FMF9
Syllabus E. Business Finance E2b. Cost of Debt

Redeemable debt 1 / 2

Redeemable debt

The company pays the interest and the original amount (capital) back.

So the MV is the interest and capital discounted at the investor’s required rate of return.

Remember the cost of debt to the company is the debtholder’s required rate of return. (Tax plays a part here as we shall see later)

To calculate the cost of debt in an exam an IRR calculation is required as follows:

  1. Guess the cost of debt is 10 or 15% and calculate the present value of the capital and interest.

  2. Compare this to the correct MV

  3. Now do the same but guess at 5%

  4. Use the IRR formula to calculate the actual cost of capital

    IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

Illustration

5 years 12% redeemable debt. MV is 107.59

Time Cash 5% PV 15% PV
1-5 Interest 12 4.329 51.95 3.352 40.22
5 Capital 100 0.784 78.40 0.497 49.7
  MV   -107.59   -107.59
      22.76   -17.67

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (22.76 / (22.76+17.67)) x (15-5) = 10.63

The Tax Effect

  • Tax reduces the cost of capital to a company because interest payments are tax deductible.

    It was ignored in the last example, but let’s say that that tax was 30%, then the actual interest cost was not 12 but 12x70% = 8.40

    Simply take the interest figure and multiply it by 1 - tax rate%.

Illustration

20% Redeemable debt. 

Tax 30%. 

What is the interest charge to be used in a cost of capital calculation for a company?

20% x 70% = 14%

Now let’s rework that last example but this time use 10% as a guess and let’s assume tax of 30%

Time Cash 5% PV 10% PV
1-5 Interest 8.4 4.329 36.36 3.791 31.84
5 Capital 100 0.784 78.40 0.621 62.1
  MV   -107.59   -107.59
      7.17   -13.65


IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (7.17 / (7.17 + 13.65)) x  (10-5) = 6.72

The cost of capital is lower than the original example as tax effectively reduces the cost to the company as interest is a tax deductible expense.