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I am afraid that I am still having trouble deriving the cost of loan capital for the business in respect to the following scenario: “The company is also financed by 7% bonds with a nominal value of £100 per bond, which will be redeemed in 7 years’ time at nominal value. The bonds have a total nominal value of £14m. Interest on the bonds has just been paid and the current market value of each bond is £107.14. Tax rate is 20% per year.”
As you can see from the table below, I am having particular problems calculating the equations for row 1 -7. As recommended, I have watched your lectures and read through the notes, but unfortunately, I am none the wiser!
Year CF DF10% PV DF 5% PV
0 Current market value (107.14) 1.000 (107.14) 1.000 (107.14)
1 – 7 Interest payable (7(1-t)) 5.60 x x x x
7 Redemption Value 100 0.513 51.32 0.711 71.11
x x
If at all possible, please could you let me know what equations I should be using to calculate the various Xs in the table above?
I am coming from a legal background so most of these concepts are new to me!
Many thanks for your continued assistance.
The cash flows are:
0 (107.14)
1-7 5.60 per year
7 100.00I have no idea what all your x’s are meant to be.
Calculate the NPV of those flows at 2 different rate of interest – the discount factors are all in the tables provided. The discounting does not involve using any equations, you just multiply the cash flows by the discount factors. You can use any two rates of interest – I would use 5% and 10%, but it doesn’t have to be these two rates. Then approximate between them to get the IRR.
I really cannot understand why you write that most of the concepts are new to you. You must have taken Paper MA (was F2) or studied the topics at university in order to have been exempt from Paper MA, and the discounting and the calculation of the IRR are very basic topics from Paper MA.
Both the discounting and the calculation of the IRR are covered in detail in my Paper MA lectures on Investment Appraisal, and there is nothing different here for Paper AFM once you have got the cash flows to use. You cannot expect me to type out all my lectures here 🙂- Topics: 2
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Hi John
Sorry, the format of the table altered when it was sent.
Yes, I understand what the cash flows are and how they are calculated. I have also correctly worked out the rows for the current market value and redemption value.
I am having trouble calculating the interest payable row, i.e. (1-7). I am still not sure how you calculate the discount/annuity factor for this period.
Using another example: If the discount rate is 5% and the post-tax interest cf is 5.60 for years 1-6, how would you go about determining the discount/annuity factor. As per the example, the answer is 5.076, but I am having trouble understanding how they arrived at this position.
The annuity factors are provided for you in the exam (you can see the table in our free lecture notes). You do not need to calculate them.
Again, please do watch my free Paper MA lectures on interest and on investment appraisal. I explain what the factors are and how to use the tables in the free lectures.
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Thanks for pointing that out to me, John.
In light of this, I have now calculated the cost of debt based on the cash flows above.
I used the following DFs: 4% and 8%.
For 4%
– Years 1 – 7: DF was 6.002 and PV was 33.61
– Redemption value: DF was 0.760 and PV was 76.10
– NPV 2.57For 8%
– Years 1 – 7: DF was 5.206 and PV 29.15
– Redemption value: DF was 0.583 and PV 58.35
– NPV -19.64I then calculated the IRR using the formula, whereby:
4 + (2.57/2.57–19.64) x (8-4) = 4.46%
Then, in terms of the cost of debt and WACC, I found out how much debt contributed to the WACC – this was 0.71. The calculation was 0.16 x 4.46. This represents the debt proportion of total market value x cost of debt.
I just wanted to get your thoughts on the above, if at all possible?
Many thanks
The IRR seems correct.
I cannot check the last bit because I don’t know the MV of equity.
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The equity beta was 0.9 and the company issued 10 million equity shares. MV was 7.50 per share. The risk-free rate of return was 4% per year and the average return on the stock market was 11%.
Using the CAPM formula: 4% + 0.9(11% – 4%) = 10.3%
So, for the equity part of WACC. I calculated 0.83 x 10.3. This equated to 8.55.
Overall, the WACC was 9.26%.
Separately, is it worth clarifying why I used the DF 4% and 8%?
Thanks
Correct (and there is no need in the exam to clarify why you used 4% and 8%).
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Thanks for your help, John.
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