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Hello John
The question is :
A co. with loan notes of 100m which are trading at a 10% premium, anticipates generating annual revenue of $210m with costs of $160m (which includes accounting depreciation of $40m). The annual investment required to sustain operations is $50m which generates a tax allowable depreciation of 30%. The co. has a cost of capital of 10%. What is the value of the co. on a discounted cash flow basis?In comparison to the answer I got the same up to the point of the net cash flow of 28m. After that, the answer has “PV Perpetuity= $280m less $110m loan notes=$170m. I do not understand the $280m. I’m thinking its the 28 x 10, but the only value of 10 is the cost of capital.
The discount factor for a perpetuity is 1/r, where r is the cost of capital (in this case 0.10 (10%)
So the present value of 28M per year in perpetuity is 28/0.1 = 280M
Thanks John, how was I supposed to derive that its a perpetuity from the question alone? the loan notes would not have been forever, and there’s mention of depreciation which means that an asset would have to be replaced eventually so there would be changes in the net cash flow.
Your question states that it anticipates annual revenue of $210M. It does not say for how long and therefore there is no choice but to assume that it continues in perpetuity.
The fact that the loan notes are not forever is not relevant – when they are repaid they would presumably be replaced by other finance anyway.
Depreciation is an accounting concept and it not relevant when we are looking at cash flows.
(Incidentally, I don’t know where you found this questions, but unless there is more that you did not type, it is nothing at all like Paper F9 exam questions! It could not possibly be asked in Paper F9 the way that you have typed it 🙂 )
Thanks again John. What I typed is exactly how the question was worded. It’s a multiple choice by the way.
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