Hi Gayle,
If I understood it correctly, you raised 2 categories of issues - One related to the question per see and the second about the current market situation.
I would like to attempt them separately.
As for the lack of full information in the question about the original issue price, redemption date - to help us define it is a current liability or not, etc. My submission is that we need not add more interpretation to the question's facts. If the question states the face value of the bond was X, and it is silent about the premium or discount, it is safest to assume it was at Face Value; else, we would have that additional information. My experience of writing and clearing the CMA exam tells me we need not complicate the question beyond what is apparent on the face of it.
As for the second part related to the current situation, I think we need to keep in mind that questions in the exam aim to test our understanding of the concepts and not necessarily linked to the current market situation. It was likely a valid interest rate a few years ago, or maybe not. As I submitted earlier, we need to use the information provided in the question and attempt a solution based on that.
Happy to connect and answer if you have a follow-up question.
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Harjjeet Gahla (ACS LLB DBF ADM)
FInancial Controller / Accountant
Calgary Alberta
Canada
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Original Message:
Sent: 04-10-2021 10:15 PM
From: Gayle Vanac
Subject: Cost of Debt Calculation
I'm not sure we have all the information we need to address this question other than the initial solution suggested of coupon rate times (1 - tax rate). The reason I say this: (1) We don't know that the bonds sold at a premium when the company issued them. (2) Even if they had sold at issue at a premium at issue, we don't know how many years to maturity for the issue, so that we could amortize the premium over the years to maturity. (3) The company is readying to satisfy the liability on the bond in the coming 12 months. This is now current liability. The bond amortization gives us the sum of interest over the years to maturity, less amortized premium, if there was one at issue.
The original solution suggested, with coupon rate times (1 - tax rate) recognizes the tax savings of using debt financing, so we get a net cost of debt for the year in which the interest was paid.
In the present environment of extremely low market interest rates, bonds with coupon rate over 3% are selling at a premium in the market. So, a bond with a 9% coupon rate sells at a premium as it comes to maturity in this market.
I hope we can think about this problem further. A cost of debt of 3.5% on a bond with a 9% coupon rate doesn't make sense.
Please help me on this.
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Gayle Vanac
None
Painesville OH
United States
Original Message:
Sent: 03-30-2021 03:51 AM
From: HARJJEET GAHLA
Subject: Cost of Debt Calculation
Hi Michael,
You are right in pointing it out. I only broached the topic and mentioned the possible impact of FV and MV on the cost in the brackets, but I did not complete the solution in my previous post to the group though I shared the full working with Ahmed.
The solution to this problem is attained by using the equation. The total expected return on this is FV and Int, which is discounted with the debt cost to arrive at the present value or the market price.
(FV+Int )/MV=(1000+92)/1040=5%
Since the question did not ask for WACC, in my opinion, the answer should be 5%, and we should not consider the impact of tax unless required to do so.
If a question asked for the after-tax cost of debt or the Weighted average cost of capital, we should use the weights and the after-tax cost of each component to arrive at WACC.
Original Message:
Sent: 3/30/2021 2:18:00 AM
From: Michael Henry
Subject: RE: Cost of Debt Calculation
Your answer is not correct.
You must use the available information to calculate the YTM (effective interest rate). Utilize this rate to calculate the after tax cost of debt.
FV = 1000
PV = -1040
PMT = 92 (.092 x 1000)
Per = 1
The rate will calculate as 5%
5% X (1-.30) = 3.5%
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Michael Henry
Controller
Original Message:
Sent: 03-29-2021 02:14 AM
From: HARJJEET GAHLA
Subject: Cost of Debt Calculation
Hi,
Cost of debt uses coupon rate and the rate of tax as decision variables.
Cost of debt = Rate of Interest * (1-Tax Rate)
In this case = 9.2%*(1-30%)=6.44%
(If we were to calculate the return on the investment made in debt security then the market value and face value factor shall be used.
As you will receive the interest on the face value but the amount invested is more than the FV, it would result in lower realization)
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Harjjeet Gahla (ACS LLB DBF ADM)
FInancial Controller / Accountant
Calgary Alberta
Canada
Original Message:
Sent: 03-28-2021 04:23 PM
From: Ahmed Ouda
Subject: Cost of Debt Calculation
I hope all of you are doing well,
I need your help to calculate the cost of debt,
- Some years ago the firm issued 10,000 bonds, each with a face value of $1,000 and paying an annual coupon rate of 9.2%. These bonds are now trading at $1,040 per bond. A coupon payment on these bonds was made yesterday and the bonds mature next year.
Effective tax rate 30%.
Ahmed Ouda
Accountant.