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Dear Tutor!
Great thanks for your outstanding lectures. I have just started with P4. Will you be so kind to help me with Q1 in Sept/Dec 2016
In answers there is said that Market value of debt (MVd) is calculated as
Per $100 $6·20 x 1·047^-1 + $6·20 x 1·047^-2 + $6·20 x 1·047^–3 + $106·20 x 1·047^–4 = $105·36
Total MVd = $105·36/$100 x $120m = $126·4m
Cost of capital = (12·2% x $360m + 4·7% x 0·8 x $126·4m)/$486·4m = 10·0%But why 0.8 (20 % tax) is applied to all debt (redeemable in4 years) but not only to interest?
thanks a lot
The examiners answer has calculated the MV of the debt correctly (and I am assuming you are happy with that bit).
With regard to the WACC, he has used the formula on the formula sheet. However strictly the formula is only correct for the debt part if the debt is either irredeemable or is redeemable at the same amount as the current MV. Neither is the case here, and so strictly the cost of debt should have been calculated as the IRR of the flows (using after tax interest but the full amount of the redemption). If you had done this the answer would have been a little different but you would still have got full marks.
(This is annoying me a little because the examiner is inconsistent – in some questions he uses the formula and in other he calculates the IRR, and in F9 the examiner always calculate the IRR. I have written to them about this but have yet to get a proper reply. However, again, for P4 you would still have got full marks 🙂 )
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