1. Is the cost iof capital really relevant factor in competiveness and strategy
ID: 2691374 • Letter: 1
Question
1. Is the cost iof capital really relevant factor in competiveness and strategy of a company likle Petrobra's ? Does the corporate cost of capital really affect competiveness? 2. Petrol Iberico a european gas company, is barrowing US$650,000,000 via a synicated eurocredit for six years at 80 basis points over LIBOR, LIBOR for the loan will be reset every six months. The funds will be provided by a syndicateof eight leading investment bankers, which will charge up-front fees totaling 1.2% of the principal amount. What is the effectiveinterest cost for the first year if LIBOR is 4.00% for the first six months and 4.20% for the second six months.Explanation / Answer
1.Yes cost of capital really relevant factor in competiveness and strategy of a company likle Petrobra's 2.Effective Interest Rate In calculating the effective interest rate of financial instruments and in particular loans and advances take into account interest received or paid, fees and commissions paid or received, expected early redemptions and related penalties and premiums and discounts on acquisition or issue that are integral to the yield as well as incremental transaction costs. You can use statistical modelling techniques which are specific to different portfolios in estimating the expected cash flows from early redemptions and related fees to the extent that these are applicable. Significant judgement is applied in selecting and updating these models. In calculating the effective interest rates of individually significant balances you can take into account a number of relevant considerations to estimate the cash flows from early redemptions including previous experience of customer behaviour, credit scoring of the customer and anticipated future market conditions at the date of acquisition. Significant judgement is applied in estimating the impact of these considerations on the expected future cash flows. ------------------------ The effective interest method is a method of calculating the amortised cost of a financial asset and of allocating the interest income over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash receipts through the expected life of the asset or, when appropriate, a shorter period to its net carrying amount. When calculating the effective interest rate, an entity estimates cash flows considering all contractual terms of the financial instrument (for example, prepayment, call and similar options) but does not consider future credit losses [IAS39R.9]. Entities are not permitted to use an expected life that is longer than the contractual life of the asset when determining the effective interest rate as that would take future credit losses (due to time value) into consideration [IAS39R.9]. Some prepayment penalty fees are included in the effective interest rate. Where a fee is charged in order to compensate the lender for the increased margin that would have been earned had the loan continued to the end of the period during which a penalty must be paid, this is considered as part of the effective interest calculation. Where the penalty fees are included in the calculation of effective interest and thus in the amortised cost balance, the prepayment option will be closely related to the loan and is not separated as an embedded derivative. This is because the amortised cost balance will always approximate the amount to be repaid if the prepayment option is exercised [IAS39R.AG30(g)]. The expected life of the loan is generally used to determine the effective interest rate. The effective interest calculation is a method of spreading any fees, costs, premiums or discounts over the asset's expected life. However, effective interest calculations do not change the nature of fixed and floating contract terms of loans. For example, when a fixed rate loan reverts to a standard variable rate before the end of its expected life, fees and costs are spread over this expected life, but the effective interest calculation does not blend fixed and floating rate cash flows to produce a single combined effective interest rate. When the interest rate changes from fixed to floating, it impacts the calculation of interest income at that time as the effective interest rate will change. Therefore interest changes are not anticipated by recalculating effective interest rates.
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