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In a specimen exam dec 2017 Q1 section A, cost of loan notes (5.4 %) has been used as a proxy cost of bank loan with a variable interest rate when calculating WACC. What’s the reason and the logic behind it ?
The cost of any form of finance depends on the return required by the investors, which in turn depends on the level of risk.
So it is not surprising the the cost of preference shares is less than the cost of equity (because they are less risk than equity).
Similarly it is not surprising that the cost of the loan notes is less than the cost of preference shares (because they are less risky than preference shares and in addition get the benefit of tax relief on the interest).We do not know the cost of the bank loan (if we were given it then obviously we would use the after-tax interest as the cost) and so we have no choice but to assume that the cost is the same as the cost of other borrowings i.e. the loan notes because it would be expected to be of a similar level of risk and there would be tax relief on the interest.
(If the question in the discussion part had asked about any reservations you might have about the calculations, then the most obvious reservation would indeed be that the cost of the bank loan might be different that the cost of the loan notes 🙂 )
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