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To find the ungeared cost of equity, the answer uses the 2700 as Ve and Vd.
How do I get this figure?In future, please say which exam the question comes from – you can’t expect me to remember the name of every question right back to 2006 🙂
Note (1) says that the investment will be $5,400,000.
Note (2) says that it will be financed 50% equity and 50% debt.
So sorry this is my first time posting a question here. I will do that next time.
For the question, why do we use the 50% equity 50% debt but not the 60% equity and 40% debt in note(iii).
And another question is that when we finding the ungeared cost of equity we use the Asset Beta Formula, isn’t the Ve and Vd we substitute into the formula are from the proxy company one? But this question does not provide any information about a proxy company.
We need the asset beta of the project. Usually we use a proxy company to find an equity beta, and then ungear it.
However, the question tells us the equity beta of the project (so we don’t need a proxy) and we use the gearing of the project to ungear it (just as we would use the gearing of the proxy company if we were ungearing a proxy company’s equity beta).
Go back to the Tampem question, I still don’t get why not we use the 60% equity and 40% debt as our Ve and Vd?
Vd = market value debt; Ve = market value equity.
And the question says the investment will change to 60% equity, 40% debt by
market values as per note(iii)
So I thought the 60% equity an d 40% debt should use for Ve and Vd.It is not the gearing of the whole company that matters, but the gearing in the project.
Imagine it was a proxy company instead – you would take the equity beta of the company and ungear it using the gearing of the proxy company.
The only difference here is that we don’t need a proxy company. We know the equity beta for the project and the gearing for the project, and that is all that we need in order to calculate the asset beta for the project.
Good day sir, i have three doubts about this question.
1) May i know why to calculate the tax shield we have used 50% debt instead of 40% debt?
Because i went through other students queries and sir suggest to assume the 50 % debt and equity investment as a proxy company, treat it the same way as we treat a proxy company2) My second doubt is that in the question they have said ‘Working capital may be assumed to be constant during the four years.’ Usually we will include it in each year into small outflow figures and collect back the total amount in last year but in this question we did collect the entire amount in last year but why we didnt had the splits of outflow figures from year 0-3.
3) Lastly in this question, we dont have to include a loss on disposal or add the balancing allowance because the question as mentioned ‘the after tax realisable value of the investment as a continuing operation is estimated to be $1·5 million (including working capital) at the end of year 4’.
Since out NCA is cost ($4.4 million) – Accumulated depreciation ($3 million) = Residual value ($1.4 million). Out of $1.5 million we removed $0.6million for working capital so we left with $0.9 million so we are getting a loss as we are selling for lesser value than residual value ($1.4million). The reason why we didnt include a loss on disposal or add a balancing allowance is because $0.9 million is after tax which means it has already added the balancing allowance. Is that correct sir?1. For APV we should use the debt capacity which is given as 50%. I explain this in my lectures on APV and this has nothing to do with thinking about a proxy company.
2. If the level of working capital remains constant then we don’t need any more working capital during the life of the project!
3. Yes – the fact that it is after tax means we can assume that balancing allowance or charge has been taken into account.
This is an extremely old question and the examiner has changed twice since this question was set!
Sir, again for the capital structure, the reason why for WACC in NPV we have used 40/60 because the capital structure of the company is expected to change, we cant use the same WACC if the business risk/capital structure has changed or about to change right sir, that is why we find the latest WACC to discount it ?
However, for APV usually we will be given a proxy company to find the BA from ungearing the BE, since this question has given the BE which is related to the investment, so we ungear it to find BA and then through CAPM we find the KE to discount it (assuming it is purely equity finance). The reason why 50% was being used to find the tax shield is because that is the original percentage of debt financing for the investment. We will only need a proxy details if there were absence for our own investment details, that is why we find related companies but this question has directly given the own investment detail which is more accurate than using a proxy company detail.
Did i get the points right sir?
To calculate the NPV we use the WACC and to calculate this we use the company gearing after the investment (60%/40%).
To calculate the APV we discount at the ungeared cost of equity, and to calculate this we need the asset beta which we get using the asset beta formula and the gearing used for the investment (50%/50%). We then add on the tax shield, calculated on the debt actually raised for the investment (50% x $5,400).
Again, this is a terribly old question and is not really very representative of questions asked by the current examiner.
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