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FM Chapter 15 Questions Test 2 – The valuation of securities – theoretical approach

 

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    • The current dividend is 50c and 4 years ago it was 40c, so we need the average annual growth per year over the 4 years.

      I do explain how we get the annual growth rate from this information in my free lectures.

  4. Hi John,
    In Q2 Is this market value not cum int? I thought we only assume ex int unless stated otherwise? I am aware of the definition being the expected future gains discounted at the required return. However this did throw me off. When do we just calculate for ex int?

    thanks

    • Is this simply due to the share redemption being the choice and thus we need to account for the interest as well? Also is the $104.10 of the cash redemption and interest not already discounted? Thus being higher than the PV of the shares?

      Thanks

  5. Dear Sir,
    For the Q 1, I take the root 3 36/31.1= 0.7 not 0.5 as you get. What I am doing wrong? Do I need a new calculator, if yes which one is the best please?

    Thank you in advance.

    • It is not the square root. It is the third root because there are three years of growth. So the average growth is (third root (36/31.1)) – 1, as I explain in my free lectures.

      It is a scientific calculator that you need. It doesn’t matter which one provided it only displays numbers and does not display letters.

  6. Dear John,
    Thanks a lot for putting together a challenging set of practice questions! I have a question though – Both Q1 and Q5 involve calculations of geometric means. As per my understanding, both questions involve 4 periods. Yet, in Q1 the model solution recommends calculating the cube root, while for question 5 a 4th root is recommended. Maybe I am missing something here and would be grateful if you could clarify the differences.
    Many thanks and kind regards,
    Rachita

    • Q1 deals with a growth rate 3 years later than time 1 thus it is the cubed root. Question 5 we are told 4 years later which is T5 and thus we obtain the 4th root.

  9. Hello John,

    Could you please help me calculate ‘g’ the growth rate in questions 1 and 5.
    I understand the answers working but cannot get the answer on my calculator!
    Question 1: I am dividing 36 by 31.1 and then doing to the power of 3
    Question 5: I am dividing 0.5 by 0.4 and then doing to the power of 4

    • You need to take the third root in the first case, and the fourth root in the second case.

      (For the fourth root you can take the square root twice. For the third root you do need a calculator that has an nth root button.)

    • I assume that you have watched my free lectures on the valuation of securities, in which case you are happy that the market value is the present value of the expected receipts discounted at the investors required rate of return.

      On $100 nominal, the interest is $6 per year for 8 years. In addition there is the redemption in 8 years time at $105
      These flows are discounted at the investors required return of 7% (the before tax return, because investors are not affected by company tax).

      If you have not watched the lectures then I do suggest that you do.

  11. Question

    Matthew has 8% convertible loan notes redeemable in 5 years at nominal of $100. Each note can be converted for 70 shares (nominal $1), currently at $1.25ps but growing at 4% pa.
    Before tax cost of Matthew’s debt is 10% and after tax is 7%.

    Dear Sir,
    I cannot understand the difference between the before-tax cost of debt and the after-tax cost of debt, and when do we use each of them.

    • Have you watched the free lectures, because it is all explained in the lectures (and there is obviously no point in attempting the tests without having watched the lectures first)?

      The market value is determined by investors and is the present value of their expected receipts discounted at their required return. Their required return is the pre-tax cost of debt, because the investors do not get the benefit of tax relief.

      The after-tax cost of debt is the cost to the company and is lower because the company does get the benefit of tax relief on the interest.

      • i was about to ask you a question in the tutor forum regarding this as i have seen in wacc questions we find an IRR to find the cost of convertible debt and in the present value calculation (using two different rates), the interest is post tax but in an mcq: market value of convertible is to be calculated and in the present value calculation the interest has no tax effect. sir i guess your above comment justifies it. 🙂 thanks as always. May God bless you with the best sir.

      • we have to find the market value we have used before tax rate which is 10% but what if the question says that company pays tax 30% then which value we should use ?

      • Why have you not read the previous replies (and why have you not watched my free lectures) ?

        It is the investors who fix the market value and company tax is of no relevance to them. The market value is based on the pre-tax interest and on the pre-tax rate (which is the investors required rate of return).

  14. Matthew has 8% convertible loan notes redeemable in 5 years at nominal of $100. Each note can be converted for 70 shares (nominal $1), currently at $1.25ps but growing at 4% pa.
    Before tax cost of Matthew’s debt is 10% and after tax is 7%.

    My working – using 10% factors:
    $8.00 * 3.791 = $30.33
    $100 * 0.621 = 62.10
    Value of note = $92.43
    Answer is showing as $96

    Have I gone wrong somewhere?

    • The redemption is not at $100. They are convertibles and they will be expecting to convert because the value of the shares they will receive is expected to be higher at $106.46.

      (Are you not getting a pop-up window showing the workings after you submit your answer? If not then maybe you have a pop-up blocker installed and you need to disable it while doing the tests.)

  16. Loan notes in issue of $100. Nominal int 6% payable annually. Redemption in Y8 at 100+5% = $105. Cost of debt 7%.

    Using 7% factors:
    My working is Y1-Y6 int at $6.00 * 5.971 = 35.83
    and the redemption of $105 * .582 = 61.11
    Total value of the note = 96.94.

    Correct answer is 94.03?

    Please help. Thank you so much.

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