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Hi! sir there is a question in Kaplan study text Chap no 06 WACC test your understanding number 9, page 216.
The question asks to calculate weighted average cost of capital. I had a problem with calculating cost of debt. The question contained both market value of debt and the credit spread table.
“Debt (8%, redeemable in 5 years) 1,000
The share price is $1.22, and the debenture price is
$110 per $100 nominal.
Extract from S&P Global Ratings credit spread tables:
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
The risk-free rate of interest is 6% and the equity risk premium is 8%.
Tax is payable at 30%”
I had no problem calculating the cost of debt using the credit spread table but for good measure I also calculated the IRR using after tax interest payments as the debt was redeemable, but it gave a completely different answer. shouldn’t both answers be the same and if not, can you please clarify why and given there is information about both methods which one should I use. Thank u!I don’t have the Kaplan books and so I cannot check the whole question (you haven’t said what the credit rating is for the debt).
Although I would (in practice) expect the costs to be similar, the theories are not perfect and so they might quite well not be exactly the same. (I assume that you did subtract the tax when using the credit spread table?).In the exam it would be normal for them to make it clear which to use (if both are given) but if not then best to use the IRR as the cost of debt.
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