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In questions that ask for the market value of a loan note. When we calculate the interest – how do you when to include the tax and when not to? In some questions they include the nom value of loan note lets say it was a 7% loan note so interest would be 0.07 x $100. When do we include the 1-t to this?
Quick recap
We discount at the debt lenders required rate of return (which is effectively the before tax cost of debt) because it is they who determine the market value and they are not affected by company tax.
The market value of debt is therefore determined by the holders of debt and is the present value of the receipts to investors discounted at the investors required rate of return.
Both the receipts and the required rate of return are before tax because investors are not affected by company tax.Depends on whether you have a before or after tax rate for the question. You need to adjust the rate if it’s after tax.
The before tax cost of debt is the rate of return required by the investors and is used when we are asked to calculate the market value of debt.Gadner Co wishes to calculate its weighted average cost of capital. The company has the following sources of finance:
$’000
Ordinary shares 8,000
10% Preference shares 2,000
8% Loan notes 6,000
Bank loan 2,000
18,000
The ordinary shares have a nominal value of $0·20 per share and are currently trading at $6·35 per share.The equity beta of Gadner Co is 1·25.The preference shares are irredeemable and have a nominal value of $0·50. They are currently trading at $0·55 per share.
The 8% loan notes have a nominal value of $100 per loan note and a market value of $108·29 per loan note. They are redeemable in six years’ time at a 5% premium to nominal value.
The bank loan charges fixed interest of 7% per year.
The yield on short-dated UK treasury bills is 4% and the equity risk premium is 5·6% per year. Gadner Co pays corporation tax of 20%.
(a) Calculate the market value weighted average cost of capital of Gadner Co. (11 marks)
In this question- I need to calculate the IRR – I use 5% as one DF but to calc IRR I need another % – how do you choose which % to use?
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