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Hi
In the BPP kit it says that you could have calculated the cost of equity by urn gearing and regearing the beta. Please can you show me the calculation as I did not get this part correct(in the solution they used MM which I find confusing)
Also please can you explain the calculation for subsidized loan and the tax relief part.
When calculating the PV of the tax shield do we PV at cost of debt or risk free rate. They said we can use both. Why?
The cost of equity for the similar company is 14%.
We know the risk free rate is 4.5% and that the market premium is 4%.
So we can use the normal CAPM formula ‘backwards’ to calculate the equity beta.
14% = 4.5% + Beta x 4%.
The gives an equity beta of 2.375.The gearing is 1:1 (market value of debt to market value of equity)
So we can use the asset beta formula (with equity beta as 2.375, and debt beta as zero as usual). The gives an asset beta of 1.381
If we use this in the normal CAPM formula it gives a cost of equity (with no gearing) as 4.5% + 1.381×4% = 10.02%
The tax relief is the tax saving on the interest payments – part of the loan carries interest at 7.5% and the rest at 5.5%. Since it is an annual saving, we discount using the annuity discount factor.
The subsidising loan is saving us 2% on the 80% of the amount that is being subsidised. Since we have already dealt with the tax saving at 25%, we only look at the benefit of the remaining 75% of the interest.
The reason you can use either the cost of debt or the risk free rate is because it is arguable. We should discount at the rate relevant to the risk involved. Since the tax saving etc. result from the debt borrowing, you can argue that they carry the same risk as the debt itself. On the other hand you can regard it as being risk free and so use the risk free rate. (In theory of course, debt is risk free and so the cost of debt and the risk free rate would be the same. In practice (and in this question ) they are not, but in the exam it does not matter which of the two rates that you use.
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Why we didnt add up issue cost in loan amount needed amongst capex and ec. We have done it in neptune.
In both Neptune and Fubuki, the cash flow on the capital expenditure is the amount given in the question, and doesn’t include issue costs.
The issue costs are dealt with after calculating the base case present value, as part of the financing effects.Hi John,
In fubuki, regarding issue cost, can’t we just do $14487.5/96?
Why is it done like $14487.5/96*4 when other Apv questions issue costs are calculated like above ( first line)?$14,487.5/0.96 = 15091.1 is the full amount raised (not the issue costs!)
The issue costs are 15091.1 – 14487.5 = 604, which is the same as 0.04 x 15091.1 = 604
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Hi Sir!
I have a question regarding the tax shield which is subsequently computed by excluding the issue costs from the amount of loan raised. it is correct to compute the interest on the whole amount raised? (including the issue costs?) and state in the assumptions that the issue costs are included in the debt raised which is equal to the debt capacity of the CO?
also, the question mentions that proceeds from the sale of the business are 16 Mil. shouldn’t we pay tax on this amount? the only tax taken into consideration in respect of this is the balancing amount related to machinery which has a sale value of 440 K. but for the rest of the amount shouldn’t we pay tax?
Thanks a lot
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