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Dominance Co is considering raising some new finance but there is disagreement at board
level how best to proceed.
The managing director thinks that the company should retain control in the hands of the
existing and loyal shareholders. The finance director feels that the gearing level should be
allowed to increase to benefit from the tax relief allowed on interest.
The existing equity is quoted at $4.20 cum div with an imminent dividend of 16c due any
day. The company earnings have grown at a fairly steady rate of 8% over recent years, but
expectations are for growth to be 2% points better in the future.
The company’s debt is 4% irredeemable bonds, which were issued at a 5% discount of
$95%. They have a nominal value of $100 but are currently quoted at $80 with the interest
having just been paid. The corporation tax rate is 25%.(Taking from the answer; Cost of equity is 14.4% and after tax cost of debt is 3.75%)
The cost of equity for Dominance Co is significantly greater than the cost of de
The main reason for this is:
A The total risk level in the business
B The specific risk in the business
C The tax shield
D The level of systematic risk in the businessAnswer:D
The tax shield is relevant but is minor when one considers the risk premium is approximately 10.4%.
The main driver for risk premium is systematic risk. All the specific risk will be ignored by the well-diversified shareholder.My question is: How did they find the risk premium figure of 10.4%, sir please clarify the concept.
Thank you.In theory the debt in the company is risk free (in practice it is not risk free but will have low risk).
The answer is saying that pre-tax cost of debt (and therefore the approximation to the risk free rate) is around 4% and therefore the risk premium is around 14.4 – 4 = 10.4%.
It is only a rough approximation – obviously an exact figure is not needed.As far as the concept is concerned, it is all explained in detail in my free lectures on CAPM
Hello John, the tax shield for this question would be 25% which is greater than risk premium (systematic risk) of 10.4% why does the kit state the tax shield is only minor compared to systematic risk? If there’s Seth wrong with tax shield would you pls explain? Thankyou-
It is important to note that the tax shield refers to the reduction in taxable income due to deductible expenses, such as interest payments on debt.
The tax shield can have an impact on the overall cost of capital for a company.So If the tax shield is greater than the risk premium (systematic risk), it could potentially reduce the cost of capital for the the tax shield in this case.
If it states the tax shield is only minor compared to systematic risk it means, in this context, the instruction is to disregard the tax shield and focus on the systematic risk.
I’m sorry but the answer mentions that the tax shield is only minor compared to risk premium, if you see the original question upwards the option C) just says tax saving
And D) says systematic risk. If the systematic risk is 10.4% as calculated above how is tax shield minor compared to it can you calculate ?As I have said as the tax shield is considered a minor factor compared to the level of systematic risk in the business, the risk premium, which is approximately 10.4%, is primarily driven by the level of systematic risk.
The tax shield, although relevant, does not have as significant an impact on the cost of equity as the systematic risk does.Thats exactly what I’m asking how is the tax shield minor at 25% compared to systematic risk of only 10.4%?
The tax shield is considered minor compared to the systematic risk of 10.4%.
The tax shield refers to the tax benefits gained from interest payments on debt. While it can have an impact on the overall cost of capital, its effect is relatively small compared to the risk premium associated with systematic risk.
Systematic risk represents the risk that cannot be diversified away and is related to the overall market or economy. In this case, the risk premium of 10.4% reflects the compensation investors require for taking on systematic risk, which is considered more significant than the impact of the tax shield.
While the tax shield, which refers to the tax benefits gained from interest payments on debt, can have an impact on the overall cost of capital, its effect is relatively small compared to the risk premium.
Therefore, when evaluating the “significance” of different factors, the risk premium takes “precedence” over the tax shield.
And this precedence of risk premium over tax shield is always the case? Thankyou.
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