i have though that the cost of equity after gearing (Ke) = 16.96, in the WACC calculation, why we have to multiply 16.96 by 100/140? why we don’t use 16.96 directly ?

Sir, am i right in assuming that when there is tax, the rate at which the cost of equity increases isn’t as high as when there is no tax, because tax relief reduces the risk for shareholders, and thus not as high a return is demanded? And if i am right regarding that, then isnt that also a factor in causing the WACC to fall? Like more of pulling down by even cheaper debt plus not as much pulling up by equity as when there is tax?
Thanks a lot!

Hi Sir,
I have question on M&M proposition with company taxes.
It is to say that company can enjoy tax shield only if they are paying tax.
If a company were in loss making position, I would assume there will be no benefit in taking debt financing as there will not be any tax savings? Am I right to say that?

In the year(s) that they make the loss then certainly there will be no tax saving.
However, they are not going to make losses every year otherwise they would close down.

The debt interest will increase the loss, and therefore there will be more loss relief available in future years when they make a profit. So they will still end up getting the tax saving – it will just be delayed.

Can you please explain why indirect costs are not considered when computing the NPV. Is this because they are not related to the Project, for which we compute the NPV?

I want to have a clear understanding with respect to indirect costs definition.

We are only concerned with extra cash flows to the company as a result of doing the project. It does not matter whether costs are direct or indirect.

What you do have to be careful about are indirect fixed costs. If total fixed costs to the company change, then the extra is relevant. However, if all that is happening is that some of an existing fixed total is being allocated to the project for profit purposes then it is not relevant – we can allocate fixed costs any we want for profit purposes, but it is only if the total changes as a result of doing the project that we bring it in for NPV calculations.

Hi! In example 1 why is it 0.4 and not 0.4 over 0.6?? It says vd over ve, where as the example has taken vd over ve+vd that is 0.4/(0.4+0.6). Thank you in advance for all the help.

Interested in your comment at the end of the example in which you suggest that MM proposition 2 is implied by CAPM and gearing equations already discussed. When I try and work through this myself I end up with a similar formulae but instead of (ke – kd) I have Market Premium. I can sort of see that ungeared return on equity less cost of risk free debt is similar to the market premium but this is only applied to one company not to the market. Is this a question of interpretation or am I just completely missing something?

If it is ungeared then then Ke – Rf will be different from the market premium because of the risk of the business (the asset beta). If it is geared, then the gearing has a multiplier effect and the excess over risk free will be higher.

Hi Tutor ,
In the example for debt/equity ratio 0.4 you said debt is 40% and equity is 60% , so if the D/E =0.6 does that imply the debt is 60% and equity 40%? and if D/E 0.25 – debt is 25% and equity 75%?

However the only extra technique needed is to be able to forecast future exchange rates using the purchasing power parity formula. This was covered in F9 and there is a chapter revising it in the P4 course notes.

Otherwise it is a question is setting up the foreign cash flows in exactly the normal way, but in the foreign currency. Then converting the foreign currency to the home currency using the forecast exchange rates. Then adding any other cash flows that there may be in the home currency, and then discounting.

It can get very messy, but the problem is more just the arithmetic involved then any extra special technique.

You put my lecturers to shame with your skill at explaining things. I think it’s because you undoubtedly understand (extremely well) what it is you are teaching.Thanks so much

sambathkun says

Hi John,

i have though that the cost of equity after gearing (Ke) = 16.96, in the WACC calculation, why we have to multiply 16.96 by 100/140? why we don’t use 16.96 directly ?

Best Regards,

John Moffat says

Because for the WACC we take the cost of equity and the cost of debt and eight them by the proportions of equity and debt.

Amer says

Am I right to assume that Ke i in the formula is the Beta asset?

John Moffat says

No – it is the cost of equity.

Amer says

Sorry, what I meant was that the cost of equity calculated is using beta asset right?

John Moffat says

That is correct 🙂

sayma says

Sir, am i right in assuming that when there is tax, the rate at which the cost of equity increases isn’t as high as when there is no tax, because tax relief reduces the risk for shareholders, and thus not as high a return is demanded? And if i am right regarding that, then isnt that also a factor in causing the WACC to fall? Like more of pulling down by even cheaper debt plus not as much pulling up by equity as when there is tax?

Thanks a lot!

John Moffat says

It is true, but the predominant factor remains the fact that debt becomes so much cheaper with tax relief on the interest.

davisyieh says

Hi Sir,

I have question on M&M proposition with company taxes.

It is to say that company can enjoy tax shield only if they are paying tax.

If a company were in loss making position, I would assume there will be no benefit in taking debt financing as there will not be any tax savings? Am I right to say that?

John Moffat says

In the year(s) that they make the loss then certainly there will be no tax saving.

However, they are not going to make losses every year otherwise they would close down.

The debt interest will increase the loss, and therefore there will be more loss relief available in future years when they make a profit. So they will still end up getting the tax saving – it will just be delayed.

andreeii says

Hi Sir,

Can you please explain why indirect costs are not considered when computing the NPV. Is this because they are not related to the Project, for which we compute the NPV?

I want to have a clear understanding with respect to indirect costs definition.

Thank you

Kind regards,

John Moffat says

We are only concerned with extra cash flows to the company as a result of doing the project. It does not matter whether costs are direct or indirect.

What you do have to be careful about are indirect fixed costs. If total fixed costs to the company change, then the extra is relevant. However, if all that is happening is that some of an existing fixed total is being allocated to the project for profit purposes then it is not relevant – we can allocate fixed costs any we want for profit purposes, but it is only if the total changes as a result of doing the project that we bring it in for NPV calculations.

andreeii says

Thanks a lot for clear explanation.

Regards,

mishalle hira says

Hi! In example 1 why is it 0.4 and not 0.4 over 0.6?? It says vd over ve, where as the example has taken vd over ve+vd that is 0.4/(0.4+0.6). Thank you in advance for all the help.

John Moffat says

Gearing can be expressed in two ways. Here it is given in the question as debt to equity. So for every 100 of equity, the debt is 40.

So Vd/Ve = 40/100 = 0.4

Samphos says

And what is the other way of expressing gearing, please?

Thank you.

John Moffat says

the ratio of debt to debt + equity

Irfan says

any body please tell me how i can complete my Ethic module to get my FIA certificate..?

John Moffat says

Please post this in the general forum and not under a lecture on something that has nothing at all to do with the ethics module.

hezz says

Interested in your comment at the end of the example in which you suggest that MM proposition 2 is implied by CAPM and gearing equations already discussed. When I try and work through this myself I end up with a similar formulae but instead of (ke – kd) I have Market Premium. I can sort of see that ungeared return on equity less cost of risk free debt is similar to the market premium but this is only applied to one company not to the market. Is this a question of interpretation or am I just completely missing something?

Thank you for the great lectures!

John Moffat says

If it is ungeared then then Ke – Rf will be different from the market premium because of the risk of the business (the asset beta). If it is geared, then the gearing has a multiplier effect and the excess over risk free will be higher.

ramya says

Sir,

The Debt : Equity ratio is 0.4 as per the example. Please explain me how did you work out the Vd as 40% and Ve as 100% ?

I have worked out the Ke as 0.15+0.7 x(0.15-0.08)x 0.4/0.6 = 18.26%

and WACC 13.2%

John Moffat says

If the ratio of debt to equity is 0.4, then if equity is 100 then debt must be 0.4 x 100 = 40.

(You are treating it as if debt to debit+equity is 0.4!)

rmracca says

Hi Tutor ,

In the example for debt/equity ratio 0.4 you said debt is 40% and equity is 60% , so if the D/E =0.6 does that imply the debt is 60% and equity 40%? and if D/E 0.25 – debt is 25% and equity 75%?

John Moffat says

I don’t think that I did say that, and I certainly used the correct figures in the example.

A debt/equity ratio of 0.4 does not mean that debt is 40% and equity 60% (if that was the case, the ratio would be 40/60!)

rmracca says

Hi Tutor ,

My apologies in advance for asking a silly question.For a given gearing ratio ( Vd/Ve ) = 0.4 , how did you work out the Vd as 40% and Ve as 100% ?

amirali92 says

If the given gearing ratio (Ve/Vd) = 0.4, this simply means the Value of Debt (Vd) = 40 and the Value of Equity (Ve) = 100. [i.e: 40/100]

If you decide to use the gearing ratio of (Ve/(Ve+Vd), your argument above [stating: Ve=40 and Vd=60] stands correct. i.e: 40/(40+60).

In conclusion, the above query you’ve put forward suggests the Debt Value being 40 and the Equity Value being 100 as explained in the first paragraph.

I hope I answered the question.

zee90 says

sir is there a lecture on NPV in foreign currency ???

John Moffat says

No – there is not a specific lecture.

However the only extra technique needed is to be able to forecast future exchange rates using the purchasing power parity formula. This was covered in F9 and there is a chapter revising it in the P4 course notes.

Otherwise it is a question is setting up the foreign cash flows in exactly the normal way, but in the foreign currency. Then converting the foreign currency to the home currency using the forecast exchange rates. Then adding any other cash flows that there may be in the home currency, and then discounting.

It can get very messy, but the problem is more just the arithmetic involved then any extra special technique.

zee90 says

thank you SIR

Naga Praveen says

The typing mistake which is mentioned in the lecture in the formula for the cost of equity is not rectified in the course notes.

Thank You

quoiquoi says

You put my lecturers to shame with your skill at explaining things. I think it’s because you undoubtedly understand (extremely well) what it is you are teaching.Thanks so much

kezeala says

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slobodanm says

very good