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Part b asks for an estimate of the revised market valuation of the companys debt
In the bpp answer they have calculated the effect by doing this calculation
Effect=0.4/1.044 +0.4/1.044^2 + 0.4/1.044^3=110 basis point reductionWhat do they mean by these figures?and they dont add up to a 110 basis point reduction.
When the basis points reduce,does the market value of debt increase or decrease?in this answer they have reduced the market value by 1.1% changeI really appreciate your time and effort
🙂I don’t know whose answer you are looking at to this question, but it does seem rather confusing. The examiners own answer is (I think) easier to understand.
The first part of your question (0.4/1.044 etc), is calculating the new market value of the existing debt. (The market value if the present value of the future receipts. The coupon rate is 4% so interest is 4 per year on $100 nominal, and the yield/required return is 4.4%).
The solution to that equation is $98.90.
So, for $100 nominal it has fallen to $98.90 – i,e, a reduction of $1.10 (I am not sure I like them calling it a 110 basis point reduction – the examiner doesn’t in his answer!)Dear Sir,
Could you explain why they used yield on bond (4.4%) as the discount factor other than the cost of debt capital (which is (1-tax rate)*yield on bond (3.08%))?
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