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Hi Sir
I can understand the definition of nominal interest, real interest rate, pre-tax cost of debt and after tax cost of debt, however, I cannot distinguish when to use them in different situations? Could you please give some examples?Thank you
The nominal and real interest rates are relevant when discounting at the WACC.
We normally discount the actual (or nominal) cash flows (after taking into account the relevant inflation rates) at the actual (or nominal) cost of capital calculated in the normal way.The real cost of capital is the cost of capital after removing the general inflation rate using the Fisher formula provided in the exam. We use this to discount the real cash flows (i.e. the cash flows without inflation). This is only relevant in the exam when discounting perpetuities because the ‘normal’ approach is not possible.
The pre-tax cost of debt is the cost of debt calculated ignoring the tax savings on the interest. This is the return to investors which determines the market value of the debt.
The after tax cost of debt is the cost of debt taking into account the tax saving on the interest. This is the cost of debt to the company and is used in the calculation of the WACC.This is all explained (with examples) in my free lectures for Paper AFM (and for Paper FM because this is revision from Paper FM).
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