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Notes

Paper F2

Financial Management p46

S t u d y

M

ost past F3 questions requiring can-

didates to take the adjusted present

value (APV) approach to investment

appraisal have indicated when it is

called for and I would expect this

trend to continue. But the presence

in a scenario of subsidised borrowing, issue costs

on new nancing or an increase in debt capacity

caused by a project are all signs that APV cal-

culations are likely to be needed. Unfortunately,

many students struggle with questions concern-

ing the weighted-average cost of capital (WACC),

never mind more complex matters such as APV.

The APV method suggests that the investment

appraisal process can be split into two distinct

parts. First, the project should be discounted at a

suitable ungeared cost of equity. The base-case

net present value (NPV) that arises ignores the

benet of tax relief on debt nance and other

nancing aspects. These are calculated separately

as the present value (PV) of the nancing side-

eects. The sum of the base-case NPV and the PV

of the nancing side eects is the APV. This is

then used in the same way as an NPV.

The base-case NPV calculation, which assumes

that only equity nance is used to fund the project,

Paper F3

Strategy

Financial

By William Parrott

Freelance tutor

The adjusted present value method of appraising

investments is not easy to learn, but any question

involving a project thats subject to signicant

nancing issues is likely to require you to use it

In association with

can also be split into two steps. The rst is to cal-

culate a cost of equity for a suitable ungeared com-

pany (keu). If the project carries the same business

risk as that of the company, the rms existing keu

can be used. If the project represents a move into

a new area with a dierent business risk from that

of the rest of the company, a keu can be found using

information from a suitable proxy company thats

already operating in that eld. You could do this

in numerous ways using the tools at your disposal,

some of which I will show in a worked example. In

the exam youll have to decide which to apply

according to the scenario. This is a key skill that

you will hone only by practising questions.

The second step of the base-case NPV calcula-

tion is a normal NPV calculation in which the keu

obtained in the rst step is used as the discount

rate. In the exam this tends to be a fairly straight-

forward process otherwise, the whole question

would be at risk of becoming too big.

When it comes to the nancing side eects cal-

culation, the main side eect is the tax relief on

interest paid, but many factors may be included,

most of which are shown in the following pro forma:

Note $ $

1. Issue costs: 1

Equity (X)

Debt (X)

Tax relief Xi

(X)

2. PV of tax relief on interest paid: 2

Normal-rate loan X

Cheap loan X

3. Cheap loan: 3

PV of interest saved Xi

PV of tax relief lost (X)

X

Total PV of nancing side effects 4 X

Notes

1. Any issue costs on debt and equity should be

accounted for. Debt issue costs are usually tax

The presence

of subsidised

borrowing, issue

costs on new

nancing or an

increase in debt

capacity caused

by a project are

all signs that

APV calculations

are likely

allowable, in which case the tax relief should be cal-

culated. Unless you are told otherwise in the exam,

assume that any debt issue costs are tax allowable

and that any equity issue costs are not.

2. The PV of tax relief on interest paid should be

calculated both for any normal or commercial-

rate loan and for any cheap or subsidised loan that

may be provided by a government or the supplier

of the asset, for instance.

3. If there is a cheap loan, the PV of the interest

saved compared with the normal commercial rate

must be calculated. This benet is then reduced,

because paying a lower rate of interest results in

the loss of some tax relief.

4. In order to determine the PV in all of the calcu-

lations shown in the pro forma, a discount rate is

required. The issue of which discount rate to apply

remains the subject of much discussion and past

exam questions and other practice questions have

involved a number of dierent rates. My advice

would be to use the pre-tax cost of debt unless the

question indicates otherwise, because this best

reects the systematic risk associated with these

cash ows. But do not use the keu, because this

would not be acceptable.

The change in debt capacity caused by a project

is the extra debt finance that a company can

borrow as a result of the project. If the change in

debt capacity diers from the loan actually taken,

the total loan on which tax relief is calculated

should reect the total change in debt capacity,

so the normal-rate loan to be used in the calcula-

tions would be deemed to be the total change in

debt capacity less any cheap loan.

You should assume that the issue costs would

be incurred on the total amount deemed to be the

normal-rate loan. These would be on top of issue

costs associated with any cheap loan. The reason

for this is that a project should be credited with

the benet of the tax relief on debt nance to the

extent that the project allows the company to raise

more debt. For example, where the change in debt

capacity exceeds the total debt actually raised,

the assumption is that the company will soon

utilise any debt capacity that is not immediately

used because of the tax-relief benet it brings. The

project that allows the extra borrowing and ben-

et to arise should be credited with its value.

If a question does not mention the change in

debt capacity caused by a project, you should

assume that the change in debt capacity is the

same as the actual debt raised.

The APV calculation is simply the sum of the

base case NPV and the total PV of the nancing

side eects. This gure is then appraised in the

same way as an NPV: if its positive, the project is

acceptable, because it can be expected to add to

the wealth of the companys shareholders.

Worked example

For the following example to be comprehensive,

it probably covers more ground than any one ques-

tion you are likely to encounter in the exam, but

each of the elements in it could appear.

Matu is a well-diversied risk-seeking plc. It

has a gearing (debt:equity) ratio of 1:3, an equity

beta of 2.25 and a pre-tax cost of debt of 5 per cent.

The company is considering the purchase of a

new machine costing $120m, which would enable

it to diversify into a new line of business. The

machine would have a three-year life, after which

it would have no residual value. The machine

would generate estimated net cash inows of $52m

a year. The supplier of the machine is willing to

lend Matu half of the machines capital cost at a

rate of 3 per cent. The remainder will be nanced

equally by debt and equity. The issue costs on the

commercial debt will be 1 per cent and the equity

issue will incur costs of 3 per cent.

A rm thats already in the trade of the new pro-

ject has a gearing ratio of 1:4 and a cost of equity

of 18.1 per cent. Its corporate debt is risk free.

A government grant of 10 per cent of the initial

capital cost of the machine is available. Matu anti-

cipates that this would be received after one year.

Corporation tax is 30 per cent, payable a year in

arrears. Straight-line depreciation on the net cost

of the machine (after deducting the grant) is tax

allowable. The risk-free rate is 4 per cent and the

market risk premium is 7 per cent.

You are required to estimate the APV of the pro-

posed project.

The rst stage is to calculate a cost of equity for

a suitable ungeared company. Because the project

is a new line of business, we need to use the infor-

mation given for a suitable proxy company. The

following three methods are available to us:

l

Using betas. Because we know the geared cost

of equity for the proxy company only, we need to

use the formula of the capital asset pricing

Study notes 41

Paper F3

Financial Strategy

If the change

in debt capacity

diers from

the loan

actually taken,

the total loan on

which tax relief

is calculated

should reect

the total change

in debt capacity

42

Paper F3

Financial Strategy

model that is, ke = Rf + (Rm Rf), where Rm Rf

is the market risk premium to calculate the

geared beta (g) of the proxy company as follows:

18.1% = 4% + (7% x g)

Using algebra, we nd that g = 2.014.

Next we use the ungear formula and assume that

the corporate debt is risk free (d = 0) to calculate

the geared beta of the proxy company (if a ques-

tion provides a geared beta for the proxy company,

you can jump straight to this part):

u = g (Ve [Ve + Vd {1 t}])

u = 2.014 (4 [4 + 1 {1 0.3}]) = 1.714.

Now we can put this ungeared beta into the cap-

ital asset pricing model formula to calculate a

suitable cost of equity ungeared:

keu = 4% + (7% x 1.714) = 16%.

l

Using the cost of ordinary share capital in a

geared entity formula. Because the geared cost

of equity and all other inputs into the formula are

known, the cost of equity for the ungeared com-

pany can be calculated. The gross cost of debt is

the risk-free rate, as the question states that the

corporate debt of the proxy company is risk free:

keg = keu + (keu kd) (Vd [1 t] Ve)

18.1% = keu + (keu 4%) (1 [1 0.3] 4)

Using algebra, we arrive at keu = 16%.

l

Using the formula for the adjusted cost of cap-

ital: kadj = keu (1 tL), where Kadj is the WACC and

L is the leverage or Vd (Ve + Vd). The WACC for

the proxy company can be calculated as normal:

18.1% x (4 5) + (4% x [1 0.3] x [1 5]) = 15.04%.

Hence 15.04% = keu (1 0.3 [1 {4 + 1}])

Using algebra again, we come to keu = 16%.

You will probably be given only enough infor-

mation in the exam to use one of the above meth-

ods, but youll need to be able to identify which

to use and apply it successfully.

Now that we have an ungeared cost of equity of

16 per cent, the next stage is to calculate the base-

case NPV as follows:

The tax savings are calculated by taking the net

cost of $108m ($120m $12m) and spreading it over

the projects three-year life. This gives an annual

allowable depreciation of $108m 3 = $36m. The

annual tax saving is $36m x 30% = $10.8m. Assum-

ing that Matu bought the asset at the start of a tax

year, the rst saving will be calculated at the end

of year one (T1), but, since tax is paid a year in

arrears, it will become a cash ow a year later (T2).

The fact that a negative base-case NPV has arisen

is not unusual, as the benefit of cheaper debt

nance has been ignored in the calculations so far.

Before starting the side eects calculation, its

worth ensuring that you understand the nanc-

ing package. From the question we can identify:

l

Debt nance from the machine supplier at 3 per

cent a year: $120m x 50% = $60m.

l

Commercial debt nance at 5 per cent a year:

$120m x 25% = $30m.

l

Equity nance: $120m x 25% = $30m.

The commercial debt nance and the equity

nance will both incur issue costs. Because $30m

must be provided from both commercial debt and

equity to buy the machine, we need to gross up to

nd the actual amount that must be raised to pay

the issue costs and then fund the machine.

Because the issue costs on the commercial debt

are 1 per cent, the total raised needs to be $30m x

100 99 = $30.30m. And, because the issue costs

on the equity are 3 per cent, the total raised needs

to be $30m x 100 97 = $30.93m.

Using our pro forma, we obtain the following:

Note $m $m

1. Issue costs: 1

Equity (30.93 x 3%) (0.93)

Debt (30.30 x 1%) (0.30)

Tax relief (0.30 x 30% x 0.952) 2 0.09i

(0.21)

2. PV of tax relief on interest paid:

Normal-rate loan

(30.30 x 5% x 30% x 2.723 x 0.952) 3 1 . 1 8

Cheap loan

(60 x 3% x 30% x 2.723 x 0.952) 1.40

3. Cheap loan:

PV of interest saved (60 x 2% x 2.723) 4 3.27i

PV of tax relief lost

(60 x 2% x 30% x 2.723 x 0.952) (0.93)

2.34

Total PV of nancing side effects 3.78

Study notes

$m T0 T1 T2 T3 T4

Net revenue 52.00 52.00 52.00

Tax @ 30% paid in arrears (15.60) (15.60) (15.60)

Initial investment (120.00)

Grant @ 10% paid after 1 year 12.00

Tax savings XXXXXX XXXX 10.80 10.80 10.80

Net cash ows (120.00) 64.00 47.20 47.20 (4.80)

16% discount factors 1 0.862 0.743 0.641 0.552

Present values (120.00) 55.17 35.07 30.26 (2.65)

Net present value (2.15)

Further reading Andrew Howarth, Financial Strategy, Financial Management, April 2011 (bit.ly/F3APVApril2011).

44 Study notes

Because this result is positive, the project should

be accepted, but its worth noting that the APV is

fairly marginal given the large scale of the invest-

ment under consideration.

The rationale behind APV

The APV approach relies on the Modigliani and

Miller (M&M) theories of capital structure. The

M&M no tax theory states that, as the gearing of

a rm changes, its WACC stays constant. If its gear-

ing rises, its nancial risk rises, as does its cost of

equity. While the rising cost of equity tries to push

the WACC up, the increased proportion of cheaper

debt nance tries to push the WACC down. These

eects are equal and opposite, leaving the WACC

unchanged. The lowest level of gearing is where

the rm has no debt, so the WACC is the same as

the cost of equity at this point: the keu. As the WACC

stays constant, it is the keu at all levels of gearing.

Under the M&M with tax theory, the WACC

falls as gearing rises. This is because the debt is

cheaper than in the no tax theory because of the

tax relief on the interest paid. Under the APV

method, the base-case NPV is calculated using

keu. This is the appropriate WACC if there were no

tax. In the nancing side eects calculation, the

key element is the calculation of the benet of tax

relief on interest paid. This benet, which in the

M&M with tax theory causes the WACC to fall,

is evaluated in absolute terms and added to the

base-case NPV to create the APV. Hence the nal

APV calculated reects the with tax theory. This

explanation should help you to understand why

the actual interest paid on the debt is not included

in the calculations.

The M&M theories take no account of the impact

of nancial distress when gearing is high, so APV

should be applied only at reasonable gearing

levels. Financial distress is caused by real-world

factors that are ignored by the M&M theories

e.g., the increased danger of bankruptcy, extra

agency costs and the risk of tax exhaustion that

may arise when gearing is high. At higher gearing

levels corporate debt is denitely not risk free.

Further problems arise with the M&M theories

failure to account for different investors tax

positions and their assumption that markets are

perfect. Where the capital asset pricing model is

used to derive keu, all of the assumptions and

limitations of that model are relevant, too.

Paper F3

Financial Strategy

The total PV of the nancing side eects is usu-

ally positive, as the biggest element tends to be

the evaluation of the tax benet on debt nance.

Notes

1. The 3 per cent issue costs come to $0.93m. I

hope you can see that, once this is paid out of the

total equity raised, the $30m needed to help fund

the machine purchase remains. The same is true

with the debt issue costs. In some answers you

may see the issue costs calculated simplistically

as 3% x $30m = $0.90m. This is slightly rough and

ready, but makes little dierence.

2. As I suggested earlier, its assumed that debt

issue costs are tax allowable. Tax relief has been

calculated by multiplying the cost by the tax rate.

Its assumed that the issue costs will be incurred

in the year before the project starts and, as a result,

the tax relief will be calculated at T0. But, as tax

is paid a year in arrears, it will not become a cash

ow until T1. Hence the saving has been multi-

plied by the one-year discount factor at 5 per cent

(pre-tax debt cost).

3. The annual tax relief on the commercial-rate

loan is calculated by multiplying the total amount

borrowed by the interest charge and the tax rate.

Assuming that the loan period will match the pro-

ject period, this tax relief will be received for three

years. But, while the interest will be paid from

year one, the tax relief will not be received until

T2, as tax is paid a year in arrears. Hence the annual

tax relief is a three-year annuity starting at T2.

In order to calculate its present value we multiply

it by the three-year annuity factor at 5 per cent

and the one-year discount factor at 5 per cent. The

present value of the tax relief on the cheap loan

is calculated the same way.

4. The annual interest saved on the cheap loan is

calculated by multiplying the amount of the debt

by the 2 per cent interest saving compared with

the commercial interest rate (5 per cent 3 per

cent). In order to calculate the present value of

this annual saving we multiply it by the three-year

annuity factor, as the rst interest saving will arise

at T1. The present value of the tax relief lost on the

interest saved is worked out as for the other cal-

culations concerning tax relief on interest.

The APV is the sum of the base-case NPV and

the PV of the nancing side eects, so the nal

APV in this example is $3.78m $2.15m = $1.63m.

The M&M

theories take

no account

of nancial

distress when

gearing is high,

so APV should

be applied only

at reasonable

gearing levels

Further reading CIMA Ocial Study Text Financial Strategy (2012-13 edition), Kaplan Publishing, 2012.

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