Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Query on calculation of Discount Factor :
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July 22, 2016 at 4:12 am #328296Joanna
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DaCosta plc is manufacturer of expensive, built to order motor cars. The company has been trading for 25 years and has seen yearon year growth of sales and profits. Whereas most of the large, massproduction motor manufacturers have experienced overcapacity and falling profit margins in recent years, DaCosta plc has a waiting list of six months for a new car. All cars are manufactured in the UK, but there are sales outlet throughout Europe and Far East. The chief executive of the company, who is still the major shareholder is considering extending the distributor network into the USA where there is a rising demand. At present, American customers have to order direct from the UK.
A detailed assessment of the costs and likely incremental revenues of opening distributorships into major US cities has been carried out. The initial cost of the investment is US$4.5 million. The cash flows, all positive and net of all taxes, are summarized below ………………
Information given:
– The riskfree rate of interest in the USA is 4% per annum and in Britian 5% per annum. These rates are not expected to change in the foreseeable future.The company’s posttax WACC is 14% per annum (UK), which it uses to evaluate all investment decisions.
*To find the US discount factor:
In the UK, the riskfree rate is 5%, and the required rate of return is 14%. The risk premium is 1.14/1.05 = 1.0857In the US, the riskfree rate is 4% and the risk premium is 8.57%. The required rate of return is therefore 1.04*1.0857 = 1.1291 or 12.91%
I tried figuring out but i do not understand why the answer is not as :
Risk – Free Rate 5% —> Required rate : 14%
RiskFree Rate 4% —> Required rate : 11.2%Thanks for helping me ๐
Regards,
Joanna.July 22, 2016 at 7:58 am #328318John MoffatKeymaster Topics: 57
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I don’t know where you found this question, but if you have copied it correctly then it is rather ridiculous.
The figures they are calculating are not the discount factors, but the discount rates (the distinction is important). Also the figures they quote for risk premiums are certainly not risk premiums.They are using the fisher formula from the formula sheet.
Since the UK WACC is 14%, this is the nominal cost of capital. With interest at 5% in the UK, the real cost of capital = (1.14 / 1.05) – 1 = 0.8571 (or 8.571%).In the US, using a real cost of capital of 8.571% and interest of 4% gives a nominal cost of capital of (1.08571 x 1.04) – 1 = 0.1291 or 12.91%
We usually use the Fisher formula with inflation rates rather than interest rates. However, inflation and interest rates in theory move together (the four way equivalence).
Again, if you have copied the terminology correctly from the question then it is actually rather appalling of whoever wrote it ๐
July 22, 2016 at 9:32 am #328343Joanna Topics: 24
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Thanks Sir.
Sorry, it was my fault in writing discount rate as discount factor as I thought it meant the same thing.
July 22, 2016 at 10:17 am #328351John MoffatKeymaster Topics: 57
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You are welcome ๐

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