Confused with cost of debts and risk free rate???

MM’s theory is based on the perfect market assumption. Therefore, all people are assumed to be able to borrow and lend at the risk-free rate. When we adapt the formula to the real world, the Kd may not necessarily be risk-free rate, but should be vary in the opposite direction with the credit rating of the company. The examination question should give you clue to assume a risk free or an effective rate. In P4, it is more likely to use the effective rate.

For APV, we will use the risk free rate (some past examination questions request to use the LIBOR) to discount the tax shield because the tax shield cash flow is highly certain in comparison with the cash flows generated from the project.

In order to arrive to the same result as with beta ungearing formula (beta_asset = beta_equity*Value_equity/(Value_equity+Value_debt*(1-T)) and CAPM formula, you have to use risk free rate as cost of debt.

abduladedokun

hopefully you have passed this paper,

1. gearing = debt / (debt + equity), simply means the level of borrowing against the capital employed in the company, now bring-in the market value of each in above formula, this now turns into the “true” gearing of the company, this always measured in %page format.

In P4 terms, the gearing is consists of the financial risk (if the company fails to serve or repay the debt, ie. financial risk)

2. ungearing = strip-out the financial risk from the “all risk” of the company/firm/organisation.

3. degear = same as above number 2, widely used in P4

4. regear = re-calculate the gearing with the “revised” financial risk.

hope this helps
good luck