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    • They certainly do not just ask for the cost of debt – they want it as part of the calculation of the WACC 馃檪

      But yes, the cost of debt to the company is always calculated after accounting for the tax relief on the interest payments.

      (However, the exam does also quite often ask for the calculation of a market value for the debt. This is calculated ignoring tax because it is the investors who determine the market value of the debt and company tax does not affect them.)

      • okay, your explanation at the last cleared my confusion. For one question (Sigra Co Dec 2012), I tried to follow your approach but the answer did not match. I am not sure where my calculation went wrong. Can you help me ?
        Q:
        Sigra Co is offering bond offer: 2% coupon bond redeemable in 3 yrs at par
        Sigra Co’s non-current liabilties include a 6% coupon bond redeemable in 3 yrs at par currently trading at $104
        Tax rate not given (probably because we need to calculate price of bond?)
        A:
        Year Cash flows($) 5% PV 10% PV
        0 (104) 1 (104) 1 (104)
        1-3 6 2.723 16.34 2.487 14.92
        3 106 0.864 91.58 0.751 79.61
        =+3.92 =-9.47

        5% +3.92
        10% -9.47
        =5% = 13.39

        Therefore, r=5%+ (10%-5%)*$3.92/$13.39=6.46% (but in recommended answer it is 4.55%)

        Thank you so much!

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

        Your interest flows are correct ($6 per year for 3 years) but the redemption in 3 years time is at par of $100 (not $106).

  2. Maybe this is more a tax question. but is it not inconsistent that interest is taxed, but the premium is not? Would companies not rather elect to structure instruments in such a way that interest is disguised as premium, in order to avoid tax payments on interest for the holders?

    • For the recipient it is likely to be taxed.
      However personal tax is always ignored in the exam, and therefore the recipient receives the full interest and the full premium.

      The only tax considered is the tax on the company (and it is considered then calculating the cost of debt to the company). Interest payments are allowable for the company and therefore save tax for the company, the repayment is not tax allowable and doesn’t save tax.

  4. Sir, pls. correct me:

    Kd is the return required by the investors, which is different from cost to the company because of the existence of tax- (1-t).

    Ke though is the same as the cost of the company as there is no tax relief for equity.

    Am I right?

    • True – Kd is the return to investors which is pre-tax. The cost to the company is Kd(1-T) if it is irredeemable debt. However if (as is more likely in the exam) it is redeemable debt then it does not equal Kd(1-T) – we need to calculate the IRR of the after-tax flows (whereas Kd is the IRR of the pre-tax flows).

      • Hi John,

        I am a little confused. You have mentioned that if debt is REDEEMABLE than it does NOT equal KDx(1-T). if that is the case than why in example 8 part 2 (redeemable debt) you have considered the coupon rate of 4.2 pa. That is $6 less 30%. If we were to follow your advise than the rate considered p.a should be 6% on nominal i.e. $6 because the example 8 states it is a redeemable debt.

        Appreciate your clarification.

      • The coupon rate gives the actual $ interest paid. This is allowable for tax and so the net payment is indeed $6 x 70% = $4.20.

        This is not the cost of debt. The cost of debt is part 2 is 10% whereas in part 1 (without tax) the return to investors is 11.86%

        The cost of debt does not equal the return to investors x 70%.

        As I explain in the lecture, it is because although the interest is tax allowable, the repayment is not tax allowable.

      • Dear Sir,

        Since the IRR is already after tax, can we pluck in this Kd into the WACC straight, without providing for another (1-T) as in the WACC formula?

  5. Hi Sir

    Example 7 part a, the cost of debt (kd) is 8.89%. After calculating you said that if the same was to be issued in stock market, the investors would desire the same return, otherwise why would they invest.
    I didn’t understand this.
    Also why is Kd calculated? the cost of debt is already known i.e, 8%. So when Kd is calculated, there will be 2 cost of debt percentages i.e, 8% and 8.89% . What is it’s difference?

    • 8% is not the cost of debt. It is the coupon rate (the interest on nominal). Maybe when the debt was originally issued, 8% was an attractive rate. However, if investors were to buy the debt now on the stock exchange they would get a return of 8.89%. So if new debt were to be issued only offering 8% nobody would buy it – the company will have to offer 8.89% for it to be attractive.

      You may find the free F9 lectures on the cost of capital to be helpful.

  11. Very nice lectures, but i have a question plz help me to explain
    eg 7 & 8 in chapter 7. which one has higher cost btw for Irredeemable debt and redeemable debt? and you guest discount rate in example 8 based on what criteria ?. Your result is far than 6%

    • I am not sure what you mean by the first part of your question – they are two separate examples and in example 7 the cost of debt is 6.22% whereas in the second example it is 10%.
      The fact that one is irredeemable and the other redeemable just means that we do the arithmetic differently – it is not the reason that one has a higher cost that the other. Either of the two could have been higher.

      In example 8, we need to calculate the internal rate of return and the approach is exactly the same as when you calculated IRR for projects in Paper F9 – we make two guesses and then approximate between them to find where the NPV is zero. I guessed at 5% and 10% for part (a), but I could have made any two guesses.
      For part (b) I guessed at 10% (simply because 10% is in the middle of the tables). If the answer had not come so close to zero then I would have made a second guess and approximated in the same way as I did for part (a).

      There is no reason that the answer should be close to 6% which is the coupon rate. What we are trying to calculate in part (a) is the return that investors are currently getting if they buy the existing debt on the stock exchange. Since they are currently getting 11.86%, then there is no way that they would lend more money to the company unless they were offered 11.86% (but it would actually cost the company less because they get tax relief on the interest, which is why workings (b) are necessary).

  12. how does you got -0.77 i didn’t understand .from 1-5 year present value was 15.92 and at 5 year was 68.31 so what did you do to get -0.77.
    other thing is suppose answer is no close to zero but still negative so should we have to guess other percentage less then 10%

    • -0.77 is the net present value of the flows: 15.92 + 68.31 – 85 = -0.77

      We are calculating the Internal Rate of Return of the flows in exactly the same was as we do for projects (and as you did for F9) by making two guesses and then approximating between them (as we did in part (a) of this question).

      For part (b) I was ‘lucky’ because the NPV was virtually zero at 10% and so I did not need a second guess. If it was not so close to zero then I would have had to make a second guess and approximate in the same sort of way as for part (a).

  18. Dear lecturer,

    Thank you for your lesson.

    I have a question, too. Why the pricing in example 7 & 8 quoted in ex int (excluding interest?)

    And I can’t remember the difference in various debts. I remember there was a exam question about vanila bond. Can you give me a more detailed information about different type of debts?

    Thank you very much.

    • @annalla, Debt is always quoted ex int in the exam, unless you are told otherwise. Here the questions actually say that they are ex int (i.e. that interest has just been paid).

      Vanilla debt is debt with no unusual features (so not convertible, no warrants attached, no premium on redemption – just interest each year and then repayment at par.)

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