F plc has in issue 8% irredeemable debentures quoted at 90 p.c. ex int. (a) what is the return to investors ( kd ) ? (b) what is the cost to the company, if the rate of corporation tax is 30%?
Question
F plc has in issue 8% irredeemable debentures quoted at 90 p.c. ex int. (a) what is the return to investors ( kd ) ? (b) what is the cost to the company, if the rate of corporation tax is 30%?
Solution 1
(a) The return to investors, also known as the cost of debt (kd), is calculated by dividing the annual interest by the market price. In this case, the annual interest is 8% and the market price is 90% (or 0.9 when converted to decimal form). So, the calculation would be:
kd = (8 / 90) * 100 = 8.89%
So, the return to investors is 8.89%.
(b) The cost to the company is the cost of debt after tax. This is calculated by multiplying the cost of debt by (1 - tax rate). In this case, the tax rate is 30% (or 0.3 when converted to decimal form). So, the calculation would be:
Cost to the company = kd * (1 - tax rate) = 8.89 * (1 - 0.3) = 6.22%
So, the cost to the company is 6.22%.
Solution 2
(a) The return to investors, also known as the cost of debt (kd), can be calculated using the formula: kd = (Interest Rate / Market Price) * 100. In this case, the interest rate is 8% and the market price is 90% (or 0.90 when not in percentage form). So, the calculation would be as follows:
kd = (0.08 / 0.90) * 100 = 8.89%
So, the return to investors is approximately 8.89%.
(b) The cost to the company can be calculated using the formula: kd(1 - Tax Rate). In this case, the tax rate is 30% (or 0.30 when not in percentage form). So, the calculation would be as follows:
Cost to the company = 8.89% * (1 - 0.30) = 8.89% * 0.70 = 6.22%
So, the cost to the company is approximately 6.22%.
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