In the lecture notes for example 8 the answer is given as 6.07 ————– *5% 6.07 ×10.22

The denominator shouldn’t that be 6.07 +10.22? This I’ve been scratching my head and redoing my workings trying to get back to the answer and this is the only way I know how.

I make it clear in the lectures on investment appraisal (where the calculation of IRR is the same) that you can use any two ‘guesses’. I happen to choose 10% as my first ‘guess’ because it is in the middle the tables.

Hi John! Since scientific calculators are allowed in the exam, can’t we just calculate the exact IRR using the fact that at IRR, NPV = 0? CF1/(1+x)^1+CF2/(1+x)^2+……-CF0=0 and then solve for x.

Also, I am using Casio fx-991ex calculator, is it allowed. It is non-programmable calculator but as regular scientific calculators that can solve for the value of ‘x’. Please advise.

You can, provided that letters never appear on the calculator screen.

However you will see when you practice questions in your Revision Kit that the questions are designed in such a way as to test your understanding – it is not a maths exam and doing what you suggest will almost certainly be of no help at all. The exam is a professional exam and not simply testing that you know how to use a calculator 🙂

In Section C of the exam, the marks are for your workings and so just using a calculator will not get the marks.

Dear sir, I have a question regarding cost of debt

In one of the questions i was doing it says that the company has in issue 200k 10% debentures that are redeemable at par in 2 years, and they have a current market value of 105.3 per cent.

in the answer it shows that the cost is 95.3 in year 0. is it constant that the capital is market value less interest (10 in this case?) I don’t understand how the capital cost is calculated.

In future please ask this sort of question in the Ask the Tutor Forum, and not as a comment on a lecture.

I would assume without seeing the question, that the market value is quoted cum int (or alternatively it says that the interest is about to be paid, which means the same thing). We need the ex int market value (as I explain in my lectures) and therefore you need to subtract the interest about to be paid.

In Example 8, since debentures are redeemed at premium of 10% at the end of 5 years, wont there be an expense of $2 each year (which in itself is not a cash flow) but it will reduce the tax expense by 2*30% = 0.6 each year .

Why is this not taken into account for calculating cost of capital?

For the sake of my confusion, for Example 8 when we are calculating cost of debt to the company, wouldn’t it make more sense that the cash flow in Time0 (issue of debt) a positive 85, while the payment of interest and redemption from Time1-5 negative 6 p.a. and negative 110 at Time5?

If you want to do that then fine – the IRR will still be the same. (All the signs will be reversed, but and NPV of +0 is the same as and NPV of -0).

The reason why we tend to show the flows the way we do is that we are used to having the flows this way when calculating the IRR of projects. Reversing the signs can make it more confusing for some people.

Sir in the any question for redeemable debt if it is asked find cost of bebt , do we need to find investors required rate of return or cost to company?

I want to clarify something regarding example 8. I understand the use of IRR in determining the interest rate – choosing two different percentages and hence you used 10 and 15.

What I don’t understand is why did you not use a DF of 7% ( 6 the debentures rate /85 the ex int) as you did in example 7 to calculate the Re (return on investment).

I thought the DF % to use is usually the same % as the rate of investors return.

In example 7, the debt is irredeemable and then we can use coupon rate/market value

In example 8, the dent is redeemable and then we have to calculate the IRR.

(You could calculate the IRR for example 7 if you wanted, but not only would it obviously take longer, but the answer would only be approximate whereas here it is exact.)

As we studied that the cost of bank loan is “Interest * (1 – t)” because there is no premium or discount when redeemed at the end of the loan.

In Kaplan book, it is mentioned: “Where the debt is redeemable at its current MV, the position of the investor is the same as a holder of irredeemable debt.”

Does both of the statements have the same meaning? Can you please explain by numbers i.e., how come the return is same for redeemable and irredeemable debts?

If you want numbers, then you must ask in the Ask the Tutor Forum and not as a comment on a lecture.

The two statements do mean the same. The cost of the debt is obviously the interest that has to be paid, and in the case of redeemable debt repayable at a premium, then the premium makes the overall cost higher. If there is no premium, then the cost is only that of the interest.

You did not say anything about discount. Is there any debt that is redeemed at discount ? What will be the effect of the discount on the overall cost ?

I have TWO questions: 1. I was proofing that the NPV is ZERO at 11.86%. MV = -85 Interest =(6*5)/((1+0.1186)^5) = 17 Repayment =110/((1+0.1186)^5) = 63 NPV = -5 Can you please comment on the above calculation as I am getting -5 as NPV.

2. Why the investors require the IRR rate (where NPV is ZERO)? As an investory they should require positive NPV which will result in gain for them. Please comment.

Question # 1 solved. I should have expanded the interest payments and discount them individually.

Question # 2 remains. Why the investors require the IRR rate (where NPV is ZERO)? As an investor, they should require a positive NPV which will result in gain for them. Please comment.

Have you watched the earlier lectures on the valuation of debt? It is the investors who determine the market value of debt – they get the return they require by fixing the market value at the PV of the future receipts. All we are doing here is ‘working backwards’ to find out what that required return is.

If you are asked to calculate the cost of capital, then you will be given the market values (as traded securities they will be quoted on the stock exchange and so in practice it is simply a question of looking in the newspapers to find the market value).

As to how the market values are determined in the first place, this is cover in chapters 15 and 16 of the lecture notes and the lectures that of with them.

Hello John Sir, thank u very much for those wonderful lectures as always.

I have a question regarding the chosen % for D.F to calculate the IRR. For Kd you took 10% and 15%, and for Company’s cost you took 5% and 10%.

I took 10% and 15% to ease calculations (because we already got annuity and discount values from previous calculation for Kd), but got 9.77% instead of 9.81%, it’s for sure answers will vary as it’s not linear. My question is does the examiner cater for this and allow a margin of error.

It is no problem – using two guesses only ever gives an approximate answer (but leave it to two decimal places just so the marker can see from your workings that you know what you are doing.

(However, if you calculated at 10% first, you should have realised that since the NPV is negative then the IRR had to be lower than 10%. It would have therefore been better to make your second guess at lower than 10%.)

If you were asked to calculate an IRR in section A, then you will be told which guesses to use.

First of all I would like to thank you for your brilliant lectures. They are clear and concise. I have a question in relation to Example 8 part b – Cost to the company.

As per explanation of example 8 the symbols on cash flows are the following:

Time 0 M.V – Negative Cash flow Time 1- 5 Interest – Positive Cash flow Time 5. Repayment – Positive Cash flow

From a cash flow perspective, as this is the cost to the Company, should the cash flows have the opposite symbol? That is:

Time 0 M.V – Positive Cash Flow – Co. receives the money Time 1 – 5 – Negative Cash Flow – Co. is paying interest Time 5: Negative Cash Flow – Co. is repaying Debt finance.

It doesn’t make any difference at all – an NPV of +0 is the same as an NPV of -0 🙂

Do it whichever way round you want. However the reason we usually to it in the same way round as the lecture is because that is the way round that we are used to setting up the flows when we are calculating the IRR when we are investing in a project.

I am getting confused. In example 8 why would the NPV would be 0 if the present value of the receipts is the market value i.e. 85c. I just don’t understand.

And is this a general rule whether we are talking about shares or debt borrowing that the market value of the share or security is the present value of the expected receipts which are dividends in the case of shares and interest in the case of debt borrowing.

In Solution to Example 7, why are we diving the Cost of debt with the Current Market Price of 90. Dont we assume that the company always issued it at USD 100 at the time of raising the debt and the cost of capital will always be kd (1-t) for every year till it redeems it, Unless of course there is a redemption at a premium.

As I explain in the lecture, if it is quoted at 90 p.c. then it means the market value is $90 for every $100 nominal. Therefore the interest each year (given a coupon rate of 8%) is $8 per year. Therefore the return to investors (Kd) is 8/90 = 8.88%, and the cost to the company is Kd(1-T).

The price at which the debt was issued is completely irrelevant.

Here the debt will never be redeemed – the question specifically says that it is irredeemable.

If the debt is redeemable (which is more common in the exam) then the approach is different – we have to calculate the IRR and the cost of debt does not equal Kd(1-T), but this is dealt with in example 8.

I assume that you mean the 10% that I used as part of my calculation of the IRR to get the cost of debt.

When calculating the IRR you make two guesses. I chose 10% as one of the guesses but any two rates will do. Using different guesses does give slightly different answers (because the relationship is not linear) but still gets full marks in the exam.

I do suggest that you watch the earlier lectures on investment appraisal where the IRR calculation is explained in detail.

freddie1980 says

In the lecture notes for example 8 the answer is given as

6.07

————– *5%

6.07 ×10.22

The denominator shouldn’t that be 6.07 +10.22? This I’ve been scratching my head and redoing my workings trying to get back to the answer and this is the only way I know how.

John Moffat says

Please ask this sort of question in the Ask the Tutor Forum, and not as a comment on a lecture.

sidishah says

Hi Sir,

sir for ( eg 8) redeemable debt how do you determine which discount rate to start from for IRR.

like u started at 10 % how do we determine this?

John Moffat says

I make it clear in the lectures on investment appraisal (where the calculation of IRR is the same) that you can use any two ‘guesses’. I happen to choose 10% as my first ‘guess’ because it is in the middle the tables.

khan3057 says

Hi John!

Since scientific calculators are allowed in the exam, can’t we just calculate the exact IRR using the fact that at IRR, NPV = 0?

CF1/(1+x)^1+CF2/(1+x)^2+……-CF0=0 and then solve for x.

Also, I am using Casio fx-991ex calculator, is it allowed. It is non-programmable calculator but as regular scientific calculators that can solve for the value of ‘x’. Please advise.

John Moffat says

You can, provided that letters never appear on the calculator screen.

However you will see when you practice questions in your Revision Kit that the questions are designed in such a way as to test your understanding – it is not a maths exam and doing what you suggest will almost certainly be of no help at all. The exam is a professional exam and not simply testing that you know how to use a calculator 🙂

In Section C of the exam, the marks are for your workings and so just using a calculator will not get the marks.

khan3057 says

Thank you sir! I really appreciate your elaborative answers/suggestions. Thank you again for being so patient with us. 🙂

lucie13 says

Fantastic lecture as always!

I am stuying for P4 at the moment and I find it very useful to refresh my memory in some subjects from F9 by watching your video again.

Thank you for your hard work.

John Moffat says

Thank you for your comment 🙂

Rana says

Dear sir,

I have a question regarding cost of debt

In one of the questions i was doing it says that the company has in issue 200k 10% debentures that are redeemable at par in 2 years, and they have a current market value of 105.3 per cent.

in the answer it shows that the cost is 95.3 in year 0. is it constant that the capital is market value less interest (10 in this case?)

I don’t understand how the capital cost is calculated.

John Moffat says

In future please ask this sort of question in the Ask the Tutor Forum, and not as a comment on a lecture.

I would assume without seeing the question, that the market value is quoted cum int (or alternatively it says that the interest is about to be paid, which means the same thing). We need the ex int market value (as I explain in my lectures) and therefore you need to subtract the interest about to be paid.

allenmendonca says

Dear Sir,

In Example 8, since debentures are redeemed at premium of 10% at the end of 5 years, wont there be an expense of $2 each year (which in itself is not a cash flow) but it will reduce the tax expense by 2*30% = 0.6 each year .

Why is this not taken into account for calculating cost of capital?

yushengng says

Hello John,

Thanks again for such wonderful lectures.

For the sake of my confusion, for Example 8 when we are calculating cost of debt to the company, wouldn’t it make more sense that the cash flow in Time0 (issue of debt) a positive 85, while the payment of interest and redemption from Time1-5 negative 6 p.a. and negative 110 at Time5?

Thank you!

John Moffat says

If you want to do that then fine – the IRR will still be the same. (All the signs will be reversed, but and NPV of +0 is the same as and NPV of -0).

The reason why we tend to show the flows the way we do is that we are used to having the flows this way when calculating the IRR of projects. Reversing the signs can make it more confusing for some people.

rakhi2rakhi says

Sir in the any question for redeemable debt if it is asked find cost of bebt , do we need to find investors required rate of return or cost to company?

John Moffat says

If you are asked to find the cost of debt then that is the cost to the company.

narmeenzang says

Hi John,

Amazing lectures thank you!

I want to clarify something regarding example 8.

I understand the use of IRR in determining the interest rate – choosing two different percentages and hence you used 10 and 15.

What I don’t understand is why did you not use a DF of 7% ( 6 the debentures rate /85 the ex int) as you did in example 7 to calculate the Re (return on investment).

I thought the DF % to use is usually the same % as the rate of investors return.

John Moffat says

In example 7, the debt is irredeemable and then we can use coupon rate/market value

In example 8, the dent is redeemable and then we have to calculate the IRR.

(You could calculate the IRR for example 7 if you wanted, but not only would it obviously take longer, but the answer would only be approximate whereas here it is exact.)

narmeenzang says

That makes perfect sense. Thank you for the super fast reply 🙂

John Moffat says

You are welcome 🙂

salman7 says

As we studied that the cost of bank loan is “Interest * (1 – t)” because there is no premium or discount when redeemed at the end of the loan.

In Kaplan book, it is mentioned:

“Where the debt is redeemable at its current MV, the position of the investor is the same as a holder of irredeemable debt.”

Does both of the statements have the same meaning?

Can you please explain by numbers i.e., how come the return is same for redeemable and irredeemable debts?

Thanks as always,

John Moffat says

If you want numbers, then you must ask in the Ask the Tutor Forum and not as a comment on a lecture.

The two statements do mean the same. The cost of the debt is obviously the interest that has to be paid, and in the case of redeemable debt repayable at a premium, then the premium makes the overall cost higher.

If there is no premium, then the cost is only that of the interest.

salman7 says

Dear sir,

You did not say anything about discount. Is there any debt that is redeemed at discount ? What will be the effect of the discount on the overall cost ?

Thanks,

John Moffat says

No – debt is either redeemed at par (nominal value) or at a premium.

salman7 says

Dear sir,

Thank you for such lectures.

I have TWO questions:

1. I was proofing that the NPV is ZERO at 11.86%.

MV = -85

Interest =(6*5)/((1+0.1186)^5) = 17

Repayment =110/((1+0.1186)^5) = 63

NPV = -5

Can you please comment on the above calculation as I am getting -5 as NPV.

2. Why the investors require the IRR rate (where NPV is ZERO)? As an investory they should require positive NPV which will result in gain for them. Please comment.

salman7 says

Dear sir,

Question # 1 solved. I should have expanded the interest payments and discount them individually.

Question # 2 remains. Why the investors require the IRR rate (where NPV is ZERO)? As an investor, they should require a positive NPV which will result in gain for them. Please comment.

John Moffat says

Have you watched the earlier lectures on the valuation of debt?

It is the investors who determine the market value of debt – they get the return they require by fixing the market value at the PV of the future receipts. All we are doing here is ‘working backwards’ to find out what that required return is.

nhassan says

excellent lecture, but the only problem i have is how to get the market values of equity and debt. Thank you.

John Moffat says

If you are asked to calculate the cost of capital, then you will be given the market values (as traded securities they will be quoted on the stock exchange and so in practice it is simply a question of looking in the newspapers to find the market value).

As to how the market values are determined in the first place, this is cover in chapters 15 and 16 of the lecture notes and the lectures that of with them.

nzeadall says

Hello John Sir, thank u very much for those wonderful lectures as always.

I have a question regarding the chosen % for D.F to calculate the IRR. For Kd you took 10% and 15%, and for Company’s cost you took 5% and 10%.

I took 10% and 15% to ease calculations (because we already got annuity and discount values from previous calculation for Kd), but got 9.77% instead of 9.81%, it’s for sure answers will vary as it’s not linear. My question is does the examiner cater for this and allow a margin of error.

Thank u

John Moffat says

It is no problem – using two guesses only ever gives an approximate answer (but leave it to two decimal places just so the marker can see from your workings that you know what you are doing.

(However, if you calculated at 10% first, you should have realised that since the NPV is negative then the IRR had to be lower than 10%. It would have therefore been better to make your second guess at lower than 10%.)

If you were asked to calculate an IRR in section A, then you will be told which guesses to use.

nzeadall says

ok thank you 🙂

John Moffat says

You are welcome 🙂

Isabel says

Dear John,

First of all I would like to thank you for your brilliant lectures. They are clear and concise.

I have a question in relation to Example 8 part b – Cost to the company.

As per explanation of example 8 the symbols on cash flows are the following:

Time 0 M.V – Negative Cash flow

Time 1- 5 Interest – Positive Cash flow

Time 5. Repayment – Positive Cash flow

From a cash flow perspective, as this is the cost to the Company, should the cash flows have the opposite symbol? That is:

Time 0 M.V – Positive Cash Flow – Co. receives the money

Time 1 – 5 – Negative Cash Flow – Co. is paying interest

Time 5: Negative Cash Flow – Co. is repaying Debt finance.

Thank you in advance for your kind response.

Regards,

Isabel

John Moffat says

It doesn’t make any difference at all – an NPV of +0 is the same as an NPV of -0 🙂

Do it whichever way round you want. However the reason we usually to it in the same way round as the lecture is because that is the way round that we are used to setting up the flows when we are calculating the IRR when we are investing in a project.

Isabel says

Yes, your answer makes a lot of sense.

That´s great. Thank you John and Happy 2016!

John Moffat says

You are welcome, and happy new year to you also 🙂

shaafia says

Why isn’t the cost of debt for irredeemable debentures simply: the expected return to investors* (1-rate of tax)???

John Moffat says

It is!

If you listen carefully to the lecture then you will find that I actually say that!!!!!

shaafia says

i am sorry i meant redeemable!!

John Moffat says

Because only the interest is tax allowable – not the repayment.

Arun says

Hi John,

I am getting confused. In example 8 why would the NPV would be 0 if the present value of the receipts is the market value i.e. 85c. I just don’t understand.

And is this a general rule whether we are talking about shares or debt borrowing that the market value of the share or security is the present value of the expected receipts which are dividends in the case of shares and interest in the case of debt borrowing.

Thanks.

venky says

Hi John,

In Solution to Example 7, why are we diving the Cost of debt with the Current Market Price of 90. Dont we assume that the company always issued it at USD 100 at the time of raising the debt and the cost of capital will always be kd (1-t) for every year till it redeems it, Unless of course there is a redemption at a premium.

Can you kindly clarify.

Thanks

John Moffat says

As I explain in the lecture, if it is quoted at 90 p.c. then it means the market value is $90 for every $100 nominal.

Therefore the interest each year (given a coupon rate of 8%) is $8 per year.

Therefore the return to investors (Kd) is 8/90 = 8.88%, and the cost to the company is Kd(1-T).

The price at which the debt was issued is completely irrelevant.

Here the debt will never be redeemed – the question specifically says that it is irredeemable.

If the debt is redeemable (which is more common in the exam) then the approach is different – we have to calculate the IRR and the cost of debt does not equal Kd(1-T), but this is dealt with in example 8.

I do suggest that you watch the lecture again.

grishasargsyan says

Hello Mr.

Thank you for lectures

How did you get 10% ( you have discounted annuity and repayment at 10%) ?

John Moffat says

I assume that you mean the 10% that I used as part of my calculation of the IRR to get the cost of debt.

When calculating the IRR you make two guesses. I chose 10% as one of the guesses but any two rates will do. Using different guesses does give slightly different answers (because the relationship is not linear) but still gets full marks in the exam.

I do suggest that you watch the earlier lectures on investment appraisal where the IRR calculation is explained in detail.

grishasargsyan says

Thank You Mr. John

You are great teacher

John Moffat says

Thank you 🙂

Greenson says

Thank you sir this information is very useful..