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Hello I just completed practice question 1 and when I checked my answer I saw that in the suggested answer the tax cash flow is pushed to the next year.
When the question doesn’t stat when the tax is paid should we assume it is paid in the next year or is having it outflow in the same year also acceptable?
I have another question regarding the practice questions, this time Question 2 part d.
In the calculation for cost of debt there is an interest payment at year 0, is it normal for the interest at year 0 to be non tax deductible and the full amount of interest to be deducted from the total debt value?
My value for Y0 is 100(0.95) – 5(1-0.35) = 91.75
Can’t seem to find the edit post button, so I’ll have to triple post.
Onto Question 5 now:
For calculating the market value of an ungeared company we are given a forumula MVU= MVG -DT.
I understand the logic is that the value of an ungeared company is equal to that of the same company geared without it’s tax benefit from debt.
What I don’t understand still is why the tax benefit portion is “DT” and not a perpetuity of the INTEREST discounted at the risk free rate. We should only get tax benefit on interest not on the full debt amount so this really confuses me.
In answer to your first question, if the question does not say when the tax is payable then you have to make an assumption. Any sensible assumption would get full marks (even though the final answer would be different). Normally you would assume either that the tax is payable immediately, or that the tax is payable one year later (unless, again, the question actually states the timing).
In answer to question 2, when calculating the cost of debt we always assume that the market value is given ex int (i.e. assuming that the current interest has just been paid) unless told different. If the value is given cum interest, then remember that it is the debt holders that ‘fix’ the market value (and the debt holders do not get tax relief) and so the difference will be the full amount of the current interest (not the after tax amount).
In answer to your third question, the two things will come to the same, provided that the debt is irredeemable.
With irredeemable debt, the market value of the debt – D – will equal Interest/req’d return
The tax relief will be equal to interest x tax rate in perpetuity.So, the present value of the tax relief will be (int x tax rate)/req’d return, which is the same as DxT
(assuming the debt is risk free (so req’d return = risk free rate), and assuming that the debt is irredeemable)Thanks for the reply.
Continuing with the practice questions I noticed that in PQ 8 part b a different method is used to calculate the net effect of using the currency options.
Instead leaving the transaction at risk then adding the gain and subtracting the premium (converted on the day of purchasing the option) the answer works it out as if we excercise the option and make the payment using the funds from the option including the premium and any remaining amount is converted on transaction day to be added/subtracted from the contract amount.
The two methods create two different answers, is the one in the suggested answers wrong?
Also there is an error for the 3 month amount, it should be a recievable amount and not payable.
As I show in the lecture and the notes, there are two ways of illustrating what happens when using options.
One way (and strictly the better one) is to convert the transaction at whatever the rate happens to be, and then if the option is exercised calculating the gain on the option. The other way is effectively to use the option to convert the option amount and then convert the balance at whatever the rate happens to be (which has what has happened in this answer).
The two ways are both acceptable (in the past some examiners answers have done it one way and some the other way). The answers can end up sometimes giving slightly different answers but that does not matter in the exam.What makes this question slightly unusual is that although in practice the option premium is payable when the option is purchased (and therefore converted at ‘todays’ spot rate), this question specifically says that the premium is not payable until the end of the option, which is why it has been converted at the rate on the date the option is exercised.
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