A firm has $4 million in bonds that mature in 4 years @ a fixed rate of 7.5% paid annually. The market price is $98. The marginal tax rate is 35%. With the bond-yield plus method, what is the cost of equity assuming an add-on of 4%?
When I input the following:
[PV] - 98
[PMT] 7.5
[FV] 100
[N] = 4
I get a rate of 8.11% , the correct figure, but when I use
[PV] 98
[PMT] 7.5
[FV] - 100
[N] = 4
I get the incorrect rate of 7.09%. I recall from quant methods that you have to input either [PV] or [FV] with a - sign, but I don’t believe it mattered which one you made negative. Why am I getting different results here? Thanks!
Whenever I teach Level I Quant, I tell my candidates to decide on one viewpoint in TVM calculations and stick with it. You can take the viewpoint of the:
Lender/bondholder
Borrower/bond issuer
It doesn’t matter which viewpoint you take – in the sense that you can get the correct answer either way – but if you always take the same viewpoint, you won’t make silly mistakes.
If you take the lender/borrower viewpoint, then,
PV is negative: you pay for the bond today, a cash outflow
PMT is positive: you receive the coupon payments, cash inflows
FV is positive: you receive the par value at maturity, a cash inflow
If you take the viewpoint of the borrower/bond issuer, then,
PV is positive: you receive payment for the bond today, a cash inflow
PMT is negative: you make the coupon payments, cash outflows
FV is negative: you repay the par value at maturity, a cash outflow