Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Dec 2012, COEDEN, Part (a)
 This topic has 3 replies, 2 voices, and was last updated 1 year ago by John Moffat.

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February 12, 2021 at 10:48 am #610125michelletsang
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I understood from the previous posts from other students that the cost of debt and market value of debt is calculated in terms of pretax, given the market value is based on the views of investors.
However, when calculating the WACC, the answer shows that WACC = 10.6% x 0.5 + 4.9% x 0.8 x 0.5 = 7.3%.
My question is given the WACC is in the views of the company and the debt is redeemable, not irredeemable, why we could simply multiply 0.8 with the pretax cost of debt (4.9%)?
February 12, 2021 at 2:31 pm #610157John MoffatKeymaster Topics: 57
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It seems you have misunderstood the previous posts that you have looked at.
The market value of debt is always calculated as the present value of the pretax flows discounted at the pretax cost of debt (which is the investors required rate of return) because it is investors who determine the market value and they are not affected by company tax.
The cost of debt is the cost to the company and is after tax. If the debt is irredeemable, then the cost of debt is Kd (1T) where Kd is the pretax cost of debt and T is the rate of tax. (Although it is more normally calculated as I(1T)/ MV, where I is the interest and MV is the market value, because this is faster).
However, if the debt is redeemable the cost of debt is calculated as the IRR of the after tax interest and redemption flows to the company (and most exam questions have redeemable debt rather than irredeemable).The reasons for this are all explained (with examples) in my free Paper FM lectures on the valuation of securities and on the cost of capital, because this is revision from Paper FM, and in my Paper AFM cost of capital lectures.
February 16, 2021 at 9:28 am #610600michelletsang Topics: 3
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Thank you for your reply. I’ve revisited the lecture notes and understood the points you mentioned.
That is why I’m confused with the approach used since 4.9% is the pretax cost of debt and is later used as the discount rate to arrive at the market value of debt. However, the way it calculated WACC is 10.6% x 0.5 + 4.9% x 0.8 x 0.5 = 7.3%. Here, the cost of debt suggested is Kd (1T) where Kd = 4.9% and (1T) = 0.8 but the debt in question is irredeemable.
As you stated, “if the debt is redeemable the cost of debt is calculated as the IRR of the aftertax interest and redemption flows to the company” but the answer did not use this approach.
February 16, 2021 at 5:19 pm #610644John MoffatKeymaster Topics: 57
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You are correct, and strictly the examiners answer should have calculated the aftertax IRR.
However, because the debt is repayable at par and the debt is not traded, which means that the market value is the same as the par value, then the IRR of the posttax flows will be exactly the same at the pretax cost as reduced by the rate of tax. Try it yourself and you will see that it is the same 🙂

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