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Hi
I was completing the multiple choice test provided and was surprised to get the following question incorrect.
“R PLC HAS IN ISSUE $400,000 8% BONDS REDEEMABLE IN 5 YEARS AT A PREMIUM OF 10%. INVESTORS REQUIRE A RETURN OF 12%. INCORPORATION TAX IS 35%.”
The answer given calculates without tax information $364,840. Why is this?
I would have used the 35% tax rate i.e. $8(1-0.35) = 5.2 * 4000 nominal bonds = $20,800.
d.f @12% 1-5 years = $20,800 * 3.605 = $74,984
Then add the redemption = $440,000 * 0.567 = $249,480
Overall value = $324,464.What am I not understanding here? Do you always ignore taxation when calculating market value?
What you are not understanding is that the market value is determined by the investors (not the company).
We always in the exam ignore personal (income tax) and therefore the investors expected receipts are the full amount of the interest.
The cost to the company will be lower, because the company saves tax on the interest. However it is not the company that determines the market value – it is the investors.
(If you are unsure, then my free lecture on this will help you where I stress the difference between the investors and the cost to the company.)
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