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Study notes 39

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.