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BPP book mentions that “if a firm has a floating rate debt than the cost of equivalent fixed interest debt should be substituted”
Suppose we are required to calculate WACC on book and market value basis, then the above statement means that the interest rate will effectively be used as a cost of debt in WACC (BOOK & MARKET value basis) ?
Apologies if this seems obvious.
However the likelihood of being asked to calculate the WACC using book values is extremely remote given that it would be pretty meaningless. From memory it has only been asked for once in the whole history of the exam and even then it was in order that you could comment on it 🙂
Noted. But I am not sure whether I understood you correctly.
If a company is paying interest than why would it look for substitute fixed interest debt (in market) so as to arrive at a cost of debt ?
Shouldn’t the company just check the interest it has paid in financial statement, suppose a company has a floating rate debt and the interest paid (according to financial statements) is $100 and the bank loan is $1000, then the cost of debt will obviously be 10%. So why find a substitute ?
Just trying to understand rather than learning the rules!
Please shed some light.
BPP has written that not because it is a rule, but simply because it was relevant in one past exam question where there was fixed rate debt and also a floating rate loan.
For the floating rate loan there was no mention of the interest currently being paid, and there was no information as to how much interest had been paid during the current year.
Therefore there was no choice but to assume that the loan carried the same risk as the fixed rate loan and therefore to use the cost of the fixed rate loan. However it was only done as an approximation because there was no choice 🙂
Floating rate loans are hardly ever mentioned in exam WACC calculations, but if they are then we have no choice but to use an approximation based on whatever information is available.
Now its clear…
Thank you 🙂
You are welcome 🙂