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Thank you for your fantastic lectures.
I have 2 questions on the topic of debt being sold on the stock exchange.
1. With the change of market value if someone sells further a debt they gave a company they may receive a lower amount than what they paid. Why would they do that rather than wait the full term and redeem the full debt (+ any possible premium).?
2. When working out a company’s cost of capital on the basis of the current market value does this only get used for cash flows and appraisals for which new capital is being raised?
If a project does not involve new capital it would seem to be more correct to use the company’s actual cost for their existing debt as the current investor’s required rate of return would be irrelevant.Thank you
1. Various reasons, for example they may need the cash sooner than they were expecting, or they may see that they could get a better return by selling the debt and investing the money somewhere else, or it could be in an extreme that they fear that the company might go bankrupt in the future and then they would end up with nothing.
2. New capital is always needed for investing in a new project. Even if they already have enough cash existing in the company then using that cash is effectively borrowing from shareholders because they would otherwise be entitled to it as dividend. In Paper FM, new investments are always appraised at the WACC using current market values for the calculation.
Thank you for clarifying.
Another question please:
We are using the minimum required return from shareholders or lenders as the cost of capital to determine if a project should follow through or not.
If through equity- the return required is the dividend SH’s expect as a percentage to the shares they have paid. This is after they have allowed for some retaining of earnings.
Using this percentage as the minimum return on an investment will not allow for the additional profit needed for those retained earnings in the company.If it is financed through debt, would it not be sensible that a company would require a decent profit above what the interest costs them?
Thank you again
The WACC is the overall cost of finance to the company (I assume that you have watched the lectures on the calculation of the WACC).
We discount at the WACC and of the NPV is positive then it means that the project is giving a return higher than the overall cost of finance. The extra resulting belongs to shareholders which will serve to increase the value of the shares which is the primary object of the financial manager.We are not looking at profits. We are looking at cash flows and checking that the cash generated from the project is greater that the cash needed to finance the borrowings.
If the project is financed purely from debt, then (in Paper FM) we assume that in the long term the company intends to keep to the current level of gearing (so next time they raise finance they would raise equity) and so still discount at the WACC. (In Paper AFM then if there is a significant change in the gearing we take a different approach, but this is not relevant for Paper FM)
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