Hi John while calculating cost of debt in wacc we have taken taxation effectbut in the regular lectures we have only taken debt without tax (Ref example 3 in chapter 16) can you let me know why different approach

The example says that the cost of debt is 7% and so it is therefore already after tax relief. The cost of debt is always after tax relief and we would only take tax off the 7% is the question had specifically said that it was pre-tax.

1) what does it mean by “assuming the company has the same gearing”? Is that means both of proxy(Reka) and Fugae has the same gearing ratio? and if yes, why dont we use the same gearing ratio to find the cost of equity of Fugae? can we just skip the step of calculating the ratio for Fugae, by simply state in the assumption? (save time).

2) Can we state in the assumption that the cost of debt of Fugae is the same as the discount factor of 4.8%? (save time)

It is better if you ask questions in the Ask the Tutor Forum because I always see them and I always reply. The system only shows a limited number of questions here and if it slips past because there are many questions, then I do not see it. Also we do not promise to answer questions here, because it is for comments rather than for questions, but we always answer questions in the Ask the Tutor Forums.

1. We know that Reka and Fugae do not have the same gearing ratio from the information in the question. We are assuming that they maintain the same gearing ratio when doing the new project.

2. We know the cost of debt is 4.8% from the question. We are not assuming anything. We need the 4.8% to be able to calculate the MV of the debt and the project specific cost of capital.

It is precisly questions like this that the examiner throws in that totally throws us off the ball. Theres loads of things going on and a lot of techniques and ways of calculating bits and peices we need to be aware of that are never taught in class or in the notes. Its simply ridiculous.

It is a high level exam. All the techniques are covered in our lectures and notes, and at the P level the examiner is entitled to ask anything from any of the earlier papers. That is why it is so vital to practice every question in your Revision Kit.

I have a problem with W7 cost of equity for Fugae luxury. CAPM model is Eri=Rf+B1(Erm-Rf), so it should be 4%+ 1.87x(6%-4%). Why do you only use 4%+1.87×6%? Thanks.

Because the question says that the market risk premium is 6%, not that the market return is 6%. The risk premium is the excess of the market return over the risk free rate and so is equal to Erm – Rf.

@ Lecturer: you really make it look easy :), very helpful. Though I have a question. Since there is no clarification on how the project would be financed. It is ok to assume that the project is financed 100% by own cash thus using luxury travel segment asset beta and inputting it straight into CAPM model to arrive at cost of equity for WACC calculation? Is this logical and acceptable approach to score full marks allocated to it? Please let me know.

Not to get full marks – no. Unless we are asked to take an APV approach, then we always discount at the risk adjusted WACC on the assumption that the gearing is unchanged.

Thanks so much for this insightful lecture. A quick question however….if the overall asset beta of Reka is 0.89, and 0.80 is attributable to its non-luxury sector, doesn’t it imply therefore that the remainder of 0.09 should relate to the luxury sector?

I have the same question as question #2 from above, namely: why don’t we have to adjust the interest flows with tax in case of mv calculation? Could you please help me understand? Btw great lecture indeed.:) Thanks,A

I had not answered Seyyo’s question because I had not seen it – I cannot always see all of the comments on lectures. It is better to ask in the Ask the Tutor Forum rather than as a comment on a lecture – I always answer Ask the Tutor questions within 24 hours.

The market value is determined by the investors – it is the present value of the investors expected receipts discounted at their required return, and company tax does not affect them. When calculating the cost to the company, the company gets tax relief on the interest and therefore we calculate the IRR of the after-tax flows.

I do suggest that you watch my free lectures on this (and if necessary the relevant F9 lectures also, because this is revision of F9).

karang says

Hi John while calculating cost of debt in wacc we have taken taxation effectbut in the regular lectures we have only taken debt without tax (Ref example 3 in chapter 16) can you let me know why different approach

John Moffat says

The example says that the cost of debt is 7% and so it is therefore already after tax relief. The cost of debt is always after tax relief and we would only take tax off the 7% is the question had specifically said that it was pre-tax.

aisy says

Hi Sir i have some questions:

1) what does it mean by “assuming the company has the same gearing”? Is that means both of proxy(Reka) and Fugae has the same gearing ratio? and if yes, why dont we use the same gearing ratio to find the cost of equity of Fugae? can we just skip the step of calculating the ratio for Fugae, by simply state in the assumption? (save time).

2) Can we state in the assumption that the cost of debt of Fugae is the same as the discount factor of 4.8%? (save time)

aisy says

Maybe the system would renotify you again if I reply here. Waiting for your response 馃榾

John Moffat says

It is better if you ask questions in the Ask the Tutor Forum because I always see them and I always reply. The system only shows a limited number of questions here and if it slips past because there are many questions, then I do not see it. Also we do not promise to answer questions here, because it is for comments rather than for questions, but we always answer questions in the Ask the Tutor Forums.

1. We know that Reka and Fugae do not have the same gearing ratio from the information in the question. We are assuming that they maintain the same gearing ratio when doing the new project.

2. We know the cost of debt is 4.8% from the question. We are not assuming anything. We need the 4.8% to be able to calculate the MV of the debt and the project specific cost of capital.

aisy says

understood. Thank you Sir 馃榾

John Moffat says

You are welcome 馃檪

kkhatani says

Hi,

It is precisly questions like this that the examiner throws in that totally throws us off the ball. Theres loads of things going on and a lot of techniques and ways of calculating bits and peices we need to be aware of that are never taught in class or in the notes. Its simply ridiculous.

John Moffat says

It is a high level exam. All the techniques are covered in our lectures and notes, and at the P level the examiner is entitled to ask anything from any of the earlier papers.

That is why it is so vital to practice every question in your Revision Kit.

helensqq says

Hi John,

I have a problem with W7 cost of equity for Fugae luxury. CAPM model is Eri=Rf+B1(Erm-Rf), so it should be 4%+ 1.87x(6%-4%). Why do you only use 4%+1.87×6%? Thanks.

Helen

John Moffat says

Because the question says that the market risk premium is 6%, not that the market return is 6%.

The risk premium is the excess of the market return over the risk free rate and so is equal to Erm – Rf.

Asad Ali Hussaini says

Sir – Video of part 2 and 3 not working – Ques 1 Dec 2014

John Moffat says

They are working fine – the problem must be at your end.

Please ask on the support page (the link is above).

monzun78 says

@ Lecturer: you really make it look easy :), very helpful. Though I have a question. Since there is no clarification on how the project would be financed. It is ok to assume that the project is financed 100% by own cash thus using luxury travel segment asset beta and inputting it straight into CAPM model to arrive at cost of equity for WACC calculation? Is this logical and acceptable approach to score full marks allocated to it? Please let me know.

thank you

John Moffat says

Not to get full marks – no. Unless we are asked to take an APV approach, then we always discount at the risk adjusted WACC on the assumption that the gearing is unchanged.

monzun78 says

thanks a lot

John Moffat says

You are welcome 馃檪

Jorge says

Thanks so much for this insightful lecture.

A quick question however….if the overall asset beta of Reka is 0.89, and 0.80 is attributable to its non-luxury sector, doesn’t it imply therefore that the remainder of 0.09 should relate to the luxury sector?

Jorge says

Hi

Please I’m ok now so don’t bother answering the question I asked

Dthind says

You are like a life saver for all ACCA students, especially the ones who are self studying.

Seyyo says

Hello Sir,

Thanks so much for the lecture, I really appreciate it. However, I would like to know ;

1) If cost of debt was assumed to be 3.84% instead of using IRR, is it also applicable to similar questions?

2) When calculating the value of debt for Fugae we took interest as it was without deducting tax

i.e interest 5.4 * annuity factor of 3.562 = 19.23

but for cost of debt we deducted tax

i.e interest (5.4 * 0.8) = 4.32…

Why is that market value of debt we deduct tax but for cost of debt we deduct tax..

Thanks so much once again..

andredemontagie says

Hi,

I have the same question as question #2 from above, namely: why don’t we have to adjust the interest flows with tax in case of mv calculation? Could you please help me understand? Btw great lecture indeed.:)

Thanks,A

John Moffat says

I had not answered Seyyo’s question because I had not seen it – I cannot always see all of the comments on lectures. It is better to ask in the Ask the Tutor Forum rather than as a comment on a lecture – I always answer Ask the Tutor questions within 24 hours.

The market value is determined by the investors – it is the present value of the investors expected receipts discounted at their required return, and company tax does not affect them.

When calculating the cost to the company, the company gets tax relief on the interest and therefore we calculate the IRR of the after-tax flows.

I do suggest that you watch my free lectures on this (and if necessary the relevant F9 lectures also, because this is revision of F9).