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ACCA Applied Skills · Financial Management · Estimating the cost of capital

Zeta Co has irredeemable loan notes with a nominal value of $100 and a coupon of 8%. The notes currently trade at $80 ex-interest. The tax rate is 25% and tax is paid in the year the profit arises. What is Zeta Co's post-tax cost of this debt?

The post-tax cost of debt is 7.5%. Annual interest of $8 is reduced by 25% tax relief to $6, then divided by the $80 market value, not the nominal value. Using nominal value or ignoring tax would give an incorrect cost.

  1. A6.0%
  2. B10.0%
  3. C7.5%Correct
  4. D2.5%

Explanation

For irredeemable debt, Kd = interest × (1 – tax rate) / market value. That is 8 × 0.75 / 80 = 7.5%. Using nominal value as the base gives 6.0%, which is wrong because the cost must be based on current market value. Ignoring tax relief gives 10.0%.

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