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in the exam kit of kaplan about the answer it writes as follows
The weighted average cost of capital relies upon a valuation of the current debt. This is achieved by discounting the current average coupon rate applied to a nominal $100 of borrowing at the current cost of debt finance:
I want to know why has been market value of debt been calculated in this way which did not take account of tax relief?as the tax rate is 25%
Md =5.6/(1.0465) +5.6/(1.0465)2 +5.6/(1.0465)3+105.6/(1.0465)4=£103.4percent
This gave market value of debt 103.4*800=$827.17
I want to know why 103.4 is written in both % and sterling2 why after tax cost of debt is not calculated?
According to me it should be 4.2/(1.0465) +4.2/(1.0465)2+ 4.2/(1.0465)3+ 104.2/(1.0465)4 =4.013+3.835+3.664+86.87=£98.32
and according to me market value of debt dhould be 98.32%*800=786.56
as 5.6( 1-.25) tax rate = 4.2The market value is the present value of the expected receipts discounted at the investors required rate of return. It is investors who fix the market value.
The investor does not get tax relief. Tax is only relevant when calculating the cost of debt to the company.
Assuming you have quoted Kaplan correctly, their statement is wrong – we do not find the market value by discounted at the cost of debt (unless they wrote ‘the pre-tax cost of debt’.
this is the fulll question please let me know where i am wrong
Rosa Nelson, the Chief Financial Officer (CFO) of Jupiter Co, has been in discussion with the firm’s advisors about refinancing the capital of the firm. She is considering a scheme to repay current borrowings of $800 million and raise new capital through a bond issue of $2,400 million. The current debt consists of several small loans raised in the Euro market with differing maturities and carrying an average rate of interest of 5·6%. The average term to maturity of the existing debt is four years. The new debt would be in the form of 10 year, fixed interest bonds with half being raised in the Yen and half in the Euro market. The yield to maturity of an appropriate government bond and the relevant credit risk premium for a company of Jupiter’s credit rating in the Japanese and the European market is shown below:
Yield to maturity Credit risk premium (basis points) 4 years 10 years 4 years 10 years Japanese Government Bonds 1·00% 1·80% 35 50 European Government Bonds 4·20% 4·60% 45 85
Jupiter’s current beta is 1·50. The current risk free rate is 4·0% and the equity risk premium is 3·0%.
The company currently earns a free cash flow to equity of $400 million after interest, tax and net reinvestment. The company consistently reinvests 30% of that free cash flow within the firm and makes the balance available for distribution to investors. The free cash flow to equity model has provided a reasonable estimate of the company’s equity market valuation in the past. The current share price, based upon 500 million fully paid, 25¢ equity shares, is 1,380¢. The current rate of tax on corporate profits is 25%. Management is of the view that the additional borrowing will lead to the company being able to increase its earnings growth rate to 4%.
You may assume: 1. Interest on the firm’s debt is paid annually. 2. The debt in issue and proposed has a zero beta. 3. The firm’s share price will be unaffected by the alteration in gearing. 4. Foreign exchange risk may be ignored.
Required:
As Deputy Chief Financial Officer prepare a briefing note for Rosa Nelson. Your note should include:
(a) An assessment of the firm’s current cost of debt, cost of equity and weighted average cost of capital. (6 marks)
(b) An assessment of the firm’s expected cost of debt, cost of equity and weighted average cost of capital after the redemption of the existing debt and the issue of the new bonds. (8 marks)
(c) An assessment of the minimum rate of return that the company needs to earn on the new debt capital before interest is paid. (6 marks)
(d) A comparison of the proposed method of raising capital for investment purposes with alternative means of raising the debt finance required. (8 marks)
Quality and presentation of the briefing note. (2 marks)
(30 marks)I don’t know why you have typed out the whole question, because I have already answered you – you have not read my reply properly!
The market value of debt is determined by the investor – it is the present value of their expected receipts discounted at their required rate of return.
On $100 nominal they will receive interest of $5.60 per year.
The rate of tax on corporate profits is not relevant to the investor – they receive the full interest.
(The tax is only relevant when calculating the cost of debt, because the company gets tax relief on the interest.)
With regard to $’s changing into sterling – that is obviously just a typing error by Kaplan.
Dear sir, i understand that we hve to discount da future cflows at ytm( which is before tax) to calculate the m.v of a bond but in calculating wacc in part a, y the examiner has again used ytm of 4.65 instead of using 4.65(1-tax rate) 3.9%? B/c ytm minus tax gives kd and in wacc we always take kd after tax! Secondly how do we knw dat dollar 800 is balance sheet value instead of market value?….jus b/c info regarding the calculation of m.v was given..so for the sake of it we calculated? Thanksss
I don’t know which answer you are looking at, but the examiners own answer writes 4.65% x 0.75, and BPP’s answer writes 4.65% x (1 – 0.25). Both of which come to 3.9% !!
The current borrowings of $800M are ‘several small loans’. Loans do not have a market value – if you borrow $800 then you owe $800! It is only traded debt borrowing (bonds etc) that has a market value.
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