- February 28, 2021 at 1:50 pm #612124
Dear john sir,
in this question’s part b) ii) where we are asked to find mv of new bonds and its YTM,
how are we really expected to know that the examiner is asking for after tax YTM (or IRR)????? in all past papers we have found before tax Kd, but in this question without any explicit mention, we are expected to find after tax Kd!!
so how are we supposed to know in exam which YTM or Kd examiner is expecting?
for part b)iii) where we are asked to find revised ke and cost of capital,
I used combined market value of both debts and weighted average debt to find revised cost of capital , do i lose marks for this approach ? examiner has separately used both Kds and MV of debt.February 28, 2021 at 3:22 pm #612142John MoffatKeymaster
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In future please do say which exam questions are from – I cannot remember the name of every question there has ever been 🙂
When calculating the cost of debt (for the WACC calculation) we always calculate the after tax cost (i.e. the IRR of the after tax flows).
When calculating the MV of debt, we always discount the pre-tax flows at the investors required rate of return (i.e. the pre-tax cost of debt).
The examiner has done the calculations correctly in his answer, but he was wrong to head up the workings for the cost of debt as the YTM and to call it Kd. The YTM and Kd are both the return to the investors i.e. the pre-tax cost of debt.
(I emailed the examiner about this several weeks ago but have yet to receive a reply.)
For part (b)(iii) you would lose some marks (but probably only 1 mark). However many sources of finance there are you should take the weighted average of all of them and not combine any together.February 28, 2021 at 3:53 pm #612149
yes exactly my point sir ! YTM is pre-tax Kd or investors required rate of return. I really got scared when i saw the examiner’s answer! thank you for making it clear.February 28, 2021 at 4:39 pm #612156
sir pls read this extra carefully, as it is going to have some major implications for me!
Have got an altogether another doubt now! Are you suggesting that if the examiner has asked us to find WACC directly or indirectly(in a mergers and acquisitions) and has provided us some bond details we should find IRR of after tax cash flows??
Instead of first finding pre-tax IRR and then multiplying it with (1-T). so this shortcut is what we would avoid? we do this for convenience in most questions where pre-tax KD already mentioned, but should not do it when the question seems to be giving enough details to find after tax cash flows IRR ourself???
you get what am trying to ask?March 1, 2021 at 7:55 am #612233John MoffatKeymaster
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We always use the after-tax cost of debt in the WACC calculation.
If it is irredeemable debt then the cost of debt is the pre-tax cost of debt multiplied by (1-T).
If it is redeemable debt (which is more common in the exam) then it is the IRR of the after-tax flows (NOT the IRR of the pre-tax flows multiplied by (1-T))
I do explain the reasons for this in my lectures on the cost of debt.
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