- The cost of debt of redeemable bonds is the internal rate of return of the valuation model on the previous slide.
- Using this model to find the after-tax cost of debt is more accurate than multiplying the before-tax cost of debt by (1 – CT), since the redemption value is not tax-deductible.
- The cost of debt can be found using linear interpolation or a financial calculator.
- Hawanini-Vora bond approximation model can also be used to calculate cost of debt:
I + (P – NPD) Kd = n P + 0.6 x (NPD – P)
I = interest payments (￡)
P = par value (￡100)
NPD = ex interest market value (￡)
n = number of years to maturity
Using the Hawanini-Vora model:
- 11% redeemable bond (I = 11, P = 100)
- Ex interest market price of ￡95 (NPD = 95)
- Redemption in five years’ time (n = 5)
11 + (100 – 95) Krd = 5 = 12.4% 100 + 0.6 x (95 – 100)
- After-tax cost of debt = 12.4 x 0.7 = 8.7%
- Bank borrowings are not traded and have no market value that interest can be related to.
- Cost of bank borrowings can be found by dividing average interest paid by average borrowings for a given period.
- Alternatively, the cost of traded debt may be used as a best approximation.
- Appropriate adjustments for taxation is needed.
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