Question on Cost of Debt — OpenTuition Forums

CCin14y ago

In Q2a of Jun 2010, the question asked to calculate the after-tax cost of debt of the 9% bond. Each bond has a nominal value of $100, to be redeemed at 10% of the nominal value after 10 years and a tax rate of 30%.

Can you please on the followings?
1) Why the $100 (nominal value per bond) is considered cash "outflow" when calculating NPV of cash flow? The company should be receiving this $100 (per bond) at issuance. Why not considered as cash "inflow"?

2) Why the after-tax interest ($6.3 /bond) and redemption amount ($110) are both considered cash "inflow"? The company should pay these two amounts to bondholders. Why not considered them as cash "outflow"?

Thx very much

John MoffatTutor14y ago#1

What you say is correct and by all means set up the schedule showing the market value as an inflow, and the interest and repayment as outflows.

However it will make no difference because the cost of debt is the Internal Rate of Return, which is when the NPV is zero.

So....if you put the flows the other way round, the NPV at the IRR will be minus zero, which is still zero (if that makes sense) :)

The reason we usually show the flows as we do is so that the IRR calculation is the same as it would be if we were calculating the IRR of a project.

CCin14y ago#2

Thanks very much, John! I'm totally enlightened. Really highly appreciate the help.

Would you mind to give some advice on another question of mine "Confusion on gearing ratio" (also posted on site)? Thx again

John MoffatTutor14y ago#3

You are welcome.