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Hello Sir
I have 2 questions….
1) I was doing a question in the BPP revision kit titled “FAQ” in the Cost of Capital Section. In requirement “A” (after tax cost of debt), the cash flow for the capital repayment in the answer is $100. Could you please tell me how that figure was arrived at?2) Also the question mentioned systematic risk of debt being zero, and from what I’ve read otherwise, that is measured in beta factors, so I am a bit confused as to which calculation that would be involved in as one of requirements was to find beta.
The question is as follows:
FAQ is a profitable, listed manufacturing company, which is considering a project to diversify into the manufacture
of computer equipment. This would involve spending $220 million on a new production plant.
It is expected that FAQ will continue to be financed by 60% debt and 40% equity. The debt consists of 10% loan
notes, redeemable at par after 10 years with a current market value of $90. Any new debt is expected to have the
same cost of capital.
FAQ pays tax at a rate of 30% and its ordinary shares are currently trading at 453c. The equity beta of FAQ is
estimated to be 1.21. The systematic risk of debt may be assumed to be zero. The risk free rate is 6.75% and
market return 12.5%.
The estimated equity beta of the main competitor in the same industry as the new proposed plant is 1.4, and the
competitor’s capital gearing is 35% equity and 65% debt by book values.
RTF
a) Calculate the after-tax cost of debt of FAQ’s loan notes.
(3 marks)
(b) Calculate a project-specific discount rate for the proposed investment.
(9 marks)
(c) Discuss the problems that may be encountered in applying this discount rate to the proposed investment.
(8 marks)
(d) Explain briefly what is meant by pecking order theory.Your assistance would be greatly appreciated.
In answer to your first question, loan notes are presumed, by default, to have a nominal value of $100, unless otherwise stated. As the question states that they are redeemable at par, the company will therefore pay back $100 per loan note.
To answer your second question, for examination purposes, debt is presumed to be risk free, hence the beta value of zero in the question. Whether they mention that or not, for the exam, presume that debt has a beta value of zero. Only use beta values to calculate the cost of equity, which in this question has a beta value of 1.21.
Is there anything else in the question that you’re unsure about?
For part (a) I get 7.2% for the loan notes. I used IRR of return to get that value, trying both 10% and 8% .
Year 0 was the ($90)
Year 1 – 10 was 100 x 10% x 70% (i.e. after tax) = $7
Year 10 was $100For part (b), I got a discount rate of 12%.
I got the asset beta of the competitor first, as 0.61.
1.4 x 0.35/(0.35 + 0.65 x 0.7) = 0.61.
Then regeared this beta using FAQ’s capital structure, to get 1.25.
0.61 x (0.4 + 0.6 x 0.7)/0.4 = 1.25
Cost of equity using CAPM is 22.4%
6.75 + 1.25 x 12.5 = 22.4%
WACC
(22.4% x 0.4) + (7.2% x 0.6 x 0.7) = 11.984, or 12%.
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