ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 7: Other aspects of capital investment appraisal

1.5 Agency effects on capital structure

Agency theory can be used to explain the capital structure of a company and its

choices of financing for new investment. Agency theory, which was developed by

Jensen and Meckling (1976), states that the governance of a company is based on

conflicts of interest between the company’s owners (shareholders), its managers and

major providers of debt finance.

Each of these groups has different interests and objectives.

 The shareholders want to increase their income and wealth. Their interest is

with the returns that the company will provide in the form of dividends, and

also in the value of their shares. The value of their shares depends on the long-

term financial prospects for the company. Shareholders are therefore concerned

about dividends, but they are even more concerned about long-term profitability

and financial prospects, because these affect the value of their shares.

 The directors and managers are employed to run the company on behalf of the

shareholders. However, if the managers do not own shares in the company, they

have no direct interest in future returns for shareholders, or in the value of the

shares. Unless they own shares, or unless their remuneration is linked to profits

or share values, their main interests are likely to be the size of their

remuneration package, and other benefits from their job and position such as

their status as company managers.

 The major providers of debt have an interest in sound financial management by

the company’s managers, so that the company will be able to pay its debts in full

and on time. Major lenders will often be concerned that a company will borrow

more because the cost of borrowing is fairly low, and invest the money in high-

risk ventures.

These conflicts of interest can have implications for capital gearing and preferences

for financing method.

 Shareholders might prefer debt finance as a new source of funding. When

managers own shares in the company, a new issue of shares might dilute their

interest in the company’s equity, and other shareholders should want to prevent

this from happening. Borrowing to finance growth rather than relying on equity

also reduces the amount of free cash for managers to spend on personal interests

and benefits.

 Providers of debt capital might be worried by the fact that debt capital gives

shareholders an incentive to invest in high-risk projects. They might therefore

oppose new borrowing by a company when they think that this will put their

interest (the security of their investment and returns) at risk.

Jensen and Meckling argued that the ‘optimal’ capital structure for a company is

obtained by trading off not just the marginal benefits and marginal costs of extra

debt (as suggested by static trade-off theory) but also by trading off the ‘agency

costs’ of additional debt and the ‘agency costs’ of additional equity.

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Adjusted present value method (APV method) of project appraisal

 Introduction to the APV method

 The decision rule for the APV method

 Base case NPV

 PV of other costs

 Present value of the tax shield (PV of the tax relief on interest costs)

 Summary of the APV method

 Reasons for using the APV method

 Comparison of NPV and APV methods

2 Adjusted present value method (APV method) of

project appraisal

2.1 Introduction to the APV method

The most common method for a company to evaluate a proposed capital

expenditure project is the discount the expected future cash flows of the project at

the WACC. Where appropriate, the cost of equity and WACC may be adjusted to

allow for the different systematic risk characteristics of the project.

An alternative approach to capital investment appraisal is the adjusted present

value (APV) method.

The APV method may be used when a business entity is considering an investment

in a project that will have different business risks and different financial risks

from its current operations. For example, a business entity might wish to evaluate

an investment in a different industry or a different market, and raise new capital to

finance the investment.

The APV method is an alternative to calculating a new cost of equity and a new

WACC, for example using the Modigliani-Miller formulae or the asset beta formula.

2.2 The decision rule for the APV method

A project is financially viable and should be undertaken if its adjusted present value

(APV) is positive. The APV of a project contains three elements, and is calculated as

follows:

Base case NPV

minus PV of other costs

plus PV of tax relief on interest

equals Adjusted present value (APV)

To calculate the NPV of a project, we must therefore calculate three amounts: the

base case NPV, the PV of other costs and the PV of tax relief on interest.

Chapter 7: Other aspects of capital investment appraisal

2.3 Base case NPV

The approach with the APV method is to calculate an NPV ignoring entirely the

way in which the project will be financed. The cost of capital should therefore be

calculated using an asset beta that is typical for the industry or type of business in

which the investment will be made. Having estimated an appropriate asset beta, a

cost of equity (cost of equity in an ungeared company) can be calculated using the

CAPM, and this is the discount rate.

The base case NPV is therefore calculated assuming the project is financed entirely

by equity, so that the method of financing is ignored.

It is therefore necessary to calculate the cost of equity in an all-equity company in

the same industry or the market in which the capital investment will be made. To do

this:

 convert a geared beta for the industry to an asset beta (ungeared beta) for the

industry, and then

 use this asset beta (ungeared beta) and the CAPM to establish the cost of equity

in an ungeared company.

Normal DCF techniques are used to establish the expected cash flows for the

project. Having established a cost of equity for an ungeared company, the expected

project cash flows are discounted at this cost of equity to obtain the base case NPV.

Example

A company operating in the insurance industry is considering whether to diversify

by investing in a project in the transport industry.

The company has a gearing ratio of 30% debt and 70% equity, and its equity beta is

0.940. Its debt capital is risk-free.

The transport industry has an average equity beta of 1.362, and firms in the

transport industry on average have a gearing ratio of 40% debt to 60% equity.

The risk-free rate of return is 5.3% and the expected market return is 8.3%.

The rate of taxation on profits is 23%.

The cash flows of the project after tax will be:

Year 0 $(600,000)

Years 1–3 $250,000

Required

Calculate the base case NPV.

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Answer

The all-equity beta for the transport industry is calculated by un-gearing the equity

beta for the transport industry.

0.23)-(1 40+60

1.362=

×β

= 0.90.

Using the CAPM, we can now calculate the cost of an all-equity financed company

in the transport industry:

5.3% + 0.90 (8.3% - 5.3%) = 8.0%.

This cost of capital should be used to discount the project cash flows, to obtain the

base case NPV.

Year

Cash flow

Discount

factor at 8%

0 (600,000)

1.000

(600,000)

–

3 250,000

2.577

644,250

Base case NPV

+ 44,250

2.4 PV of other costs

Other costs are the costs arising a consequence of the project, but not directly related

to the project cash flows. Typically, these costs include the costs of raising new

equity to finance the project, or the costs of obtaining debt finance.

Issue costs might be an allowable expense for tax purposes. When they are tax-

allowable, the PV of issue costs must allow for the reduction in tax payments that

will occur. The PV of the issue costs is therefore net of the present value of any tax

relief on the costs.

Unless you are given other information, you should assume that the PV of other

costs is calculated using the

risk-free cost of capital as the discount rate.

Examination hint

If a company plans to raise new capital to finance a project, it will want to raise

enough capital to finance the project after paying the issue costs. For example,

suppose that a company intends to issue new equity to raise $20 million and issue

costs are 5% of the amount raised. The company needs $20 million after paying the

issue costs, and presumably the issue costs will be paid for out of the proceeds from

raising the finance.

$20 million is therefore 95% (100% – 5%) of the capital to be raised.

The capital to be raised = $20 million /0.95 = $21,052,632.

Chapter 7: Other aspects of capital investment appraisal

This means that the issue costs will be $1,052,632.

Since the finance will be raised at the beginning of the project, the PV of the issue

costs for the equity is $1,052,632, minus the PV of the tax relief on the issue costs.

Example

Assume that in the previous example, the investment of $600,000 would be financed

by $400,000 of new equity and $200,000 of new debt.

Issue costs are 5% of the funds raised for equity and 2% of the funds raised for debt

capital.

The risk-free cost of capital is 5.3%. The rate of taxation on profits is 23%. Issue costs

are allowable for tax purposes.

Required

Calculate the PV of the issue costs for financing the project. Assume that tax is paid

in the year following the year in which the taxable profit occurs.

Answer

The finance required is:

 Equity: $400,000 after issue costs and $400,000/0.95 = $421,053 before issue costs.

 Debt: $200,000 after issue costs and $200,000/0.98 = $204,082 before issue costs

Issue costs before tax:

Equity $400,000 × 5/95

21,053

Debt $200,000 × 2/98

4,081

Total issue costs

25,134

The PV of issue costs is calculated using the risk-free rate of 5.3% as the discount

rate. There is tax relief on the issue costs, which will be received one year in arrears.

Year

Item

Cash flow

Discount factor at

5.3%

$ $

0 Issue costs (25,134)

1.000

(25,134)

1 Tax saved at 23% 5,781

1/(1.053)

5,490

PV of issue costs

(19,644)

2.5 Present value of the tax shield (PV of the tax relief on interest costs)

When a new project is financed wholly or partly with new debt finance, there will

be tax relief on the interest. The PV of these tax benefits should be included in the

APV of the project.

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The PV of the tax relief on interest is calculated by:

 calculating the interest costs in each year

 calculating the savings in taxation arising as a consequence, for each year of the

project

 discounting these savings in taxation to a present value, using the pre-tax

(before-tax) rate of interest on the debt as the discount rate.

Calculating interest payments

The amount of interest costs in each year will depend on the terms of repayment of

the debt capital.

 If the debt finance is repaid in full at the end of the term of the borrowing, the

interest cost is calculated simply as:

Amount borrowed × Interest rate on the loan or the bonds

 If the loan is an amortising loan, and the debt is repaid gradually over the term

of the loan, you will need to work out:

− the annual payment on the loan, principal repayment + interest, and

− separate this total annual payment into the principal repayment and the

interest payment.

This separation of interest charges and the loan principal repayment is necessary

because the tax relief applies to the interest payments only and not to the repayment

of the loan principal.

Example

In the previous example, suppose that the company obtains borrows $204,081 in the

form of a three-year amortising loan at 5.3% interest.

The annuity factor for years 1 – 3 at 5.3% is 2.708.

The rate of taxation is 23% and tax is payable in the year following the profit to

which the tax relates.

Required

Calculate the PV of the interest tax shield.

Answer

The annual payments on the amortising loan can be calculated using the annuity

factor for Years 1 – 3 at 5.3%, which is the cost of borrowing:

Amount borrowed

$204,081

= $75,362

Annuity factor at 5.3%, Years 1 - 3 2.708

Chapter 7: Other aspects of capital investment appraisal

The interest costs each year are calculated on the amount of the loan principal still

unpaid at the beginning of the year. The amount of principal repaid each year is the

difference between the total annual payment and the interest charge. In this

example, the figures are calculated as follows:

Year Loan principal unpaid Interest at 5.3% Loan principal repaid

$ $ $

1 204,081

10,816

(75,362

–

10,816) 64,546

(64,546)

2 139,535

7,395

(75,362

–

7,395) 67,967

(67,967)

3 71,568

3,793

(75,362

–

3,793) 71,569

(71,569)

(1)

(rounding error)

Having calculated the interest payments on the debt finance, we can now calculate

the tax relief on the interest payments, and the PV of this tax relief.

Year

Item

Cash flow

Discount

factor at 5.3%

$ $

2 Tax relief on Year 1 interest

(23% × 10,816)

2,488

1/(1.053)2 2,244

3 Tax relief on Year 2 interest

(23% × 7,395)

1,701

1/(1.053)3 1,456

4 Tax relief on Year 3 interest

(23% × 3,793)

872

1/(1.053)4 709

PV of tax shield

4,409

2.6 Summary of the APV method

Taking the three previous examples together, the APV of the investment project

would be calculated as follows:

Base case NPV 44,250

- PV of other costs (19,644)

+ PV of tax relief on interest 4,409

= APV 29,015

The APV of the project is positive; therefore on financial considerations (but

ignoring the project risk) the project is worthwhile and should be undertaken.

2.7 Reasons for using the APV method

The APV method might be used in preference to adjusting the weighted average

cost of capital (WACC) of the company using the Modigliani-Miller formulas. This

is for several reasons.

 The APV method does not rely on assumptions about the new WACC of the

firm if the project is undertaken.

 The APV method allows for the specific tax relief on the borrowing to finance

the project, and does not assume that the debt will be perpetual debt.

 The APV method allows for other costs, such as the costs of raising new finance

(issue costs).

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It might be argued that APV is therefore the best method of estimating the effect of a

new investment on the value of the business entity, and the wealth of its

shareholders.

2.8 Comparison of NPV and APV methods

The NPV method of project evaluation and the APV method provide different

valuations for proposed capital investment projects. It is possible that one method

might indicate that a project is acceptable financially, whereas the other method

indicates that the project is not viable.

The NPV and the base case NPV are calculated using the same cash flows, except

that the cash flows for the base case NPV should exclude ‘other costs’ such as

financing costs, whereas these are included in the calculation of an NPV.

Example

A company is considering whether to invest in setting up a new business. The cost

of the investment would be $9 million. The project would be financed by raising

$4.5 million of new equity finance and the same amount of new debt finance. The $9

million would be used to purchase assets for $8 million. There would be an

investment of $700,000 in working capital, and issue costs would be $200,000 for the

equity and $100,000 for the debt finance.

The purchased assets would attract capital allowances in the form of a 25% annual

writing down allowance on a reducing balance basis.

The pre-tax operating cash flows from the investment are expected to be as follows:

Year Pre-tax operating

cash flows

$000

1 1,800

2 2,100

3 2,400

4 2,700

Tax on profits is at the rate of 30%. Assume that tax payments occur in the same

year as the profit or benefit to which they relate.

At the end of Year 4, the intention is to sell off the business as a continuing

operation, and the expected receipts from the sale, net of tax, are $3.60 million.

The following information is also relevant:

(1)

The investment will alter the company’s gearing to 80% equity and 20% debt

capital.

(2)

The equity beta for the project is 1.25.

(3)

The debt finance for the project will be the same as for the company’s other

debt, which is 7% before tax.

Chapter 7: Other aspects of capital investment appraisal

(4) The issue costs of raising the new equity and debt finance would not be

allowable for tax purposes.

(5)

The risk-free rate of return is 5% and the market return is 9%.

Required

(a) Calculate the NPV of the project.

(b)

Calculate the APV of the project.

Answer

Workings: Capital allowances and tax relief

Year Written down value Capital allowance Tax relief

25% 30%

$000 $000 $000

8,000

1 (2,000)

2,000 600

6,000

2 (1,500)

1,500 450

4,500

3 (1,125)

1,125 338

3,375

4 (844) 844 253

There is no balancing charge, because it is assumed that the disposal value at the

end of year 4, net of tax, includes the estimated tax effect of the disposal of the

business.

Net present value

Cost of equity K

= 5% + 1.25 (9 – 5)% = 10%.

WACC = [80% × 10%] + [20% × 7% × (1 – 0.30)] = 8.98%, say 9%.

Year 0

3 4

$000

$000 $000

Investment (9,000)

Sale value

3,600

Operating cash flow

1,800

2,100

2,400 2,700

Tax (30%)

(540)

(630)

(720) (810)

Tax relief (workings)

600

450

338 253

Net cash flow

(9,000)

1,860

1,920

2,018 5,743

Discount factor 9% 1.000

0.917

0.842

0.772 0.708

Present value

(9,000)

1,706

1,617

1,558 4,066

NPV = – $53,000

Adjusted present value

The project will be financed 50% with equity and 50% with debt capital.

Asset beta = 1.25 × 4,500/[4,500 + (4,500 × 0.70)] = 0.7353.

Cost of ungeared equity K

= 5% + 0.7353(9 – 5)% = 7.94%, say 8%.

Paper P4: Advanced Financial Management

The cash flows for discounting are the same as for the NPV method, with the

exception that issue costs should be removed. These are $300,000 in Year 0.

Year 0

3 4

$000

$000 $000

Net cash flow

(8,700)

1,860

1,920

2,018 5,743

Discount factor 8% 1.000

0.926

0.857

0.794 0.735

Present value

(8,700)

1,722

1,645

1,602 4,221

Base case NPV = + $490,000

Other costs

There is no tax relief on the issue costs, so the PV of issue costs (all in Year 0) is

$300,000.

PV of the tax shield

It is assumed that interest costs each year will be $4,500,000 × 7% = $315,000.

Tax relief on these interest costs at 30% will be $94,500 per year for 4 years.

This tax relief should be discounted at 7%.

PV of tax relief on interest = $94,500 × 3.387 = $320,000.

Summary

$000

Base case NPV 490

- PV of other costs (300)

+ PV of tax relief on interest 320

= APV + 510

The APV is + $510,000, indicating that the project should be undertaken, whereas

the NPV is negative, indicating that it should not be undertaken.

In this particular example, the APV and NPV methods give conflicting

recommendations.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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