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Hello sir. I’m studying along with your materials to pass the AFM paper in this Dec.
When ungearing equity beta, we take into consideration the positive effect of tax deductible so the formula is Ve+Vd(1-T)/Ve * Ba = Be.
This is what I’ve understood so far. The thing I want to ask is if, M&M’s theorems are based on the tax deductible interest payment, then I think where ‘(1-T)’ should apply is PV of interest payment, not whole market value of debt. because obviously there is principal amount of debt which is not tax-deductible. Therefore I’m having a hard time to why this ungearing formula applies tax rate to Vd, but not to Kd or interest payment.. Could you kindly shed some light on this? Thank you in advance.The MV of debt is the PV of the full interest payments (before tax) discounted at the investors required rate of return.
The company saves tax on the interest payments, and since the saving is T multiplied by the interest, then PV of the saving must be T multiplied by the PV of the full interest payments i.e. T. multiplied by the MV of the debt.
thx for reply.
However, referring to your AFM revision lecture question 1, appendix 2.1, Fugae co’s MVd is 388.1 whereas PV of series of all interest payment is;
$5.4 interest discounted at 4.8%, PV of perpetuity is $ 112.5
$ 112.5 per bond * 3.8M bonds = $ 427.5M PV of all interest payment.How come they are different in numbers? Is my calculation wrong?
M&M assume that debt is irredeemable whereas in Fugae it is redeemable in 4 years time.
When it is redeemable, the amount payable on redemption distorts it because it is not tax allowable.So do you mean that we anyway move on with the given assumption regardless of error in the figure of MVd although it might significantly affect the result of say, ungearing fugae co.?
Since ungearing equation includes MVd(1-T) as a demoninator.Yes. I know it is strange but one of the assumptions of all M&M theory is that debt is irredeemable. In practice that is not the case, but we still use the M&M formulae to estimate the effect of changes in gearing.
Thanks John. Now everything about it clears up. I really appreciate your support. Have a nice day ahead.
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