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ACCA Applied Skills · Financial Management · Sources of finance and their relative costs

Rho Co has a $100 nominal 5% redeemable loan note, interest paid annually in arrears, redeemable at par in 3 years. The current market price is $100 ex-interest. Ignoring tax, which is the correct pre-tax cost of debt?

The pre-tax cost is 5%, because a bond priced at par and redeemable at par has an internal rate of return equal to its coupon rate. Discounting at 5% gives a present value of exactly $100.

  1. AApproximately 3.0%
  2. BApproximately 5.0%Correct
  3. CApproximately 6.7%
  4. DApproximately 8.0%

Explanation

The IRR equates the price to the PV of interest and redemption. When the price equals par and redemption is at par, the IRR equals the coupon rate. Check: at 5%, PV = 5 x 2.723 + 100 x 0.864 = 13.62 + 86.38 = 100. So the cost is 5%. 3.0% is wrongly computed from a different base.

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