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Hi sir
In the question it states that ‘overall cost of capital of 11% is reasonable compensation for the risk undertaken…’
To me this would imply that 11% is the WACC as is says ‘over all’…but in bpp solution they use 11% as the Ke for caclulating the free cash flow??In the same question, part c, I was a bit confused over why we wouldn’t discount the option escerxise price to PV, since we discount the Pa, the asst value?
I also posted this topic to the general p4 forum, apologies
Thanks
I have not got the BPP solution, but certainly in the examiners answer (and I assume BPP is the same) they have used 11% as the cost of capital – not as the cost of equity.
They have used the dividend valuation formula (because it gives the present value of any growing set of flows) but instead of using the current dividend they have used the current free cash flow, and instead of using cost of equity they have used WACC.
This gives the total value of the firm.
Then they have subtracted the value of the debt to determine the value of the equity.We never discount the exercise price. Pa is the value now, Pe is the exercise price – it is the same when we are dealing with share options.
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