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Hope everyone is doing well. My question is, when we are using the MM + tax model to find the cost of equity, why is kd(cost of debt) in the formula found using the spread approach. And why is spread set equal to 0, while it is clearly stated in the question that the basis points for subsidized loans are less by 200 points. And when we find the cost of debt, for the present value of financial cashflows in the APV format, we use a totally different kd.
Thank you!They have not used any ‘spread approach’. When using the MM formula we assume that debt is risk free and is therefore Kd (which is the return to investors, not the cost of debt) is 4.5% as per the question (the yield on government debt). If instead you had used the asset beta formula then again, (as always when using that formula) you would have assumed the debt to be risk free.
When calculating the tax shield on the interest and the subsidy benefit we use the actual debt interest paid by the company.
So, whenever I am using the MM + tax model, if there is no Kd given in the scenario of either of the companies ( our comapny and the proxy company ), and no data given to compute the Kd, then I can use the risk free rate instead in place of Kd right?
Thank you.When you are using the MM formula to calculate the ungeared cost of equity you should use the risk free rate for Kd.
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