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The cost of capital – Cost of debt – ACCA Financial Management (FM)

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  1. sir i have a confusion between investors rate of return and the coupon rate written beside the debentures ? what is the relation of that coupon rate with investors rate of return and how are these things related to market value . as far as i know in past we financed capital and are paying investors at coupon rate but if investors want to buy it NOW so that would depend on investors rate of return presently and the market value presently , am i right ?

    • The coupon rate is the rate of interest on the nominal value.

      The investors required rate of return is the rate of interest the want to get (which depends on factors such as rate of interest they can get elsewhere) and it is this required rate to return that detemines the amount they are prepared to pay for the debentures i.e. the market value.

      If you have more questions then please ask in the Ask the Tutor forum rather than as a comment on a lecture.

  2. Hi Sir,

    I enjoyed watching this lecture, very well explained. Just a question, for the return to investors on irredeemable debt, the calculation is essentially the same as the interest yield we saw in Chapter 12. Do they mean the same thing? And similarly, is the return to investors on redeemable debt the same as the Redemption yield?

    Thanks a lot in advance.

    Regards,
    Tim

  4. Dear sir,

    Would you say that, for exam purpose, “irredeemable debt” is the same thing as a perpetuity, and therefore we could use the perpetuity formula of:

    Market Value of perpetuity = payment amount/investor’s required rate of return

    • I do explain in the lecture. We know from an earlier chapter that the MV of the debt is equal to the PV of the future receipts discounted at the investors required rate of return. Given that we know the MV and we know what the future receipts are, then the investors required rate of return must be the IRR of the flows.

  6. Hello sir
    I was doing exam kit ques of Fence Co of June 2014. There the IRR was coming 4.4% whereas of mine it was coming 5.7%
    But WACC as per answer was 9.3% and mine was coming 9.5%
    Will it be correct

  7. Hi John,

    Firstly thank you so much for these lectures you are wonderful at explaining.
    I do have one thing that I am stuck on, in example 7.. I understand the return investors receive is now 8.89%, 8/$90 which they purchased the bonds for on the stock exchange. What i don’t get as why we, the company, can claim for tax relief on $8.89 and have an expense of $6.22, because aren’t we still only paying $8 in interest? like.. the return % for investors has increased to 8.89% but this doesn’t mean we pay them $8.89.. do we?

    thank you and sorry for the inconvenience

  8. Hi John,

    I was wondering if you could explain something to me that’s been troubling me all day during revision of cost of capital.

    In the video at 13:38 you are working out the IRR and you give the calculation as 10%+(6.06/16.28*5%) which give you the answer of 11.86%. However in the lecture notes for the answer to example 8 the calculation is give as 10%+(6.07/6.07*10.22*5%), if I do this calculation I get answer of 61.1%. The examples in the Kaplan study books use the same methodology and I’m having the same problem getting back to the answer.

    If there an obvious trick to this that I’m missing or is best to ignore the formula given in the materials and for the denominator just workout the difference between the two NPV’s?

    • Argh I can’t believe I didn’t spot this earlier, in the formula given in the notes it says to minus one NPV from the other in the denominator. I think that means the lecture notes needs a minor edit on page 152 to Answer to Example 8 part (a)

    • If you are referring to example 8 (a) then I use 10% and 15% as the guesses. 5% is the difference between them.

      It might help you to revise the calculations of the IRR by watching the Paper MA lectures on investment appraisal.

    • I certainly do explain it in the lecture!!!!

      Part (a) of example 8 in the lecture notes asks for the return to investors, and part (b) of the example asks for the cost of debt.

      I work through both parts in the lecture.

  11. Dear Tutor,

    Lane Co has in issue 3% convertible loan notes which are redeemable in five years’ time at their nominal value of $100 per loan note.
    Alternatively, each loan note can be converted in five years’ time into 25 Lane Co ordinary shares.
    The current share price of Lane Co is $3·60 per share and future share price growth is expected to be 5% per year.
    The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%.
    What is the current market value of a Lane Co convertible loan note? (Answer: $82·71)

    Solution:
    Conversion value = $3·60 x 1·05(5) x 25 = $114·87
    Discounting at 10%, loan note value = ($3 x 3·791) + ($114·87 x 0·621) = $82·71

    Why the annual interest don’t need the after-tax value ? (3% x $100 x (1-30%) = $2.1)

    Thank for help.

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

      The after-tax interest is only relevant when calculating the cost of debt to the company.

      When calculating the market value, we use the interest pre-tax because it is the investors who determine the market value and they are not affected by company tax. This is explained in the lectures on the valuation of securities.

  12. Hi sir, in the calculation of cost of debt with redeemable debt, can I reverse all the signs? In other words, from the company’s perspective, market value will be a cash inflow since you imagine you issue new debt now and receive the cash while interest expense and redemption will be a cash outflow.

    To me, this makes more sense and in the calculation of IRR, we will get the exact same answer but I’m more concerned about whether I will get marked down for this.

  14. HI john. Thanks for the amazing lecturer videos u provide, they make complicated stuff to easy peasy lemon squeezy.

    in example 8 u find that investor’s required return (Kd) is equal to 11.86%. can we say that for every 100 unit of debt they require an interest of 11.86 without selling the note at discount.

    also i want to know is there any relationship between the Kd and the market value of debt.

    • Nobody is paying out anything because the debt has already been issued.

      As I explain in the lecture, we are looking at the existing debt to determine what return investors are currently requiring because if we issue new debt then we are going to have to offer the same return. We find out what return they are currently required by looking at the return on the existing debt borrowing.

  16. An item of plant with a carrying amount of $240 000 was sold at a loss of $90 000 during the year. Depreciation of $280 000 was charged (to cost of sales) for property, plant and equipment in the year ended 31 March 2018.
    PTC uses the fair value model in IAS 40: Investment Property. There were no purchases or sales of investment property during the year

    • This has nothing whatsoever to do with this lecture or to do with anything in Paper FM, and nor have you said what your problem is!

      If you have a question then please ask it in the relevant Ask the Tutor Forum.

    • Have you watched the earlier lecture on calculating the IRR, because it is exactly the same ‘rule’.
      You can use any two ‘guesses’. I tend to use 10% as my first guess because it is in the middle of the tables.

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