Redeemable bonds

  • 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.

Redeemable bonds

  • 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

Redeemable bonds

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

  • 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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