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Dear tutor,
Can u explain for me this ques
” a co. Has bonds outstanding which have a coupon rate of 8% and ARE TRADING ON A YIELD TO MATURITY OF 12%. The co. Has marginal tax rate is 30%. The cost of debt is closest to??”
I don’t know what ” trading on a yield to maturity of 12%” meaning? And don’t know how to calculate cost of debt?
Using : kd = interest/ Po???Thank u in advance
The yield to maturity is the redemption yield – the overall return to investors.
If you have watched the free lectures, you will know that the market value of the debt is the present value of the receipts (interest plus redemption) discounted at the return to investors.
The cost of debt is IRR of the after-tax flows.If the debt is irredeemable (which appears to be the case here assuming there was no other information in the question) then the cost of debt will be 12% x (1 – 0.3). i.e. after tax.
I do suggest that you watch the lectures – they are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Ok just the different wording makes it difficult to understand.
We use after tax cost of debt as discount rate also called yield rate & return to investor which is 12% (before tax)
Therefore 12% need to be converted to post tax
8% is used to calculate cost of debt by the trial-and-error method right?No – we use the before tax cost of debt to calculate the market value of debt.
We use the after-tax cost of debt when calculating the WACC to use for the discounting of investments.
The trial and error method of calculating the IRR is only needed when it is redeemable debt (and then any two guesses are OK – there is no particular reason for using 8% as one of the guesses).
Again, I do suggest that you watch the free lectures.
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