Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Exam paper- Dec-08-Jupitor Co.
- This topic has 3 replies, 2 voices, and was last updated 10 years ago by John Moffat.
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- March 21, 2014 at 9:17 am #162769
Section (c) of the subject question demand a minimum rate that must be earned by the new debt. Although I understood that approaching this question with a mathematical formula, you would get more accurate figures, I approached this question with pure logic inspired by real life experience and found that the cost of new debt is what the minimum of return it must generate giving the following working to substantiate it.
Current cash flow 400.00
Add back interest net of Tax 33.60
(800*5.6%)
Total 433.60Found the terminal value using this cash flow , the new cost of equity and retention rate given.
ie., 433.60 X 1+ (.0921*.30) /.0921-(.0921*.30) = $6,908 Million.
The above establishes that with the new cost of equity and without debt interest the firm’s share price would not fall from the current level.
Further we have to ensure that the same will not fall even after the payment of interest on new debt capital.
Gross interest of existing finance: 33.60/.75 = 44.80
This means without any debt
the firm will generate cash flow 444.80Less interest on new Debt (93.00)
(2400*3.875%)Net cash flow under new debt 351.80
Deficit compared to current level 48.20
This means The new debt has to generate 93.00
minimum to retain current level of earningsThis equal to the amount of interest of 3.875%
New DebtDo you think this will work and will get some credit?? Please advice me whether or not my understanding is correct,
Thanks
March 21, 2014 at 5:53 pm #162782You would certainly get credit, because you have basically used the right approach (and is really more or less the same approach as the examiner).
However, the one real problem with your workings is that you have calculated the terminal value using the new cost of equity but assuming no interest. If there was no debt interest (so no gearing) the cost of equity would not be 9.21%.
Despite that, you would certainly get credit for your workings even though you would not get full marks.
March 22, 2014 at 8:51 am #162797Hmmmm!! you are correct,we should have cost of equity not being affected by the gearing, if my working needed to accept with full marks.
Thank you very much John, you rock!!!!!!
March 22, 2014 at 8:58 am #162798You are welcome
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