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I discovered following questions when I was doing a practice
(b) Five-year Sterling 7% fixed rate secured bank term loan of up to £50 million, initial arrangement fee 1%. The cost of debt is calculated using IRR method and the loan is thought to be redeemable debt.
(c) $15 million one-year commercial paper, issued at $US LIBOR plus 1.5%. This could be renewed on an annual basis. An additional 0.5% per year would be payable to a US bank for a back-up line of credit. The cost of debt is calculated as irredeemable debt.
(d) 80 million Swiss Franc five-year fixed rate secured bank loan at 2.5%. This may be swapped into fixed rate $ at an additional annual interest rate of 2.3%. An upfront fee of 3.0% is also payable. This one also uses IRR method.
(e) £42 million 10-year Sterling Eurobond issue at 6.85%. This may be swapped into $ at an annual interest rate of 4.95%. Eurobond issue costs of 2%, and upfront swap costs of 1.7% would also be payable. IRR method
(f) $40 million floating rate six-year secured term loan from a US bank, at $US LIBOR plus 3%. This one is calculated as irredeemable debt.
So I was confused about how to make judgement whether the debt is redeemable or irredeemable according to information given.And is there any relations between upfront fees and redeemable debt.If the amount of the repayment is the same as the current market value (which in your examples is the amount originally borrowed), then you can calculate the cost debt in the same way as though it were irredeemable debt. (It is not that we are assuming it is irredeemable).
It is only when the repayment is different from the original borrowing that we need to calculate the IRR. Usually we are looking at bonds, where the the repayment is almost always different to the current market value, which is why we usually need to calculate the IRR.
(It is because the basic cost would be interest/market value, but there is a sort of extra ‘bonus’ at the end which makes the overall cost different – hence the need for the IRR.)
In your examples, in the case of (b) (d) and (e) the two are different (because of the issue costs) and so it is IRR.
In the case of (c) and (f) there are no issue costs and so the two are the same and you can calculate as though it was irredeemable debt.Dear John,
1) Is the way we treat redeemable and irredeemable bonds the same (in terms of
calculation, not definition)?2) For convertible bonds, the questions will state something like this:
-20 million loan in the form of 6% convertible bond on which interest is payable annually.
Conversion may be undertaken on the basis of 50 equity shares for every $100 from the
beginning of year five onwards.Can I ignore the second sentence (Coversion….onwards) ? Because for the questions that I have done regarding convertible bonds so far, the answers have nothing to do with the second sentence.
1. No it certainly is not. For redeemable we need to calculate the IRR, for irredeemable we can calculate it directly.
You should watch my free lectures on this – you cannot expect me to type them all out here 🙂2. For the calculation – yes, you would assume that if conversion takes place then it would happen at time 5. However, you would mention that conversion could in practice be delayed.
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