Q. Estimation of current cost of debt?
The debenture will be used to estimation the current cost of debt as it is the only marketable debt. The present market value of the debenture is $45m, $85m less the $40m amount of the bank loan. Tax relief has been absent from the estimate of the cost of debt. The annual after tax cost of interest payments on the debenture is $40m×10%(1-0·3) or $2.8m, assuming no lag in time before tax relief on interest is available.
To find the redemption yield, with four years to maturity the following equation must be solved.
45 = (2.8 /(1+ kd ))+ (2.8 /(1+ kd )2)+ (2.8/(1+ kd )3)+(42.8/(1+ kd)4)
By trial and error
At 5% interest
2·8 * 3·546 = 9·93
40 * 0·823 = 32·92
_____
42·85
5% discount rate is too high
At 3% interest
2·8 * 3·717 = 10·41
40 * 0·888 = 35·52
_____
45·93
Interpolating
3 + (0.93/0.93 2.15) * 2% = 3·60%
The after tax cost of debt is 3·60%
Market value of equity $214m
Market value of debt $85m
Weighted average cost of capital
17·28% *214/299+ 3·60%*85/299= 13·39%
The discount rate to be utilized in the investment appraisal is 13·39%.
No further adjustment for inflation is essential as the estimates of the cost of equity and cost of debt already include inflation.