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SA5 Chapter 7 Page 3 questions

G

gracege36

Member
Hi all,
I'm reading page 3 of chapter 7, there are some concepts I don't quite understand and I hope someone could please help me out.

As shown in the simple example on page 3, I don't get why:
1)if the debt was due for repayment immediately it would be expected to have market value of 500m?
2)the equity has value greater than zero because the debt is not due for repayment immediately, and by the maturity date the value of the company's assets may be greater than 600m face value of the debt.

If I understand correctly, for 1) it's expected to have market value of 500m because if it doesn't the company is lost to the debtholder, for 2) for the same reason?
 
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1) yes - there are 500m assets, and the debt has the prior claim on all of them.
2) yes - jus as an "out of the money" option does not have zero value, so the equity of this company does not have zero value.

There are various ways to view value in an equity share investment. If the company is a good going concern, and you can see profits and dividends into the future, then the dividend discount model allows a present value approach to valuing the equity investment. In CA1, an alternative for a going concern, would be to look at similar companies and find an appropriate PE ratio. Then use this to multiple with the current earnings to find an appropriate value. But a third would be to get a market value for the assets, deduct the prior claim of the debt, and say that what is left belongs to the equity shareholders. (There are probably other ways too, but these would be the most common). It is the last approach that is being used here, but it doesnt mean that the others are not valid. (However if a company is experiencing hard times, and perhaps has very uncertain profits and dividends, the first two approaches can be very hard to do.)
 
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