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F9 December 2015 paper, Section B, Question 1 – a
They ask: (a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your findings.
The answer of this qn says: Market value of equity = 15,000,000 x 3·75 = $56,250,000
Market value of each irredeemable loan note = 6/0·07 = $85·71
Market value of irredeemable loan notes = 10,000,000 x 85·71/100 = $8,571,000
Market value of each 7% loan note = (7 x 5·582) + (105 x 0·665) = $39·074 + 69·825 = $108·90
Market value of 7% loan notes = 12,000,000 x 108·90/100 = $13,068,000
Total market value of debt = 8,571,000 + 13,068,000 = $21,639,000
Debt/equity ratio based on market values = 100 x 21,639,000/56,250,000 = 38·5%
This is slightly less than the average debt/equity ratio of companies similar to Gemlo Co and so the company appears to have
a similar financial risk to these companies.MY QUESTION HERE: When calculating market value of each 7% loan note, I can`t understand from where come 105, pls explain for me. Thank you!
The loan notes have a nominal value of $100, and are redeemed at a 5% premium after 7 years. So the amount paid on redemption is $100 + (5% x $100) = $105.
(and the market value is the present value of the interest and the redemption amounts, discounted at 6%).My free lectures will help you with this – the lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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Hi Sir,
Why we did not include reserves in equity while calculating debt/equity ratio, aren’t Reserves part of Equity ?
Reserves are part of equity and if gearing is every measures on book values (the values in the SOFP) then equity is the share capital plus reserves.
However when using the market values of shares (as we usually do because it is more realistic) then we do not add on the reserves. The reason is that the most obvious reason for the market value being higher is because the company has made profits – the market value effectively includes the reserves.
I do explain this in my free lectures 🙂
Hi,
how are you today?
Sorry for come back to this topic but how can I know that the nominal value of the loan note is 100?Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial position are as follows:
$m $m
Equity
Ordinary shares ($1 nominal) 15
Reserves 153
––––
168
Non-current liabilities
6% Irredeemable loan notes 10
7% Loan notes 12
––––
22
––––
190
––––
Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and is assessing its current financial position as part of preparing a business case in support of seeking new finance.
The business expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year.
The planned business expansion by Gemlo Co has already been announced to the stock market. Information on the expected increase in profit before interest and tax has not yet been announced and the company has not decided on how the expansion is to be financed.
The ordinary shares of the company are currently trading at $3·75 per share on an ex dividend basis. The irredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will be redeemed at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times.
Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a market value basis and an average interest cover of 9 times.
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