Practice question 6.6(iii)

[Oscar]

Hi,

I've gone through the practice questions for Chapter 6 in the course notes, and was confused as to the approach taken in part (iii) of question 6.6

In part (i) we are asked to comment on why the analysis is flawed - namely that there is an implicit assumption that the required return on debt and equity is constant when the gearing has changed. In part (iii) the solution then assumes the required return on debt is the same as under the previous capital structure.

Why is this assumption valid for (iii) but not (i)?

Thanks in advance
Oscar

 

[Colin McKee]

Yes - it is mentioned as one of the two problems in part (i). The biggest problem is, however, that the cost of equity is assumed to remain the same, which breaks the M&M theories, and is the core of the question. But you are right that the debt yield is assumed to stay the same when the equity cost is adjusted for later in the question. The reason for this is two-fold: one, there is nothing else in the question to allow a more detailed approach. We have no idea whether the debt could be raised at the same rate or if a slight higher credit margin would be required on the company's debt, so we have no option but to go ahead with the rate we have. And secondly the equity cost will have a much bigger impact as it rises linearly with gearing. So it is good to at least account for this, which we can do easily with M&M formulae. I hope that helps. Similar assumptions have popped up in past questions, both in SA5 and in CT2 in the past, so its probably OK a a question.