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Sir, I read in one of the answers where you state that when calculating the market value of the debt:
“it is the investors who determine the Market value of the debt & they don’t get the benefit of company tax relief so their required return is equal to the before-tax cost of capital”.Could you please explain that how the shareholders determine the market value and whether it is based on something or they can make any figure for the market value of the debt – I am confused here a little please explain!
As I explain in my free lectures, the market value of debt is the present value of future receipts (interest and redemption) discounted at the investors required rate of the return.
The future receipts are known for certain (because debt pays interest at a fixed rate). The required return will depend very much on the level of interest that investors could receive elsewhere (but is given in the exam when you are required to determine the market value).
Please do watch my free lectures on the valuation of securities (both equity and debt) which is commonly asked in the exam. I do explain both the logic and the arithmetic (with examples) in detail in my lectures.
I watched your lecture where you say that Market value is the present value of future dividends to be received discounted at the shareholder’s required rate of return (which I understood).
BUT I am afraid that I do not understand that how shareholders determine the required rate of return because they can ask whatever rate they want which the company might not be able to pay them because it is the company who has to pay them the required rate of return which they want.
Secondly, I am confused with this line that I asked you above “that shareholders do not get the benefit of company tax relief so their required return is equal to the before-tax cost of capital”
Please shed some light on these issues. Thanks for your time 🙂
Individual lenders cannot get any return they want. However if lenders overall want a return of (say 10%) then they will get 10% because they will change the market value so as to make sure they are getting 10%. It is investors who determine the market value.
As to why they might want 10%, it will be a combination of the rate of interest being paid by the government on government borrowings and how risky they consider investing in debt of the company is. However if it is relevant in the exam you would be told the return required.
Still using the same example, if shareholders want a return of 10% then the will fix the market values that the interest they are getting is 10% of the market value.
However, as far as the cost to the company is concerned, even though they might be having to pay 10% to the investors, the interest is allowable for tax and so they will save tax as a result of paying the interest. Therefore the effective cost to the company will be lower.
I explain the calculation of the cost of debt to the company (depending on whether the debt is redeemable or irredeemable) in my free lectures on the cost of capital.
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