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Hello John.
Can you please expain in 12/10 in the formula for calculation of cost of ungeared equity Kd equals risk-free debt rate (4.5%)
I am looking at solution published in BPP Revision kit.
Based on BPP Study text I expected that Kd will equal cost of debt for Haizum Co. This was not given in scenario but in theory could be calculated as risk-free debt rate (4.5%)+ market risk premium (4%)thanks in advance
When calculating the ungeared cost of equity using the asset beta formula, we always assume that the beta of debt is zero unless specifically told otherwise (which is unlikely).
Kd is the return to investors which is before tax, and the cost of debt is after tax, so the cost of debt is not equal anyway to Kd.
The cost of debt will never ever equal the risk-free rate plus the market risk premium!!
The cost of debt will equal (risk free rate + (beta of debt x market premium)) less tax relief on the debt.I really do suggest that you watch my free lectures on CAPM.
(If in fact you are asking about the tax benefits when calculating the APV, then there are arguments for discounting them at either the risk free rate or at the return to investors on the debt – the examiner always allows either, even though they give different answers. For this you need to watch our free lectures on APV.)
John,
my question was about M&M formula usage in this question.
Your lecture notes (page 57) define Kd as pre-tax cost of debt.I was wondering whether it was correct to assume that pre-tax cost of debt for Haizum (Kd) equals 4.5% (which is five-year government debt yield in scenario). It is in published answer.
Isnt it strange that pre-tax cost of debt of Haizum equals government yield?Ahhh…now I understand what you are asking!!
The problem is that M&M in all of their formulae (and the asset beta formula derives from them as well) assumed that debt was risk free (whereas in practice it is not).
If debt were risk free, then Kd would obviously equal the risk free rate.In the exam, if you know both Kd and the risk free rate then I would use Kd (although you would get the marks for using either – even though the give different answers) but it would be sensible whichever you used to write down your assumption. (Throughout P4, it is vital to write down your assumptions always (which is why question 1 almost always specifically asks you to write your assumptions))
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