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Hi John
There is a question in the above paper that is confusing me a little.
‘A 6% loan note, with a nominal value of $100 per loan note, is due to be redeemed in 3 years time at a discount of 7%. Interest is paid annually in arrears. Upon redemption the loan note is convertible into 25 ordinary shares, currently priced at $3.5o per share cum div – a dividend of $0.25 is about to be paid. Share price is expected to grow at 8% annually in the future. Investors expect a yield of 6% and corporation tax is payable by the company at a rate of 25%’
What is the current market value of the loan note?
I did $3.50-0.25 = 3.25*(1.08)^3=4.09 x 25 = $102.35 – this is the answer in the booklet
But I remember for your lectures you did one step further
t0 = current market value (which we are trying to find)
t1->t3 = 6%(I-0.25) tax shield on loan note = 4.50*2.673 (3 year annuity at 6%) = $12.03
t3 = $102.35 (above)*.864 (3 year discount factor at 6%) = $88.43$88.43+$12.03=$100.46 which is also one of the answers
What is the difference between the $102.35 & the $100.46?
Thanks very much
GrahamNowhere in my lectures do I do what you suggest in the second workings when calculating the MV of debt!!!
It is investors who determine the market value and therefore it is the PV of the future receipts discounted at the investors required rate of return, which in this example is 6%. Company tax has no affect on the investors.
Tax is only relevant when calculating the cost of debt to the company, because the company saves tax as a result of the interest payments. So when calculating the cost of debt we calculate the IRR of the after tax flows.
Ah sorry John.
Just on the free lectures and the revision Chapter 15 The Valuation of Securities Theoretical Approach, example 12 and around 18mins into the lecture, you calculate the MV of debt using the above. I think the only difference is I reduced the tax by the tax shield.
Sorry, but I’m confused as when to use what you described?
Thanks
GrahamIt is as I wrote before.
When calculating the market value of both shares and loans/debentures, tax is of no relevance because investors are not affected by company tax and it is investors who determine the market value (and example 12 does not have any mention of tax anyway 🙂 )
When calculating the cost of capital to the company, then tax is relevant and this is all explained in Chapter 17 and the lectures working through the chapter.
Hi John
Thanks so much. I really was going insane trying to figure that out but your explanation above is clear. The corp tax in the past exam question was a red herring!
Graham
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