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Dear Tutor, please clarify what how the inflated Sales revenue and VC were computed for years 2 – 4. Also, would it have been okay to use the real rate of 9% to discount the CF and not inflate the numbers for sales, VC & FC?
Thanks very much.
MJThe sales in year 2 are (20 x 200000) + (8 x 350000) = 6800000 at current prices.
However because it is year 2, there will be 2 years inflation at 3% per year.
So the nominal (actual) revenue will be 6800000 x (1.03)^2 = 7214120.It the same workings for all years (the time 3 revenue will need inflating for 3 years and so on).
No – you cannot use the real rate. That would only be possible if it was the same inflation rate applied to all the flows, and if it was the same as the general inflation rate. If that was the case then you could discount the current price flows at the real rate. However that hardly ever happens in the exam (and you only do it if the question asks you to).
Otherwise, as here, you discount the nominal (actual) flows at the nominal (actual) cost of capital.Ok understood. I was taking the inflated amt for Y1 and multiplying it by 1.03…..great, thanks a lot once again.
Hi Mr Moffat, re Q3 Dec 2012, in part a it was assumed that the overdraft was ignored for computation of WACC which I found very surprising especially given that it is not a insignificant amt. Is this a reasonable assumption? Can we make similar assumptions in the exam and state that assumption?
Also for part c, in paragraph 2 of the answer there is reference to a rate if 6.5% which I am unable to work back. Please clarify.
Many thanks
MusaHow we deal with an overdraft always really need an assumption – it depends on whether it is intended to be a long-term source of finance.
Giving the wording in the question, I would probably have treated it as long-term and included it in the WACC (although the problem then would have been what cost to use since although it is currently 6%, it is expected to increase).
Provided you state your assumption you would still get the marks.I am puzzled by the 6.5% as well. I think it is probably a misprint and what it should have said is that OK if there is a 1% increase it will mean an extra 150,000 interest. The current interest payable is 6% x 15M = 900,000. So in % terms, the increase is 150,000/900,000 = 16.7%.
However, numbers were not required for this part and so it is not too serious 🙂
It was only to illustrate (even if it does appear to be an error!).Another clarification please: Q4ciii. Why when the debt/equity ratio was calculated on book value basis, the entire shareholders equity (including reserves ) $67.2mm was used but only ordinary shares used for calculating on a market value basis? I.e why wasn’t reserves considered as equity in part iii?
Thanks.
Because surely one of the reasons that the market value is more than the nominal value is because the company has been earning money and retained it.
The market value effectively includes the reserves.
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