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Sep 2009 (UK) Q10

Discussion in 'CT2' started by tess, Sep 10, 2018.

  1. tess

    tess Member

    This question is about a company with losses for tax purposes; nominal value is $10m and market value of loan stock is $7m.

    The answer says the company's cost of debt is more than the rate at which it pays interest (8%) without any adjustment for tax.

    I'm struggling to find the section in the CMP that would explain how to do Q10. Is it because:
    - losses for tax purposes affect the tax deductibility of the loan stock (I thought not...?), or
    - market value of loan stock is less than nominal value

    Guidance would be appreciated, thank you!
     
    tess, Sep 10, 2018
    #1
  2. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Hi tess

    For what it's worth, I think this is a tough multiple choice question. Chapter 15, Section 3 (Cost of debt) is the relevant reference.

    The fact that the current Market Value < Book Value indicates that the current cost of debt to the company is more than 8%pa (ie it would have to offer a coupn higher than 8% if it issued the debt today).
    If a company is making profits (ie the usual assumption!?), the cost of debt can be offset against those profits, so we make an adjustment for tax to reduce the effective cost of debt. However, in this question, we're told the company will be loss-making throughout the term of the loan stock, so we don't make this tax adjustment.

    Best wishes
    Lynn
     
    Lynn Birchall, Sep 10, 2018
    #2

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