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Hi John.
1. (From revision kit:) The APV method ‘assumes’ Mogdiliani and Miller’s ‘Proposition 2’, such that the ungeared cost of equity does not take into account the “cost of financial distress”.
What is meant here by ‘cost of financial distress’? (I understand what the term generally means, but not in this specific context i.e. how it is implied) and what part of the (alternative) WACC method represents it?
2. In the NPV, my revision kit says “inflation effects both future cash flows and the discount rate used”.
I was not aware that inflation alters the discount rate used in the calculation when calculating NPV of a project. I do not see an adjustment calculation in the practice questions. Again, is this an implicit thing in the cost of capital?
1. MM assume that debt is risk free because they get fixed interest. However they ignore the fact that there is always the extra risk of the investors losing their money if the company goes bankrupt.
2. Higher inflation will mean a higher money cost of capital (although since we always discount at the money cost of capital this is irrelevant for the calculations in the exam).
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