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Hi
I have a question in relation to calculating the cost of debt. Using the scenario below, I should be grateful if you could assist?
The scenario is as follows: “The company is also financed by 7% bonds with a nominal value of £100 per bond, which will be redeemed in 7 years’ time at nominal value. The bonds have a total nominal value of £14m. Interest on the bonds has just been paid and the current market value of each bond is £107.14. The risk-free rate of return is 4% and the average return on the stock market is 11% per year. Tax rate is 20% per year.”
I understand that as the bonds are redeemable, there is no set formula to rely upon, and I will need to calculate the cost by using the investment appraisal, IRR.
I am having trouble documenting the cash flows and then finding out the NPVs. Is it possible if you could provide a breakdown of the steps involved?
Many thanks
There is an outflow at time 0 of 107.14.
Then inflows of an annuity from times 1 to 7 of the after-tax interest of 5.60 per year
Then an inflow on redemption of 100 at time 7.You calculate the NPV at any two (sensible) rates of interest and then interpolate between them to estimate the rate of interest at which the NPV is zero.
I go through lots of examples of calculating the cost of debt in my free lectures for Paper AFM (and the lectures for Paper FM (was F9), because it is revision from Paper FM).
As far as calculating an IRR, see my lectures for AFM, for FM and for Paper MA (was F2).
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