanks for your feedback. I just want to have a final clarification.

Lets say for example 10, I will revise the original question to give cost of debt instead of market price first. The question will give me 6M 10% debenture that are redeemable in 6 years time at a premium of 10%. It gives me the risk free rate at 7% and credit spread 3.7% (which mean the cost of debt to company is 10.7% * 0.7 = 7.5% as in original question). Annuity for 6 years at 10.7% = 4.267

With this revised question, as you said, I will have to take pre-tax cash flow discounted at pre-tax cost of debt of 10.7% to find market price of debt = 10 * 4.267 + 110/1.107^6 = 102.4

The new market price is different from original market price of 105 in original question. I am not sure if it is because of rounding, or whether my understanding is incorrect here? If I have taken after-tax cash flow discounted at after tax cost of debt, then I should get 105 as in original question. Hope you can help clarify my doubt

Thank you

John Moffat says

The problem is that with redeemable debentures the cost of debt is not Kd(1-t) (which is what you have assumed). That is only the case with irredeemable debentures. I explain this in the lectures.

duybachhpvn says

Hi John,

For example 10, what will happen if we are not given the ex-int price of the debenture, but we are given the risk free rate 11% and credit spread of the company at 1.5% instead?

We will have to calculate the market value of the debenture in such case. However I dont know if we have to use pre-tax cash flow discounted at pre-tax cost of debt or we have to use after-tax cash flow discounted at after-tax cost of debt. According to your previous lecture, we must use after-tax cash flow for redeemable debt.

Thanks

John Moffat says

The cost of debt is calculated using the after-tax flows.

However the market value of debt is determined by the investors and therefore is the pre-tax flows discounted at their required return, which is the pre-tax cost of debt. The investors are not affected by company tax – only the company is affected.

duybachhpvn says

Thanks for your quick reply. I would like to clarify on this a bit. When we are calculating the cost of debt using after-tax cash flows, we are effectively using the market value of the debt (ex-interest price) given in the question as well? Then why does the reverse is not correct, using after-tax cash flow to calculate market value of debt?

Thanks

John Moffat says

The market value is determined by the investors and is based therefore on the pre-tax flows.

The cost of debt is the cost to the company and is therefore based on the after-tax flows.

The market value (fixed by the investors) is the amount that the company raises and on which they have to be interest but get tax relief.