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Hello Sir,
Its BPP case study Question current 2017 version of kit no 81.
I have two problems in the model answer which I can’t reconcile with my current understanding:
1 – In calculating redemption yield for calculating kd for manufacturing division the model uses kd(1-t). and uses this throughout in WACC calculation aswell. Is it because tax was already calculated when we did our IRR calculations?and when author, makes his assumption.
2 – He says “The consequence of making the assumption that debt is risk-free is that formulae tend to overstate the financial risk in a geared company and to understand the business risk in geared and ungeared companies by a compensating amount”
I can’t get anything about this statement.
Could you help please I would really appreciate that. Thank You sir
1. Both the wording and the symbols used in the answer are appalling and confusing, If we had wanted the redemption yield then because this is the return to the investors and would have calculated the IRR of the flows before tax.
However, what is needed for the WACC is the cost of debt to the company which is the IRR of the after tax flows.
So the calculation is correct it is just the wording that is dreadful.2. In the formula for the asset beta we assume always that the beta of the debt is zero (i.e. that debt is risk free). In practice debt will have a bit of risk and therefore it will have a beta (although it will be small).
If there was a debt beta in the formula then the result would be that the equity beta would be a bit smaller. So by assuming that the debt beta is zero ends up giving a higher equity beta than would really be the case and is therefore overstating the financial risk.
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