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The cost of capital (part 3) – ACCA (AFM) lectures

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  3. Hi John

    Thanks for this lecture! I just have one point it would be great if you could clarify (and i appreciate that you have been asked a few times about this point, but i couldn’t find an response that clearly answered my question!)

    On the point about only using the (1-T) part of the WACC formula for irredeemable debt, why is this? I understand that you don’t use it for redeemable debt as, when calculating the IRR, you use the post-tax cash flows and so the tax point is already addressed.

    However, when calculating the rate for irredeemable debt, we still use post-tax cash flows to calculate (e.g in example 7, when calculating the cost to the company the calculation is 8 x 0.7 / 90) so why do we need to factor in the tax again when doing the WACC calculation?

    Many Thanks!

    • We don’t 馃檪

      In the WACC formula we either use the pre-tax cost of debt and then multiply by (1-t), or (and better) we simply use the after-tax cost of debt and do not multiply by 1-t. (It is really confusing of them to give it on the formula sheet because you don’t need to use the formula at all 馃檪 )

  5. For Dec-22 exam we can apply the IRR formula* (in the CBE platform).
    For that we need the cash flows for each year separately.
    Please confirm my understanding below:
    cell A1: Year 0 = -105
    cell A2: Year 1 = 7
    cell A3: Year 2 = 7
    cell A4: Year 3 = 7
    cell A5: Year 4 = 7
    cell A6: Year 5 = 7
    cell A7: Year 6 = 117
    IRR = (A1:A7,10%) = 7.33%

    Since this value differs from the IRR calculated in the video above (7.51%), my question is: will the answer (7.33%) be considered correct?

    Thank you for your time!

    *Note (this is taken from the ‘Help/Formulae Sheet’ in the CBE platform):
    IRR formula = IRR (values, [guess]).
    Where: “values” is the range of cash flows for which you want the internal rate of return; and “guess” is a rate you think is close to the result of the IRR given as a decimal.
    E.g.: = IRR(B15:F15,0.12) >> calculates the internal rate of return of cells B15-F15 using 0.12 as an estimate, with B15 being Year 0.

  6. Hi Mr. John,

    Wonderful lecture, everything was clearly explained however I do have (trivial?) a doubt.

    Since my exam attempt is Computer Based (CBE) and not paper-based, Excel is provided to show the relevant calculations. The calculation of IRR in excel is quite simple and takes very little time as compared to paper based but there’s usually a difference between the IRR calculated by excel and the IRR calculated by trial and error method. Will such a difference affect my marks? In example 10, IRR calculated by excel is 6% instead of 7.51% and the resulting WACC is 13.31% instead of 13.56%. I know its a minor difference but will it affect the marking?

    Thanks again for the superb lectures.

    • Thank you for the comment.

      The answer using the spreadsheet it more accurate than making two guesses 馃檪
      However do it whichever way you prefer – the fact that they answers are slightly different is irrelevant for the marking.

  7. Hi,

    I have a question for calculating IRR. Do we have to use the guessing approach illustrated in the video? Since many financial calculators (e.g. Texas Instruments BA II Plus) can calculate IRR directly, can we use these calculators instead?

    Thanks in advance.

  8. Hello,
    I have a question on calculating the IRR. When we choose discount factor in example 10, we take 10% and 5%. Is that just random?
    I have taken 10% and 15% when calculating and got Kd as 6.63% and overall WACC as 13.41%, so slightly different answers. Just wondering if this is wrong.
    Thank you.

    • 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?

      • 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.

    • Because the investors for equity holders bear the highest risk, so say when a company is liquidated the ordinary shareholders are the last ones to paid if any residual value remains, however, the debt holders are always paid first. Hence, the cost of equity is always higher than debt.

      Hope this clarifies and John hope I am correct in my understanding.

  11. 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.)

  12. 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

    • 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.

      • Hi John ,

        I just have small confusion about what you said about redeemable debentures , cost of debt is Kd and Kd(1-t) for irredeemable however in qtn 9 where the debt was irredeemable , how comes we didn’t use Kd(1-t)

      • Hello,

        Can you please give a bit more clarification on the use of (1-T) for both types for debt?

        As far as I understand, we use the (1-T) part of the formula with irredeemable debt as the whole debt is tax allowable – as there’s not repayment. On the other hand, we do not use the (1-T) with the redeemable debt as we have already allow for the tax when calculating the IRR and if we use it would be duplicated?

        Thanks!

  13. 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

    • 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?

        Thanks

      • 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.

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