Revision 1 Advanced Investment Appraisal
Chapter 4 WACC and APV
[pic]
1. Cost of Equity
1.1 Dividend valuation model
1.1.1 If the future dividend per share is expected to be constant in amount, then the cost of equity will be calculated by the following formula:
[pic]
[pic] is the cost of equity capital
[pic] is the annual dividend per share, starting at year 1 and then continuing annually in perpetuity.
[pic] is the ex-dividend share price
1.1.2 If the future dividend per share is expected to grow constantly, the cost of equity can be calculated as follows (dividend growth model):
[pic] or [pic]
1.1.3 Weaknesses of the dividend growth model
(a) The model does not incorporate risk
(b) Future dividend growth rate is not constant in perpetuity
(c) Estimating the future dividend growth rate is also difficult – historical dividend trends cannot predict the future growth rate accurately
(d) The model assumes that business risk are constant in future periods – the business operations and the economic environment are subject to constant change
1.2 Estimating the growth rate
1.2.1 By simple average – find the dividend growth rate each year and then take the average.
1.2.2 By geometric growth method – similar to the compounding method.
Newest dividend = Oldest dividend × (1 + g)n
1.2.3 By earnings retention model (Gordon’s growth model) – using the following formula:
g = bre
Where re = accounting rate of return or ROCE or ROI
b = earnings retention rate
1.3 The capital asset pricing model (CAPM)
1.3.1 The CAPM can be used to calculate a cost of equity and incorporates risk.
1.3.2 It is based on a comparison of the systematic risk of individual investments with the risks of all shares in the market.
1.3.3 Systematic risk (market risk):
➢ is the risk of market wide factors such as the state of economy
➢ affect all companies in the same way, and it cannot be diversified away
1.3.4 Non-systematic risk (unsystematic risk or business risk or unique risk):
➢ is the risk factors that will impact each firm differently
➢ good diversification can almost eliminate unsystematic risk
[pic]
1.3.5 Systematic risk is measured using beta factors.
1.3.6 Beta factor is the measure of the systematic risk of a security relative to the market portfolio (e.g. Heng Seng Index).
1.3.7 Beta = 1, a 1% change in the market index return generally leads to a 1% change in the return on a specific share.
0 < Beta < 1, a 1% change in the market index return generally leads to a less than a 1% change in the returns on a specific share.
Beta > 1, a 1% change in the market index return generally leads to a greater than 1% on a specific company’s share.
1.3.8 The CAPM formula:
(Rj) = Rf + β(Rm - Rf)
Where:
Rj is the cost of equity capital
Rf is the risk-free rate return
Rm is the return from the market as a whole
β is the beta factor of the individual security
1.3.9 Assumptions of CAPM
➢ Well-diversified investors
➢ Perfect capital market
➢ Unrestricted borrowing or lending at the risk-free rate of interest
➢ Uniformity of investor expectations
➢ All forecasts are made in the context of one time period only
1.3.10 Problems of CAPM
➢ Diversification
◆ Under the CAPM, the return required from a security is related to its systematic risk rather than its total risk
◆ The assumption is that investors can diversify all or most of the unsystematic risk, but, in practice, markets are not totally efficient and investors do not all hold fully diversified portfolios
➢ Excess return – expected return is difficult to determine because it is just predicted from historical data
➢ Risk-free rate – it is not easy to determine again because interest rates vary all the time
➢ Risk aversion – shareholders are risk averse, and so demand higher returns in compensation for increased level of risk
➢ Beta factors – it based on historical data and it may be a poor basis for future decision making
➢ Usual circumstances – e.g. the seasonal ‘month-of-the-year’ effects and ‘day-of-the-week’ effects that appear to influence returns on shares
1.4 Comparison between DVM and CAPM
1.4.1 DVM:
➢ Estimate the future dividend and growth rate are very difficult
➢ Assume the business risk, and hence business operations and the cost of equity, are constant in future periods
➢ Do not consider risk – it should be noted that share price fall as risk increases, indicating that increasing risk will lead to an increasing cost of equity
1.4.2 CAPM
➢ Consider the company’s level of systematic risk
➢ Give rise to a much smaller degree of uncertainty than the future dividend growth in the DVM
2. Cost of Debt
2.1 The formulae of the cost of debt for the various types of debt are as follows:
|Type of debt |Cost of debt |
|Irredeemable debt without tax |[pic] |
|Irredeemable debt with tax |[pic] |
|Redeemable debt |Same as IRR |
|Non-trade debt (bank loan) |Interest rate × (1 – T) |
|Preference shares |[pic] |
3. The Weighted Average Cost of Capital (WACC)
3.1 Weighted average cost of capital is the average cost of the company’s finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of capital.
3.2 A general formula for the WACC is as follows:
[pic]
Where ke = the cost of equity
kd = the cost of debt
Ve = the market value of equity in the firm
Vd = the market value of debt in the firm
3.3 Wherever possible market value should be used because book values based on historical costs and their use will seriously understate the impact of the cost of equity finance. If the WACC is underestimated, unprofitable projects will be accepted.
3.4 When is suitable for using in investment appraisal?
➢ When the risk of the investment project is similar to the current risks of the investing company
➢ From the point of view of business risk:
◆ Similar to the business risk of existing operations
◆ If not, a project specific discount rate should be considered
◆ CAPM should be applied under this situation
➢ From the point of view of financial risk;
◆ Similar to the financial risk of existing operations
◆ If not, adjusted present value (APV) or the CAPM-derived project specific cost of capital can be adjusted to reflect the financial risk of the project
➢ Other factors to consider
◆ Project size should not have been significant when compared with the size of the company.
➢ If the above factors are not similar, WACC should not be applied.
4. CAPM and Portfolios
(Jun 08, Jun 12, Dec 12, Dec 15)
4.1 The beta factor of an investor’s portfolio is the weighted average of the beta factors of the securities in the portfolio.
4.2 Practical implications of CAPM for an investor are as follows:
(a) Investor should decide what beta factor he would like to have
(b) Low beta factors in bear market and sell shares with high beta factors
(c) High beta factors in bull market
5. Project Specific Cost of Capital
(Jun 08, Dec 08, Dec 09, Dec 11, Dec 12, Pilot 13, Jun 14, Dec 14, Dec 15)
5.1 When an investment has differing business and financial risks from existing business, project specific discount rate should be used.
5.2 A discount rate should be calculated which is specific to the project, and which takes account of both the project’s systematic risk and the company’s gearing level. The discount rate can be found using the CAPM.
Step 1 Get an estimate of the systematic risk characteristics of the project’s operating cash flows by obtaining published beta values for companies in the industry into which the company is planning to diversify.
Step 2 Adjust these beta values to allow for the company’s capital gearing level. This adjustment is done in two stages.
(a) Convert the beta values of other companies in the industry to ungeared betas, using the formula:
|[pic] |
[pic] is the asset or ungeared beta
[pic] is the equity or geared beta
[pic] is the beta factor of debt in the geared company
[pic] is the market value of the debt capital in the geared company
[pic] is the market value of the equity capital in the geared company
T is the rate of corporate tax
(b) Having obtained an ungeared beta value [pic], convert it back to geared beta [pic], which reflects the company’s own gearing ratio, using the formula:
[pic]
Step 3 Having estimated a project-specific geared beta, use the CAPM to estimate:
(a) A project-specific cost of equity, and
(b) A project-specific cost of capital, based on a weighting of this cost of equity and the cost of the company’s debt capital.
5.3 Weaknesses in the formula:
(a) It is difficult to identify other firms with identical operating characteristics.
(b) Estimates of beta values from share price information are not wholly accurate. They are based on statistical analysis of historical data, and as the previous example shows, estimates using one firm’s data will differ from estimates using another firm’s data.
(c) There may be differences in beta values between firms caused by:
(i) Different cost structures (e,g, the ratio of fixed costs to variable costs)
(ii) Size differences between firms
(iii) Debt capital not being risk-free
(d) If the firm for which an equity beta is being estimated has opportunities for growth that are recognized by investors, and which will affect its equity beta, estimates of the equity beta based on other firm’s data will be inaccurate, because the opportunities for growth will not be allowed for.
6. Traditional View of Capital Structure and its Assumption
6.1 Tradition view of capital structure
6.1.1 The rate of return required by each source of finance depends on its risk from an investor point of view, with equity being seen as the most risky and debt seen as the least risky.
6.1.2 WACC would therefore be expected to decrease as equity is replaced by debt, since debt is cheaper than equity.
6.1.3 As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing.
6.1.4 Ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up.
6.1.5 As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value, at which point its market value will be maximized.
6.1.6 Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at high level of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt.
[pic]
6.1.7 Company should gear up until it reaches optimal point and then raise a mix of finance to maintain this level of gearing. However, there is no method, apart from trial and error, available to locate the optimal point.
6.2 Assumptions of tradition view
6.2.1 Assumptions:
➢ The company pays out all its earnings as dividends.
➢ The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no transaction costs for issues.
➢ The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings.
➢ Business risk is also constant, regardless of how the company invests its funds.
➢ Taxation, for the timing being, is ignored.
7. M&M (1958) View of WACC
7.1 In their 1958 theory, M&M demonstrated that the WACC remained constant as a company geared up.
7.2 The assumptions are that:
➢ A perfect capital market exists, in which investors have the same information, upon which they act rationally, to arrive at the same expectations about future earnings and risk.
➢ There are no tax or transactions costs.
➢ Debt is risk-free and freely available at the same cost to investors and companies alike.
7.3 They claimed that the increase in the cost of equity due to financial risk exactly offset by the decrease in the WACC caused by the lower before-tax cost of debt.
7.4 Since in a perfect capital market, the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing levels and the market value of the company is also constant.
7.5 Therefore, the market value of a company depends on its business risk alone, and not on its financial risk.
7.6 WACC cannot reduce to a minimum.
[pic]
8. M&M (1963) with Tax
8.1 When corporate tax was admitted into the analysis of M&M, the interest payments on debt reduced tax liability, which means that the WACC fell as gearing increased, due to the tax shield given to profits.
8.2 Therefore, a company can reduce its WACC to a minimum by taking on as much debt as possible.
[pic]
8.4 However, this does not happen in practice due to existence of other market imperfections (市場的不完善) which undermine the tax advantages of debt finance.
8.5 The principles of the M&M theory with tax gave rise to the following formula for cost of equity.
(Dec 10, Jun 13)
|[pic] |
| |
|Where: |
|ke = the cost of equity in a geared company |
|[pic] = the cost of equity in an ungeared company |
|Vd, Ve are the market values of debt and equity respectively |
|kd = the cost of debt pre-tax |
9. Alternative Theories of Capital Structure
9.1 Static trade-off theory
9.1.1 Static trade-off theory states that firms in a static position will seek to achieve a target level of gearing by adjusting their current gearing levels.
9.1.2 We know that a firm enjoys an increase in tax savings with an increase in debt financing due to the tax deductibility of interest. However, an increase in debt financing will also result in an increase in the chances of the firm going bankrupt because of its increased commitment in interest payments. This is the effect of financial leverage.
9.1.3 Failure to meet those interest payments because of inadequate cash on hand will cause the firm some financial distress, and the ultimate form of financial distress is bankruptcy.
|9.1.4 |KEY POINTS |
| |(a) An optimum capital structure exists where the additional costs of liquidation costs balances the additional benefit |
| |from interest tax shield. |
| |(b) Firm value varies with debt level when there is financial distress cost. It is indicated by upward movement of the |
| |line due to gain from tax shield and then downward movement due to increasing financial distress costs. |
| |(c) There exists a certain combination of debt and equity financing that will enable a firm to minimize its cost of |
| |capital and to maximize its value. |
[pic]
9.2 Pecking order theory
9.2.1 Pecking order theory has been developed as an alternative to traditional theory. It states that firms will prefer retained earnings to any other source of finance, and then will choose debt, and last of all equity. The order of preference will be:
|Financing instruments |Explanation |
|Retained earnings |Already have the funds |
| |Do not have to spend any time persuading outside investors of the merits of the |
| |project |
| |No issue costs |
| |To avoid any unwanted signals, managers will try to finance as much as possible |
| |through internal funds |
|Debt |The degree of questioning and publicity associated with debt is usually |
| |significantly less than that associated with a share issue. |
| |Moderate issue costs |
| |Secured debt (which is less risky) should be issued first, followed by unsecured |
| |(risky) debt |
|Convertible debt |Hybrid of debt and equity |
|Preference shares |Hybrid of debt and equity |
|Equity shares |Perception by stock markets that it is a possible sign of problems. Extensive |
| |questioning and publicity associated with a share issue |
| |Expensive issue costs |
10. The Adjusted Present Value (APV) Technique
(Jun 08, Dec 10, Dec 11, Jun 13, Jun 14)
10.1 Basic principle
10.1.1 The APV method evaluates the project and the impact of financing separately. Hence, it can be used if a new project has a different financial risk (debt-equity ratio) from the company, i.e. the overall capital structure of the company changes.
|10.1.2 |Carrying out an APV calculation |
| |APV consists of two different elements: |
| | |
| |APV |
| |= |
| |Base case NPV |
| |+ |
| |Financing impact |
| | |
| |Value of a geared project |
| |= |
| |Value of an all equity financed project |
| |+ |
| |PV of financing side effects |
| | |
10.2 The investment element (Base case NPV)
10.2.1 The project is evaluated as though it were being undertaken by an all equity company with all financing side effects ignored. The financial risk is quantified later in the second part of the APV analysis. Therefore:
(a) Ignore the financial risk in the investment decision process.
(b) Use a beta that reflects just the business risk, i.e. beta asset.
10.3 The financing impact
10.3.1 Once the base case NPV is identified, the PV of the financing package is evaluated.
10.3.2 Financing cash flows consist of:
(a) issue costs
(b) tax reliefs
(c) Subsidised/cheap loan
10.3.3 As all financing cash flows are low risk, they are discounted at either:
(a) the cost of debt (kd) or
(b) the risk free rate
10.3.4 General format of the “financing part” of APV calculation:
|Base case NPV |X/(X) |
|PV of issue costs: | |
|Equity |(X) |
|Debt |(X) |
|PV of the tax shield: | |
|Normal loan |X |
|Cheap loan |X |
|PV of the cheap loan: | |
|Interest saved |X |
|Tax relief lost |(X) |
|Adjusted present value |X/(X) |
Question 1 – APV and Islamic finance
The managers of Strayer Inc are investigating a potential $25 million investment. The investment would be a diversification away from existing mainstream activities and into the printing industry. $6 million of the investment would be financed by internal funds, $10 million by a rights issue and $9 million by long-term loans. The investment is expected to generate pre-tax net cash flows of approximately $5 million per year, for a period of ten years. The residual value at the end of Year 10 is forecast to be $5 million after tax. As the investment is in an area that the government wishes to develop, a subsidised loan of $4 million out of the total $9 million is available. This will cost 2% below the company’s normal cost of long-term debt finance, which is 8%.
Strayer’s equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by market value. The average equity beta in the printing industry is 1.2, and average gearing 50% equity, 50% debt by market value. The risk-free rate is 5.5% per annum and the market return 12% per annum. Issue costs are estimated to be 1% for debt financing (excluding the subsidised loan), and 4% for equity financing. These costs are not tax allowable.
The corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed investment.
(12 marks)
(b) Explain the difference between APV and NPV as methods of investment appraisal and comment upon the circumstances under which APV might be a better method of evaluating a capital investment than NPV. (5 marks)
(c) Explain the major differences between Islamic finance and other conventional forms of finance such as those being considered by Strayer. Identify, and briefly discuss, two Islamic financial instruments that could be of use to Strayer in the above situation. (8 marks)
(Total: 25 marks)
(Amended ACCA 3.5 Strategic Financial Management June 2002)
Question 2 – APV and ethical issues
The financial management team of Tampem Inc is discussing how the company should appraise new investments. There is a difference of opinion between two managers.
Manager A believes that a net present value should be calculated using a suitable WACC as a discount rate. Manager A believes that positive NPV investments are quickly reflected in increases in the company’s share price.
Manager B states that NPV is not good enough, as it is only valid in potentially restrictive conditions, and should be replaced by APV (adjusted present value).
Tampem has produced estimates of relevant cash flows and other financial information associated with a new investment. These are shown below:
|Year |1 |2 |3 |4 |
| |$000 |$000 |$000 |$000 |
|Investment pre-tax operating cash flows |1,250 |1,400 |1,600 |1,800 |
Notes:
1. The investment will cost $5,400,000 payable immediately, including $600,000 for working capital and $400,000 for issue costs. $300,000 of issue costs is for equity, and $100,000 for debt. Issue costs are not tax allowable.
2. The investment will be financed 50% equity, 50% debt, which is believed to reflect its debt capacity.
3. Expected company gearing after the investment will change to 60% equity, 40% debt by market values.
4. The investment equity beta is 1.5.
5. Debt finance for the investment will be an 8% fixed-rate debenture.
6. Capital allowances are at 25% per year on a reducing-balance basis.
7. The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises.
8. The risk-free rate is 4% and the market return 10%.
9. The after-tax realisable value of the investment as a continuing operation is estimated to be $1.5 million (including working capital) at the end of Year 4.
10. Working capital may be assumed to be constant during the four years.
Required:
(a) Calculate the expected NPV and APV of the proposed investment. (10 marks)
(b) Discuss briefly the validity of the views of the two managers. Use your calculations in (a) to illustrate and support the discussion. (5 marks)
(c) Provide examples of ethical issues that might affect capital investment decisions, and discuss the importance of such issues for strategic financial management.
(10 marks)
(Total: 25 marks)
(Amended ACCA 3.7 Strategic Financial Management December 2006 Q3)
Question 3 – APV
Fubuki Co, an unlisted company based in Megaera, has been manufacturing electrical parts used in mobility vehicles for people with disabilities and the elderly, for many years. These parts are exported to various manufacturers worldwide but at present there are no local manufacturers of mobility vehicles in Megaera. Retailers in Megaera normally import mobility vehicles and sell them at an average price of $4,000 each. Fubuki Co wants to manufacture mobility vehicles locally and believes that it can sell vehicles of equivalent quality locally at a discount of 37·5% to the current average retail price.
Although this is a completely new venture for Fubuki Co, it will be in addition to the company’s core business. Fubuki Co’s directors expect to develop the project for a period of four years and then sell it for $16 million to a private equity firm. Megaera’s government has been positive about the venture and has offered Fubuki Co a subsidised loan of up to 80% of the investment funds required, at a rate of 200 basis points below Fubuki Co’s borrowing rate. Currently Fubuki Co can borrow at 300 basis points above the five-year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of $250,000, has produced the following information.
1. Initial cost of acquiring suitable premises will be $11 million, and plant and machinery used in the manufacture will cost $3 million. Acquiring the premises and installing the machinery is a quick process and manufacturing can commence almost immediately.
2. It is expected that in the first year 1,300 units will be manufactured and sold. 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. After the first year the selling price per unit is expected to increase by 3% per year.
3. In the first year, it is estimated that the total direct material, labour and variable overheads costs will be $1,200 per unit produced. After the first year, the direct costs are expected to increase by an annual inflation rate of 8%.
4. Annual fixed overhead costs would be $2·5 million of which 60% are centrally allocated overheads. The fixed overhead costs will increase by 5% per year after the first year.
5. Fubuki Co will need to make working capital available 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.
Fubuki Co’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 $400,000 of the price at which the project is sold. No tax allowable depreciation is available on the premises.
Fubuki Co uses 8% as its discount rate for new projects but feels that this rate may not be appropriate for this 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. 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 raised for the project.
Although no other companies produce mobility vehicles in Megaera, Haizum Co, a listed company, produces electrical-powered vehicles using similar technology to that required for the mobility vehicles. Haizum Co’s cost of equity is estimated to be 14% and it pays tax at 28%. Haizum Co has 15 million shares in issue trading at $2·53 each and $40 million bonds trading at $94·88 per $100. 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 Fubuki Co should proceed with the project. (17 marks)
(b) Discuss the appropriateness of the evaluation method used and explain any assumptions made in part (a) above. (8 marks)
(Total 25 marks)
(ACCA P4 Advanced Financial Management December 2010 Q2)
Question 4 – APV and MIRR
Neptune is a listed company in the telecommunications business. You are a senior financial management advisor employed by the company to review its capital investment appraisal procedures and to provide advice on the acceptability of a significant new capital project – the Galileo.
The project is a domestic project entailing immediate capital expenditure of $800 million at 1 July 2008 and with projected revenues over five years as follows:
| |30 June 2009 |30 June 2010 |30 June 2011 |30 June 2012 |30 June 2013 |
|Year ended | | | | | |
|Revenue ($ million) |680.00 |900.00 |900.00 |750.00 |320.00 |
Direct costs are 60% of revenues and indirect, activity based costs are $140 million for the first year of operations, growing at 5% per annum over the life of the project. In the first two years of operations, acceptance of this project will mean that other work making a net contribution before indirect costs of $150 million for each of the first two years will not be able to proceed. The capital expenditure of $800 million is to be paid immediately and the equipment will have a residual value after five years’ operation of $40 million. The company depreciates plant and equipment on a straight-line basis and, in this case, the annual charge will be allocated to the project as a further indirect charge. Preconstruction design and contracting costs incurred over the previous three years total $50 million and will be charged to the project in the first year of operation.
The company pays tax at 30% on its taxable profits and can claim a 50% first year allowance on qualifying capital expenditure followed by a writing down allowance of 40% applied on a reducing balance basis. Given the timing of the company’s tax payments, tax credits and charges will be paid or received twelve months after they arise. The company has sufficient other profits to absorb any capital allowances derived from this project.
The company currently has $7,500 million of equity and $2,500 million of debt in issue quoted at current market values. The current cost of its debt finance is $LIBOR plus 180 basis points. $LIBOR is currently 5·40%, which is 40 basis points above the one month Treasury bill rate. The equity risk premium is 3·5% and the company’s beta is 1·40. The company wishes to raise the additional finance for this project by a new bond issue. Its advisors do not believe that this will alter the company’s bond rating. The new issue will incur transaction costs of 2% of the issue value at the date of issue.
Required:
(a) Estimate the adjusted present value of the project resulting from the new investment and from the refinancing proposal and justify the use of this technique.
(14 marks)
(b) Estimate the modified internal rate of return generated by the project cash flows, excluding the effects of refinancing. (6 marks)
(c) Briefly discuss the advantages and disadvantages of using MIRR to evaluate the project. (5 marks)
(Total 25 marks)
(Amended P4 Advanced Financial Management June 2008 Q5)
Question 5 – APV
You have recently commenced working for Burung Co and are reviewing a four-year project which the company is considering for investment. The project is in a business activity which is very different from Burung Co’s current line of business.
The following net present value estimate has been made for the project:
All figures are in $ million
|Year |0 |1 |2 |3 |4 |
|Sales revenue | |23.03 |36.60 |49.07 |27.14 |
|Direct project costs | |(13.82) |(21.96) |(29.44) |(16.28) |
|Interest | |(1.20) |(1.20) |(1.20) |(1.20) |
|Profit | |8.01 |13.44 |18.43 |9.66 |
|Tax (20%) | |(1.60) |(2.69) |(3.69) |(1.93) |
|Investment/sale |(38.00) | | | |4.00 |
|Cash flows |(38.00) |6.41 |10.75 |14.74 |11.73 |
|Discount factors (7%) |1.000 |0.935 |0.873 |0.816 |0.763 |
|Present values |(38.00) |5.99 |9.38 |12.03 |8.95 |
Net present value is negative $1·65 million, and therefore the recommendation is that the project should not be accepted.
In calculating the net present value of the project, the following notes were made:
(i) Since the real cost of capital is used to discount cash flows, neither the sales revenue nor the direct project costs have been inflated. It is estimated that the inflation rate applicable to sales revenue is 8% per year and to the direct project costs is 4% per year.
(ii) The project will require an initial investment of $38 million. Of this, $16 million relates to plant and machinery, which is expected to be sold for $4 million when the project ceases, after taking any taxation and inflation impact into account.
(iii) Tax allowable depreciation is available on the plant and machinery at 50% in the first year, followed by 25% per year thereafter on a reducing balance basis. A balancing adjustment is available in the year the plant and machinery is sold. Burung Co pays 20% tax on its annual taxable profits. No tax allowable depreciation is available on the remaining investment assets and they will have a nil value at the end of the project.
(iv) Burung Co uses either a nominal cost of capital of 11% or a real cost of capital of 7% to discount all projects, given that the rate of inflation has been stable at 4% for a number of years.
(v) Interest is based on Burung Co’s normal borrowing rate of 150 basis points over the 10-year government yield rate.
(vi) At the beginning of each year, Burung Co will need to provide working capital of 20% of the anticipated sales revenue for the year. Any remaining working capital will be released at the end of the project.
(vii) Working capital and depreciation have not been taken into account in the net present value calculation above, since depreciation is not a cash flow and all the working capital is returned at the end of the project.
It is anticipated that the project will be financed entirely by debt, 60% of which will be obtained from a subsidized loan scheme run by the government, which lends money at a rate of 100 basis points below the 10-year government debt yield rate of 2·5%. Issue costs related to raising the finance are 2% of the gross finance required. The remaining 40% will be funded from Burung Co’s normal borrowing sources. It can be assumed that the debt capacity available to Burung Co is equal to the actual amount of debt finance raised for the project.
Burung Co has identified a company, Lintu Co, which operates in the same line of business as that of the project it is considering. Lintu Co is financed by 40 million shares trading at $3·20 each and $34 million debt trading at $94 per $100. Lintu Co’s equity beta is estimated at 1·5. The current yield on government treasury bills is 2% and it is estimated that the market risk premium is 8%. Lintu Co pays tax at an annual rate of 20%.
Both Burung Co and Lintu Co pay tax in the same year as when profits are earned.
Required:
(a) Calculate the adjusted present value (APV) for the project, correcting any errors made in the net present value estimate above, and conclude whether the project should be accepted or not. Show all relevant calculations. (15 marks)
(b) Comment on the corrections made to the original net present value estimate and explain the APV approach taken in part (a), including any assumptions made.
(10 marks)
(Total 25 marks)
(ACCA P4 Advanced Financial Management June 2014 Q2)
Question 6 – WACC
Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities and the remaining funds would be retained for future investments.
The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the company’s risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal.
Coeden Co financial information
Extract from the most recent statement of financial position
| |$000 |
|Non-current assets (re-valued recently) |42,560 |
|Current assets |26,840 |
|Total assets |69,400 |
| | |
|Share capital (25c per share par value) |3,250 |
|Reserves |21,780 |
|Non-current liabilities (5.2% redeemable bonds) |42,000 |
|Current liabilities |2,370 |
|Total capital and liabilities |69,400 |
Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co.
The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that Coeden Co’s current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%.
Other Information
Coeden Co’s current equity beta is 1.1 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4% and the market risk premium is estimated to be 6%.
There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 0.4. It has been estimated that the hotel services business accounts for approximately 60% of the current value of Coeden Co and the property company business accounts for the remaining 40%.
Coeden Co’s corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest.
Required:
(a) Calculate, and comment on, Coeden Co’s cost of equity and weighted average cost of capital before and after implementing the proposal. Briefly explain any assumptions made. (20 marks)
(b) Discuss the validity of the assumption that the market value of equity will remain unchanged after the implementation of the proposal. (5 marks)
(Total = 25 marks)
(Amended ACCA P4 Advanced Financial Management December 2012 Q1)
Chapter 5 Valuation and the Use of Free Cash Flows
1. Yield Curve and Bond Price
(Dec 11)
1.1 In all your previous learning, the risk free rate has been given as a single figure, based on the return required on government bonds.
1.2 However, in reality the return required will usually be higher for longer dated government bonds, to compensate investors for the additional uncertainty created by the longer time period.
1.3 Therefore, you might be given a “spot yield curve” for government bonds, instead of a “single risk free rate”. Then to calculate the yield curve for an individual company’s bonds, add the given credit spread to the relevant government bond yield.
2. Free Cash Flow
(Dec 08, Jun 09, Dec 10, Jun 11, Dec 11, Jun 12, Dec 12, Jun 13, Dec 13)
2.1 Definition of free cash flow
2.1.1 The idea is to provide a measure of what is available to the owners of a firm, after providing for capital expenditures to maintain existing assets and to create new assets for future growth and is measured as follows:
|Free cash flow = |EBIT |
| |– Tax on EBIT |
| |+ Non cash charges (e.g. depreciation) |
| |– Capital expenditure |
| |– Net working capital increases |
| |+ Net working capital decreases |
| |+ Salvage value received |
2.2 Free cash flow to equity
2.2.1 The free cash flow derived in the previous section is the amount of money that is available for distribution to the capital contributors. If the project is financed by equity only, then these funds could be potentially distributed to the shareholders of the company.
2.2.2 However, if the company is financing the project by issuing debt, then the shareholders are entitled to the residual cash flow left over after meeting interest and principal payments. This residual cash flow is called free cash to equity (FCFE).
2.2.3 Free cash flow to equity can be measured as follows – direct method:
|Free cash flow to equity = |Net income (EBIT – net interest – tax paid) |
| |+ Depreciation |
| |– Total net investment (change in capital investment + change in working |
| |capital) |
| |± Net debt issued (new borrowings less any repayment |
2.2.4 Using the indirect method, FCFE is calculated as follows:
|Free cash flow to equity = |Free cash flow (using formula in section 2.1.1 above) |
| |– (net interest + net debt paid) |
| |+ Tax benefit from debt (net interest × tax rate) |
2.2.5 Combined approach (direct and indirect), FCFE is calculated as follows:
|Free cash flow to equity = |Net income (EBIT – net interest – tax paid), (i.e. Profit after tax) |
| |+ Depreciation |
| |– Capital expenditure |
| |± change in working capital |
| |± Net debt issued/paid (new borrowings less any repayment) |
| |± Net share issued/repurchased |
3. Valuation of Equity
3.1 Asset-based valuations
3.1.1 Choice of valuation bases – the difficulty in an asset valuation method is establishing the asset values to use. Values ought to be realistic. The figure attached to an individual asset may vary considerably depending on whether it is valued on a going concern or a break-up basis.
(a) Historic basis – unlikely to give a realistic value as it is dependent upon the business’s depreciation and amortization policy.
(b) Replacement basis – if the assets are to be used on an on-going basis.
(c) Realisable basis – if the assets are to be sold, or the business as a whole broken up. This won’t be relevant if a minority shareholder is selling his stake, as the assets will continue in the business’s use.
3.2 Income/earnings based methods
3.2.1 Price earnings (P/E) ratio method
P/E = Market price per share ÷ EPS
3.2.2 Earning yield method
|Earnings yield = |EPS |× 100% |
| |Market price per share | |
3.3 Dividend valuation model (DVM)
3.3.1 The dividend valuation model is based on the theory that an equilibrium price for any share on a stock market is:
(a) The future expected stream of income from the security.
(b) Discounted at a suitable cost of capital.
3.3.2 Equilibrium market price is thus a present value of a future expected income stream. The annual income stream for a share is the expected dividend every year in perpetuity.
[pic]
4. Valuation by Free Cash Flow
(Dec 09)
4.1.1 The valuation using free cash flows is very similar to carrying out a NPV calculation. The value of the organization is simply the sum of the discounted free cash flows over the appropriate horizon.
4.1.2 Alternatively, if the free cash flows are growing at a constant rate every year, the value can be calculated using the Gordon Model (also known as the Constant Growth Model).
[pic]
Where:
g = growth rate
ke = cost of capital
4.3 Terminal values
The terminal value of a project is the value of all the cash flows occurring from period N + 1 onwards, i.e. beyond the normal prediction horizon of periods 1 to N.
5. Assessing Default Risk Using Option Pricing Model
(Jun 14)
5.1 The role of option pricing models in the assessment of default risk is based on the limited liability property of equity investments.
5.2 The value of N(d2) is the probability that a call option will be in the money at expiration. In this case it is the probability that the value of the asset will exceed the outstanding debt, i.e. V1 > F. The probability of default is therefore given by 1 – N(d2). This is show as the shaded part in the following figure.
[pic]
Question 1 – Free cash flow to equity and terminal value
Kodiak Company is a small software design business established four years ago. The company is owned by three directors who have relied upon external accounting services in the past. The company has grown quickly and the directors have appointed you as a financial consultant to advise on the value of the business under their ownership.
The directors have limited liability and the bank loan is secured against the general assets of the business. The directors have no outstanding guarantees on the company’s debt.
The company’s latest income statement and the extracted balances from the latest statement of financial position are as follows:
|Income statement |$000 |Financial position |$000 |
|Revenue |5,000 |Opening non-current assets |1,200 |
|Cost of sales |3,000 |Additions |66 |
|Gross profit |2,000 |Non-current assets (gross) |1,266 |
|Other operating costs |1,877 |Accumulated depreciation |367 |
|Operating profit |123 |Net book value |899 |
|Interest on loan |74 |Net current assets |270 |
|Profit before tax |49 |Loan |(990) |
|Income tax expense |15 |Net assets employed |179 |
|Profit for the period |34 | | |
During the current year:
1. Depreciation is charged at 10% per annum on the year end non-current asset balance before accumulated depreciation, and is included in other operating costs in the income statement.
2. The investment in net working capital is expected to increase in line with the growth in gross profit.
3. Other operating costs consisted of:
| |$000 |
|Variable component at 15% of sales |750 |
|Fixed costs |1,000 |
|Depreciation on non-current assets |127 |
4. Revenue and variable costs are projected to grow at 9% per annum and fixed costs are projected to grow at 6% per annum.
5. The company pays interest on its outstanding loan of 7·5% per annum and incurs tax on its profits at 30%, payable in the following year. The company does not pay dividends.
6. The net current assets reported in the statement of financial position contain $50,000 of cash.
One of your first tasks is to prepare for the directors a forward cash flow projection for three years and to value the firm on the basis of its expected free cash flow to equity. In discussion with them you note the following:
– The company will not dispose of any of its non-current assets but will increase its investment in new noncurrent assets by 20% per annum. The company’s depreciation policy matches the currently available tax write off for capital allowances. This straight-line write off policy is not likely to change.
– The directors will not take a dividend for the next three years but will then review the position taking into account the company’s sustainable cash flow at that time.
– The level of the loan will be maintained at $990,000 and, on the basis of the forward yield curve, interest rates are not expected to change.
– The directors have set a target rate of return on their equity of 10% per annum which they believe fairly represents the opportunity cost of their invested funds.
Required:
(a) Prepare a three-year cash flow forecast for the business on the basis described above highlighting the free cash flow to equity in each year. (12 marks)
(b) Estimate the value of the business based upon the expected free cash flow to equity and a terminal value based upon a sustainable growth rate of 3% per annum thereafter. (6 marks)
(c) Advise the directors on the assumptions and the uncertainties within your valuation. (7 marks)
(Total 25 marks)
(Amended P4 Advanced Financial Management December 2009 Q1)
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