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Hi,
I wondered whether someone can help me understand this question:
Today is 1 January 2005. Wilco plc has £100,000 5% 2008 redeemable loan notes in issue. Interest is paid annually on 31 December. The ex-interest market Value of a loan note on 1 January 2005 is £90 and the loan notes are redeemable at a 5% premium. Tax on profits is 20%.
What is the cost of debt?The answer is 8.15%
However, when I look at how BPP have calculated this, it seems that I am supposed to calculate the IRR – but how would I know that from the question?
Also, when calculating the IRR, it’s using discount factors at 7% and 9% – to calculate the NPVa and NPVb – Where did those %s come from?
If you have a copy of the BPP FM workbook this question is in chapter 11 – cost of capital, activity 6 on page 242.
Any help would be appreciated.
ThanksRedeemable debt is no longer a perpetuity. Therefore redeemable debt, like convertible debt, debt with a definite end it is calculated using IRR.
IRR is calculated using two rates, you choose these, one should give you a + and the other a negative.for IRR to give you the most accurate of the rate/cost of debt.Thanks
So if a question like this came up in the exam, you’re saying I can just pluck 2 rates out of thin air??
– Sorry, I’m not trying to be rude, but I just don’t understand how that can be possible.Yes you do if the first comes out with a + novel you go higher
If – you go lower
Have you not watched the lectures on Redeemable Debt?No – I literally dont have a lot of time after working all day. I will just leave this one as it’s way above my head.
It’s very simple
When you see redeemable or convertible it is a debt with an end.
So you have to calculate the IRR of the c/flows
MV Debt
Int (1-t)
RedemptionYou use 2 rates from 1-20
So my advice is……
If you always start with 10% if your answer is + choose 15 if it’s – choose 5%Sorry, when you say “If your answer is + choose 15″… what do you mean exactly?
I won’t know what my answer is prior to choosing the rate, so I’m very confused.Also, I did as you suggested and plucked 2 rates out of thin air and I got the answer wrong.
6% convertible loan notes with a NV of $100 and trading at $108.51. On 31 Dec x9 the investors holding the loan notes might convert them into 20 ordinary shares.
The ordinary shares are trading at $5.55/share and have a NV of $0.50 per share. Tax is 15%I chose 5% and 7% for the IRR
@5%:
Y0 Loan note (108.51) * 1 =(108.51) PV
Y1-3 After tax interest = 6%*.085 = 5.10 * 2.723 (AF1-3) = 13.89
Y3 Redemption ($5.55 *1.06^3) = 132.20 * 0.864 = 114.22
Total ( -108.51 + 13.89 + 114.22) 19.60@7%:
Y0 Loan note (108.51) * 1 =(108.51) PV
Y1-3 After tax interest = 5.10 * 2.624 = 13.38
Y3 Redemption = 132.20 * 0.816 = 107.88
Total ( -108.51 + 13.38+ 107.88) 12.75IRR= 5 + 19.6/(19.6+12.75) * (7-5)
Answer = 6.21%Answer per text book using the rates 10% and 15% – again, they don’t say why they have chosen these rates:
10+3.45/(3.45+9.87)*(15-10)=11.3%
I thought that maybe I had put the brackets in the wrong place in the calculator, but when I edit my entry and replace my numbers with the ones from the text book, I get 11.3%, so there isn’t an issue with my input – it has to be due to the interest rates I have chosen.
Your answer is wrong
What is the difference between 5 & 7%
Well when you do IRR you really want one NPV that’s a + answer and one that is negativeYou are adding the difference in NPV you should be deducting one from the other
So if you have a negative that is like adding them together
15% / 5%
NPV -10.4 / 19.6
= 5 + (19.6/(19.6- -10.4))*(15-10). = 11.5%
Same as saying = 5 + (19.6/(19.6+10.4))*(15-10) which is 11.5%
If you have two positives like you have it works like this:
7% / 5%NPV 12.7 / 19.6
= 5 + (19.6/(19.6-12.7))*(7-5)
= 10.7%
Both of these are correct – the further out your rates are from each other, the more of an estimate it is
OK so if I get 10.7% in the exam using 5% and 7%, would it be marked right or wrong?
Because how am I supposed to know which % will give me a negative result.It would be marked correctly – it should be within the accepted guidelines
But you will get a more accurate result with a + and –
Which you do by choosing 15% and another rate it’s simple
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