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Quick Q sir,
BB is an all equity financed company with a cost of equity of 10%.
The directors are proposing to raise 200M to invest in a new project. The investment will carry a similar risk to BB’s current business.It has proposed that the investment is finances by an issue of an undated bond carrying a 5% interest pre tax.
Earnings for BB are forecast to be 100M in the first year after the new investment. Tax is 30%.
Calculate BB’s value if it issues the bond and undertakes the project.
Solution
Vq=Vu+TB
TB= 20%*200=40m
But I am struggling to find the Value of ungeared debt. It should just be the value of equity with no debt- is it the 100m earnings? If so why do we take this?
Thanks
I don’t know what you mean by “value of ungeared debt”. There is no such thing as ungeared debt.
Also you have either mistyped the question (or there was a typing error in the question itself). For the answer you have typed, the tax rate must be 20% (not 30%).According to M&M, if there was no tax then the WACC and the total MV (debt + equity) would stay the same regardless of the level of gearing.
With tax, the total MV of the company will increase due solely to the tax relief on the interest. If they raise 200M from debt, then the interest will 5% x 200M = 10M p.a.. The tax saving as a result will be 20% x 10M = 2M. The present value of 2M a year in perpetuity discounted at 5% = 2/0.05 = 40M, which is exactly the same as the 200M raised multiplied by 20% (and always would be assuming irredeemable debt, which is a MM assumption).
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