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- This topic has 3 replies, 2 voices, and was last updated 6 years ago by John Moffat.
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- November 21, 2017 at 6:18 pm #417191
Hi Sir
In the June 2012 paper (Part C: Zitoni Co), we’re asked to calculate the difference in the outcomes between a money market hedge and buying forward exchange contracts.
Am I correct in interpreting that the forward exchange contract has Euros at a higher value (appreciated value) than their current spot rate?
Secondly, the question goes asks whether the forward exchange contract (FEC) or money market hedge is preferable and I can see the FEC produces a higher value, but wouldn’t the choice also depend upon the forward exchange contract costs compared to the interest charge on the borrowed monies, in the money market, to compare the net result of the two options?
Totally Separately:
One of my question bank answers (from my course provider) states that both the Traditional Theory and Modigliani and Miller’s Capital Structure Theory, maintain that ‘debt is always risk free’ (in both theories), but I thought, based on the model/diagram, for the traditional theory, that debt is not always risk free because, at the extreme levels, the cost of debt starts to rise and therefore, I would have thought, that the statement was incorrect?
I was thinking about Pecking Order theory and how it could affect the WACC, could I please ask, is my thinking/understanding here correct: many firms, in reality, may not examine their capital structure when raising finance, some may follow the Pecking Order theory and raise all or some proportion of their funds, with any available retained profits (providing they have the cash balances to support this). This could then, inadvertently, reduce total equity (depleting reserves), and reduce both the firm’s debt capacity and gearing ratio, and so this could cause their cost of debt to rise (because the threat of insolvency/bankruptcy increases) and, greater financial risk, could push up equity investors required return, and this could also inflate the cost of equity, and so without even raising share capital or debt finance, the WACC can increase?
November 22, 2017 at 9:39 am #417342You are correct in saying that the euro is appreciating against the dollar.
With regard to the comparison of using forward rates as against the money market hedge, you are correct with regard to the fact that we ignore bank charges (we always ignore them in the exam). However you are not correct in saying that we ignore interest charges – money market hedging certainly takes into account the interest. My free lectures on this will help you – I explain the different methods of hedging in detail, with examples.
Although M&M assume that debt is risk free in their proofs, is it not risk free in practice (that is one of the limitations of M&M), and traditional theories of gearing do not assume it is risk free.
Pecking order theory looks purely at the ease of raising finance and does not consider the effect on the WACC. It certainly is possible that the WACC could increase as a result of following this approach. (Although if more money is being raised, then it will always be either from shareholders or from debt – using retained earnings is using shareholder finance in that it is otherwise payable to them as dividends.)
Do watch my free lectures – they are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
November 25, 2017 at 1:43 pm #417946Hi Sir
Yes sir, thank you, I have watched all of them, most, more than once! They really help.
Could I please ask, why, in the Sensitivity (example 1) lecture, the contribution is not adjusted for taxes? Is it because we were not given the tax rate, in the question?
In the Dec 2011 paper, Warden Co, had a question involving sensitivity analysis where there was taxation featured in the scenario.
If we were given the tax rate, would we need to: multiply the PV of the total lifetime contribution by ‘(1 – T)’ before dividing NPV by the tax adjust PV of contribution?
If we were asked about the sensitivity of the project to changes in fixed costs, how would we adjust for the tax effect? I’m asking because I think you would need to multiply the PV of fixed costs by ‘(1+T)’ because they would provide a tax saving, but I’m not sure, could you please advise?
Lastly, the Kaplan full text, has a very short passage on ‘Sensitivity Analysis – the certainty equivalent approach’ – it’s the only place I’ve seen it, the calculative technique seems very straightforward, but I can’t figure out it’s purpose – is it basically saying: ‘at a minimum, these are the cash flows that will be achieved’ and does that mean, after you’ve certain cash flows, and discounted back to PV by the risk free rate, that there’s no point in calculating ‘NPV/PV x 100’ because the cash flows are certain?
Sorry, but there’s literally no explanation of how to interpret the purpose and outcomes of this approach.
Thank you again.
November 25, 2017 at 3:56 pm #417966In example 1, since there is no mention of tax we assume there is no tax.
In Warden, yes – you multiply by 1-t because as the flows change so too will the tax on them, so we are taking the after tax amount.
With fixed costs – yes, what you have written in correct.
The purpose of calculating the sensitivity is that when estimates are uncertain then if the sensitivity is very big then you are not too worried if the estimates are a bit wrong.
However, the lower the sensitivity then the more worried you are about the estimates being wrong (because if they are wrong by anything more than the sensitivity % then you will have made the wrong decision). For flows where the sensitivity is very low you would either (in real life) spend more time trying to make sure the estimates were more correct, or might even decide not to take the risk of doing the project. - AuthorPosts
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