Guys
Plz help me out in a very simple q.
q no 3 pg no 113 of corporate finance
I am getting ans as 14 by using formula re= ro+ (r0-rd) (1-t) d/e
but as per book its 16
formula should be sth different - I think there is an erratum.
I believe formula should be r0 + (r0 - rd(1-T))*d/e
e.re + d.rd (1-T) = ro.(d+e)
e.re = ro.e + (ro - rd(1-T)) .d
dividing by e
re = r0 + (r0 - rd(1-T)).d/e
There is no error. I’m getting 16%. I can’t recognize your setup, but simply use the formula for calculating the WACC.
WACC = [wd * rd * (1 - T)] + [we * re]
0.1 = (0.5 * 0.05 * 0.8) + (0.5 * x)
Solve for x.
yes Aether by using simple set up ans is 16
but why is ans 14 as per m&m formula in book.
Whats the error there
is it possible that we can use this formula only when we are given wacc of all equity firm initially ?
pretty sure the formula has been corrected in the erratum. This is an error that has been showing up from at least the past 3 years - but they never get the chance to update the books.
and as for your question - look at aether’s explanation - pretty sure WACC has been given to you. Without WACC - it does not make sense for Debt to figure in … at all. …
cpk this is ridiculous. They have solved all examples and questions at end with this formula .
and you will end up with the wrong answer - they wrote the formula that way - but solved it correctly. If you put in the numbers you will NOT get the answer they are - same thing you are seeing with the 14% vs. 16% for the above problem. Believe me - I have experienced this when I wrote Level II in 2009/2010 both years, and subsequent years while I have been on the forum too. Wait for the CFAI site to come back up (down now for maintenance) and look at th erratum for Level II - they would have corrected the formula to
re = r0 + (r0 - rd(1-T)).d/e
from
re = r0 + (r0 - rd)(1-T).d/e
yes just checked their site its down. Will check errata as soon it is back.
Man this is pathetic that CFA guys cant correct this error 
Total mood off while attempting this end questions in reading
That also means most questions at end have wrong answers
Guys, this is not an error (confirmed in the November errata as well). The equation you guys are referring to applies to an all equity company. That is, use the r0 equation if a company is going from an all equity structure to a (debt + equity) structure.
The company in question 3 already has debt in its structure.
It’s NOT an error for sure. Try deriving the formula …
yeah … derive it properly please
e.re + d.rd (1-T) = (d+e) r0
and then get re please
cpk i checked the errata its not mentioned there.
Alladin please help. Sooraj ?
report the mismatch that you are seeing and see what they say. I am very certain this formula was an erratum in previous years, and if the same is showing up now - and you are NOT getting the answer they show you with that formula - go ahead and report it. See what they come back with.
Guys, contacting the CFA is not going to help your cause. The material is correct as given. The r0 formula is the cost of equity once you take debt into consideration. Once you find the cost of equity, you still have to apply the regular WACC formula.
Refer to problem 15. Notice how Bema is going from zero debt to issuing debt? That’s where the r0 formula applies.
Problem 3 has nothing to do with the r0 formula.
If you do get in touch with the CFAI, I’d love to find out if the collective wisdom of 1000s of individuals before us wasn’t enough to address this error over the past 3 years (your claim cpk).
Aether i feel you are right. R0 formula is used to find ke when intiallt wacc of all equity firm is given.
Then we will find new ke by applying the formula. Then we will find new WACC
but are you seeing the fact that even when you are using the r0 formula the brackets are messed up…
it should be r0 + (ro-rd(1-T))*d/e instead of
r0 + **(ro-rd)(1-T)**d/e
that is what I am saying is the erratum.
when company has not debt - d = 0 so you get r0 = re – which is fine in the context of things.
but when there is DEBT - the formula is all wrong, gives the wrong answer 14% vs. 16% which it should be.
My erratum only relates to the placing of the brackets in the formula - not anything else.
Look at the two bolded portions in the formulae above…
Hey cpk. I am a big fan of your contributions to this board.
With all due respect however, you are mistaken here:
Please see http://en.wikipedia.org/wiki/Modigliani–Miller_theorem
I thought the curriculum was wrong until I watched the Elan video and the instructor actually derives the relationship. It’s not based on simple math, its based on returns to bondholders and equityholders. I can’t explain it here, but the following formula is the correct one:
r0 + **(ro-rd)(1-T)**d/e
violates the WACC calculation which is E.re + d.rd(1-T) = (d+e)r0.
and r0 = wacc
What you have posted corresponds to modigliani miller II hypotheses - and if you read just below where the formula is put on the wikipedia site - it says so itself: The formula however has implications for the difference with the WACC.
http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital
and we agree - that r0 is the WACC of the company. Here in Corp Finance we are talking about using WACC - if I am not mistaken. If you used the WACC formula and derive the value for re which is pretty simple algebraic manipulation - you will see the formula with the wrong placement of brackets is WRONG. Try it then tell me.
I had myself asked this be put as an erratum in 2010 when I did Level II - it was accepted and was an erratum then.
cpk, same here: resepect the input, so mean no offense.
Based on your last post, I think I know the reasoning behind your claim - you’re thinking r0 = WACC. It’s not.
r0 is cost of capital for an all-equity firm. I think the best way to clarify is for you to revisit the L2 reading on capital structure :). I do think the authors could have done a better job of explaining this material, but it is what it is. To add some clarification (if you decide to revisit the material), the CFAI does use rWACC for representing the weighted avg. cost of capital within the M&M theory.
Here are a few EDU reources that confirm the formula:
http://www.rdboehme.com/MBA_CF/Chap_15.pdf
Proof on page 8: http://www.uh.edu/~ghong/fina6335/ch_15.PDF
Hopefully, this will be enough to clear the air!