FIRST ATTEMPT ASSOCIATE – UYO

ADJUSTED PRESENT VALUE [APV]

1. INTRODUCTION.
i. APV is another method of computing a new cost of equity and a new WACC when
a new project has a different business and financial risk from the current
operations of a company leading to changes in the company’s overall capital
structure.
ii. APV evaluates the project investment side and the financing impact side
separately.
iii. APV has two elements:
- The project investment element: this requires the computation of an NPV as if
the project is an all-equity financed project using an asset beta of the industry
or type of business the investment will be made [computation of the base case
NPV].
- The financing impact: this requires the computation of the present value of the
financing side effects [the present values of issue costs, tax savings on issue
costs and tax reliefs on debt interests].
iv. APV is the sum of the two elements as given below:
APV = Base Case NPV + Financing Impacts
↓ ↓ ↓
Value of a Value of an all – equity Present value of financing
Geared -project. = Financed - project. + Side effects.
v. Benefits of using APV:
- It is the best method of calculating the impact of a new project on the value of
the company and the wealth of its shareholders.
- It does not depend on assumptions about the new WACC of the firm if the
project is undertaken.
- It allows for specific tax relief on funds borrowed to finance the project.
- It does not rely on the assumption that the debt is in perpetuity.
2. The Base Case NPV.
i. This is the investment side of an APV computation that evaluates projects as if
there are being undertaken by all – equity financed companies. It does this by;
- Ignoring the financial risk associated with the methods of financing the
projects.
- Using betas of assets that reflect just the business risks.
ii. Computation procedure.
- Obtain a geared beta for the industry into which the investment is to be made.
- Find the project’s asset beta by converting the geared beta obtained in [1]
above to an asset or ungeared beta for the industry using; Ba = Be
ve
{ }.
Ve+Vd [1−t ]
- Use the asset beta obtained in [2] above in the CAPM formula to compute the
base case discount rate [cost of equity of an ungeared company].
- Obtain the project’s cash flows and discount them at base case discount rate
obtained in [3] above to get the base case NPV.
3. The Financing Impact.
i. This is made up of the present value of the financing packages of issue costs and
tax savings.
ii. The financing cash flows are discounted at either the cost of debt [Kd] or the risk –
free rate [Rf].
iii. Funds to be raised must be grossed up because the finance required is always net
of issue costs.

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Example; if finance to be raised is ₦2,000,000 [net of issue costs] and issue costs
₦ 2,000,000
are 3%, then the amount to be raised is = = ₦2,061,855.67 =
100 %−3 %
₦2,061,856.
3
Issue cost = x ₦2,000,000 = ₦61,856 or 3% x ₦2,061,856 = ₦61,856
100−3
iv. The present value of issue costs is always net of the present value of tax relief. Tax
relief on issue cost = issue cost x corporate tax rate.
v. Issue cost on equity has no tax effects.
vi. The present value of tax relief on interest: this will depends on whether the
debenture is an amortised debt or interest is paid at a fixed amount per annum.
vii. If debenture interest is paid at a fixed amount annually,
- Interest = amount borrowed x interest rate.
- Tax relief = amount borrowed x interest rate x corporate tax rate.
viii. If the debt is an amortised debt where repayment is made up of both interest and
principal elements,
amount of debt
- Find the annual repayment amount. Annual amount =
relevant annuity factor
- Find the annual interest. Annual interest = amount borrowed x interest rate.
ix. APV Presentation format:
₦
Base case NPV Xx
PV of issue costs:
Equity [xx]
Debt [xx]
PV of tax relief:
Issue costs Xx
interests Xx
APV XX
x. Decision rule: If the APV is positive, accept the project.
4. Subsidised /Cheap Loans.
i. If a loan is cheap or subsidised, the interest cost will be lower or saved and the
benefit is reduced because the tax relief will be lower or lost.
ii. Present value of subsidised or cheap loan = PV of interest saved – PV of tax relief
lost.
iii. Example:
A company requires ₦1 million in debt finance for 5 years. It has borrowed
₦700,000 in the form of 10% debentures redeemable in 5 years and the remainder
under a government subsidised loan scheme at 6%. The tax rate is 30% payable
one year in arrears. Calculate pv of tax relief and pv of cheap loan.
Solution:
[a]. PV of tax relief. Normal Loan Cheap Loan
Annual tax relief [total loan x interest rate x tax rate]:
[₦700,000 x .10 x .30] 21,000
[₦300,000 x .06 x .30] ------------- 5,400
Annuity factor for years 2 – 6 at 10% 3.446 3.446
Annual tax relief X Annuity factor 72,366 18,608
[b]. PV of Cheap Loan.
Interest saved Tax relief lost
Annual amount of interest saved: 300,000 x [10% - 6%] 12,000 -----------

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FIRST ATTEMPT ASSOCIATE – UYO

Tax relief lost: {300,000 x [10% -6%] x .30} --------------- [3,600]

Annuity factor for 5 years at 10% 3.791 ------------
Annuity factor for 2 – 6 years at 10% -------- 3.446
45,492 [12,406]
iv. For the above reason, APV presentation format will be adjusted as follows:
₦
Base case NPV Xx
PV of issue Costs:
Equity [xx]
Debt [xx]
PV of tax relief:
Normal loan Xx
Cheap loan Xx
PV of cheap loans:
Interest saved Xx
Tax relief lost [xx]
APV XXX
5. Where Geared Beta for the Industry is not given.
i. If geared beta for the industry into which the investment is to be made is not given
but other data about the proxy are given, an ungeared beta can be computed
using:
a. The M&M cost of equity formula. This is given as;
Vd
Keg = Keu + [Keu – Kd]{ }[1-t]
{Ve
b. The M&M WACC Formula. This is given as;
ve
WACCg = WACCu {1-[ ][t]}
ve +vd
ve vd
WACCg = ke{ } + kd[1-t]{ }
ve +vd ve +vd
6. PV of Growing Annuity.
i. If projects have constant cash flows and come with growth [inflation], the growing
annuity formula can be used to compute the present value of each item of cash
flow.
ii. It is given as;
A 1+ g
PV of growing annuity = {1-[ ]n}
r−g 1+ r

QUESTIONS.
1. ROUNDTOP Plc is a company currently engaged in the manufacturing of baby equipment.
It wishes to diversify into the manufacture of snowboards.
The investment details:
The company’s equity beta is 1.27 and its current debt to equity ratio is 25:75, however
the company’s gearing ratio will change as a result of the new project.
Firms involved in snowboard manufacture have an average equity beta of 1.19 and
average debt equity ratio of 30:70.
Assume that the debt is risk – free, that the risk – free rate is 10% and that the expected
return from the market portfolio is 16%.
The new project will involve the purchase of new machinery for a cost of ₦800,000 [net of
issue costs], which will produce annual cash inflows of ₦450,000 for 3 years. At the end of
this time it will have no scrap value.

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Corporation tax is payable in the same year at a rate of 33%. The machine will attract
writing down allowance of 25% per annum on a reducing balance basis, with a balancing
allowance at the end of the project life when the machine is scrapped.
The financing details:
The new investment will be financed as follows:
Debentures [redeemable in three year’s time] -------------- 40%
Right issue of equity ----------------------------------------------- 60%
The issue costs are 4% on the gross equity issued and 2% on the gross debt issued. Assume
that the debt issue costs are tax deductible.
Required.
Calculate the APV of the project.
2. Bassman Plc is considering diversifying its operations away from its main area of business
[food manufacturing] into the plastics business. It wishes to evaluate an investment
project, which involves the purchase of a moulding machine that costs ₦450,000. The
project is expected to produce net annual operating cash flows of ₦220,000 for each of the
three years of its life. At the end of this time its scrap value will be zero.
The assets of the project can support debt finance of 40% of its initial cost [including issue
costs]. The company is considering borrowing this amount from two different sources.
First, a local government organisation has offered to lend ₦90,000, with no issue costs, at
a subsidised interest rate of 3% per annum. The full ₦90,000 would be repayable after 3
years.
The rest of the debt would be provided by the bank, at Bassman’s normal interest rate.
This bank loan would be repaid in three equal annual instalments.
The balance of finance will be provided by a placing of new equity.
Issue costs will be 5% of funds raised for the equity placing and 2% for the bank loan. Debt
issue costs are allowable for corporation tax.
The plastics industry has an average equity beta of 1.368 and an average debt:equity ratio
of 1:5 at market values. Bassman’s current equity beta is 1.8 and 20% of its long – term
capital is represented by debt which is generally regarded to be risk – free.
The risk –free rate is 10% per annum and the expected return on an average market
portfolio is 15%.
Corporation tax is at a rate of 30%, payable in the same year. The machine will attract a
70% initial capital allowance and the balance is to be written off evenly over the remainder
of the asset life and is allowable against tax. The firm is certain that it will earn sufficient
profits against which to offset these allowances.
Required.
Calculate the APV and determine whether the project is worthwhile.
3. Katam Plc has adopted a strategy of diversification into many different industries in order
to reduce risk for the company’s shareholders. This has resulted in frequent changes in the
company’s gearing level and widely fluctuating risks of individual investments. Presently,
the company has a target debt-to-asset ratio i.e. D/[E+D] of 255, an equity beta of 2.25
and a pre-tax cost of debt of 5%.
On January 1, 2016, Katam Plc with a year end of December 31, is considering the purchase
of a new machine costing ₦750 million, which would enable it to diversify into a new line
of business. The new business will generate sales of ₦522.50 million in the first year,
growing at 4.5% p.a. A constant contribution margin ratio of 40% can be expected
throughout the 15- year life of the project. Incremental fixed cash costs will be ₦84.32
million into the first year growing by 5.4% p.a.
A regional development bank has offered a 10-year loan of 3% interest to finance 40% of
the cost of the machine. The balance of 60% will be financed equally by a 10-year
commercial loan [with annual interest of 5%] and a fresh round of equity.

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FIRST ATTEMPT ASSOCIATE – UYO

The issue cost on the commercial loan will be 1% and the new equity will incur issue cost
of 3%. All issue costs are on the gross amount raised for the respective capital. Issue costs
on debt are allowed to tax purposes.
A firm that is already in the business of the new project has a gearing ratio of 20% [debt to
asset] and cost of equity of 18.1%. Its corporate debt is risk-free.
Tax rate is 30% payable in the year the profit is made. Tax depreciation of 20% on cost is
available on the new machine. Katam Plc has weighted average cost of capital of 14% and
cost of equity of 17.5%. The risk-free rate is 4% and the market risk-premium is 7%.
Required.
a. Estimate the Adjusted Present Value [APV] and advise whether the project should be
accepted. [21 Marks]
b. Explain:
i. The circumstances under which the use of APV is appropriate.
ii. The major advantages and limitations of the use of APV method.[9 Marks].
4. Agbeloba Limited [AL] is an unlisted company based in Akure, Nigeria. Over the years, the
company has been producing and selling agricultural support tools. AL is now considering
the production and sale of yam pounders.
Although this is completely new venture for AL, it will be in addition to the company’s core
business. AL’s directors plan to develop the project for a period of four years and then sell
it for ₦24 million to a group of young investors.
The government is excited about the project and has offered AL a subsidised loan of up to
80% of the investment funds needed at the beginning of the project, at a rate of 200 basis
points below AL’s borrowing rate. Currently AL can borrow at a basis points above the five-
year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of ₦5,000,000, has produced
the following information:
i. The company can buy an existing suitable factory at a cost of ₦16.5 million
payable now.
ii. ₦4.5 million is required now to buy and install the necessary plant and machinery.
iii. The company will produce and sell 1,300 units in the first year. Unit sales will grow
by 40% in each of the next two years before falling to an annual growth rate of 5%
for the final year.
iv. Unit selling price for the first year will be ₦3,750 but this will increase by 3% per
year thereafter.
v. In the first year, total variable cost per unit will be ₦1,800 but this will increase by
8% per year thereafter.
vi. In the first year, the fixed overhead costs will be ₦3.75 million, of which 60% are
centrally allocated overheads. The fixed overheads will increase by 5% per year
after the first year.
vii. AL will require working capital of 15% of the anticipated sales revenue for the
year, at the beginning of each year. The working capital is expected to be released
at the end of the fourth year when the project is sold.
viii. AL’s tax rate is 25% per year on taxable profits. Tax is payable in the same year as
when the profits are earned. Tax allowable depreciation is available on the plant
and machinery on a straight – line basis. It is anticipated that the value
attributable to the plant and machinery after four years is ₦600,000 of the price at
which the project is sold. No tax allowable depreciation is available on the factory.
ix. AL uses 12% as its discount rate for new projects but feels that this rate may not
be appropriate for the new type of investment. It intends to raise the full amount
of funds through debt finance and take advantage of the government’s offer of a
subsidised loan.

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FIRST ATTEMPT ASSOCIATE – UYO

x. Issue costs are 4% of the gross finance required. It can be assumed that the debt
capacity available to the company is equivalent to the actual amount of debt
finance to be raised for the project.
xi. Although no other companies produce yam pounders in the country, Casscare Plc.
[CL] produces cassava crushing machines, using almost similar technology to that
required for yam pounder. CL’s cost of equity is estimated to be 14% and it pays
tax at 28%. CL has 15 million shares in issue, trading at ₦2.53 each and ₦40 million
bonds, trading at ₦94.88 per ₦100; and
xii. The five-year government debt yield is currently estimated at 4.5% and the market
risk premium at 4%.
Required.
a. Evaluate, on financial grounds, whether AL should proceed with the project.
b. Discuss the appropriateness of the evaluation method used and explain the
assumptions made in part [a].

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