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In the answer Q2/2010 one assumption is: “It is assumed that the annual reinvestment needed on plant and machinery is equivalent to the tax allowable depreciation.”
But as I understand the calculation of NPV (as a rule and also in this question) we assume that there is no reinvestment since the depreciation is added back to the the cash flow (or actually not substracted from profits; only the tax relief of depreciation is reducing the tax paid) If that assumption had been made we should have reduced the final cash flows by the amount of the depreciation (since the depreciation and reinvestend would have cancelled out each other). What am I missing?
Another issue in MM proposition 2 (with tax) kd -cost of debt is the cost of risk-free rate if we assume the debt is ris-free(is the same assumption that eliminates the second term of the asset beta formula; beta of debt=0)
Thank you very much Sir!
For your first question, please tell me whether it is the June exam or the December exam. It seems more likely to be Q2 of June 2010, but I cannot find your quote in either the question or the examiners answer.
With regard to MM proposition 2, Modigliani and Miller do not assume that debt is risk free.
December 2010 question.
In the same question as I understand they do assume that debt is risk free to be able to calculate the ungeared cost of equity from MM prop 2. as kd (cost of debt)=risk free int rate.
Thank you again, Sir.
I am now out for the rest of the day, so I cannot look at the paper – I will reply to the first part of your question later.
With regard to calculating the tax shield on debt raised, the examiner always allows it to be calculated using either the return on debt, or the risk free rate – there are arguments both ways. Obviously that can give different final answers but either gets full marks (and the examiner usually says that in his answer – I can’t remember whether he did in this one)
I am back home now.
The more I think about it, the more I think you are correct.
I must admit that when I did the question I treated it like a normal APV project appraisal and did not bother about the sentence referring to reinvestment being equal to the depreciation. In a normal NPV or APV question it is not relevant and not mentioned.
It is only in questions asking for FCF or FCFE where it becomes relevant.
However, since he did mention it, and he did mention it as an assumption, I think that what you have said is correct. (And it spoiled my meal because I spent the whole time working on it in my head 🙂 )
Thank you very much Sir, and sorry for spoiling your meal:). Since studying P4 I always have something on my mind that bothers me till I understand it in full.
Back to Q2/dec 2010 we may conclude there is a mistake in the answer sheet since that assumption is mentioned in part b as being applied in part a to the calculation of NPV, but in part a actually the assumption does not apply. (calculation of NPV is in the “usual” way with no reinvestment in non-current assets).
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