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Hi John,
I’m trying to solve section a) of this question in Revision Kit and have some differences with the answer. I have difficulty to understand some below points from the answer:
1, Discount rate
As I learnt that the CAPM is calculated based on equity beta. Hence, all the components for CAPM have already provided in the question. Why in the answer, it used asset beta for calculated cost of equity?
And why dont we use to WACC of Oberberg as discounted rate for the CF?
2, Free cash flow
I think that it should included the interest expenses in taxable profit each year. The interest expenses are just deducted when calculated cash flow, but in here we need to add it to calculate the tax expense, is it right?
3, I confuse of the discount rate used in adjusted present value calculation. Please am I right when I understand in this: We used to discount rate (of Oberberg or Intergrand) depend on which kind of cash flow comes from? Ex: The benefit of publicity and lost exports are for Intergrand, hence we used WACC of Intergrand (10%), and the sales of assets and free cash flows is for Oberberg, hence we used WACC of Oberberg (9%)?
Thanks for your kind help.
The requirement in the question specifically asks you to calculate the value by discounting at an all equity rate and adjusting by the present value of all other relevant cash flows.
This is the same as asking you to calculate the APV.The current equity beta takes into account the current level of gearing. To get an all equity financed rate we need to remove the effect of the gearing – if it was all equity (i.e. no gearing) then the equity beta is the same as the asset beta.
With regard to the free cash flow, since we are calculating the APV, interest payments are irrelevant in arriving at the cash flows. The benefit of the tax saving on the interest is dealt with separately as always in APV calculations.
But I found the same case in another question (77 Trosoft – 12/04). Although there is not mention that we have to calculate the value by discounting at an all equity rate, the answer also used the asset beta instead of equity beta when calculating cost of equity?
In addition, please help me with the question 3 in above. Cause now I still confuse it.
Thank you very much.
But the Question Trosoft specifically says in the requirements that you should use the APV method! Have you actually watched my lectures on APV? (Or if you are not watching the lectures for any reason then have you studied it in your Study Text?)
With APV we always discount at the all equity rate (and then deal with the tax benefits of the gearing separately), and if it is all equity then the equity beta is the same as the asset beta.
I really do suggest that you watch the free lectures – they are a complete free course covering all the important topics for Paper P4.
With regard to your question 3, we discount the flows at the rate relevant to the risk of those flows.
Thanks John. I will go through your lecture notes all. We always appreciate for your help.
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