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Cost of redeemable debt

Cost of redeemable debt

Redeemable debts are those which will be repaid to the debt investors after a specific period, while irredeemable or perpetual debt is not repaid back to the debt investors—only interest on this is paid regularly.

If debt is redeemable, the cost of debt is calculated as the redemption yield on the debt. The redemption yield is Internal Rate of Return (IRR). It is the discount rate which equates the market value of the debt with the present value of interests and capitals.

However, there is an exception. If debt is redeemable but issued at par, is redeemable at par and is currently trading at its nominal value, the cost of debt can be correctly calculated using the irredeemable debt formula rather than calculating the redemption yield. Both methods would give the same answer.

Question

Assume that 10% debenture that was issued at par ($100) is redeemable in 5 years’ time at par and is currently trading at par. Tax is currently at 20%.

Solution:

 I=10% x 100 = $10

t=20%=0.2

P=$100

Kd = I (1 – t) / P = 10 (1-0.2) / 100 = 8%

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