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Sir in the mm+tax model kd is cost of debt which in this qs is 7.5% for fubuki then why have they used 4.5% which is the risk free rate?
As I explain in my free lectures on APV, there are arguments for using the risk free rate and for using the normal cost of borrowing. The examiner always accepts either (and specifically writes this in his answer).
Sorry Sir I think I was not clear. the examiner has mentioned that we can use either but not for the discount factor used in base case NPV calculation or has he?
The marking scheme says we can use either when discounting the tax effects and subsidy benefits.
My doubt is that we need ungeared cost of equity for base case NPV . I used MM+ tax model and took 7.5% as kd instead of 4.5%. the examiner did not mention anything for this. I am really sorry for asking such doubts .
I am sorry – I misunderstood your first question.
M&M assume that debt is risk free, and therefore in the formula we should use the risk free rate (despite it being stated as Kd). If you were not told the risk free rate then we would use Kd but you should then state that you were assuming that it was risk free.
Having said that, appreciate that only 2 of the 17 marks were for calculating the ungeared cost of equity (and you might well have still got 1 of the marks if you had used 7.5%) and as always you would still have got the other 15 marks assuming you had done everything else correctly even if you had used 7.5% 🙂 )
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