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ACCA P4
Advanced Financial Management (AFM)
高级财务管理
ACCA Lecturer: Lily Wang
1 Introduction
Beta revisited
• Asset beta-relfects pure systematic business risk
• Equity beta-reflects business and gearing risk
• Betas can be geard and ungeard:
Ve
asset equity
Ve Vd (1 T )
Investment Appraisal
If the business riskof the new project differs from the entity's
existing business risk
A risk adjusted WACC can be calculated, by recalculating the cost
of equity to reflect the business risk of the new project. (Degearing
and regearing beta factors)
If the capital structure (financial risk) is expected to change when the new
project is undertaken
Basic principle
If the business risk of the new project is different from the business risk of a
company's existing operations, the company's shareholders will expect a
different return to compensate them for this new level risk. Thus, the
discount rate for project's cf is not existIng WACC, but a risk adjusted
WACC which incorporates this new required return to the shareholders
Example
B plc is a hot air balloon manufacturer whose equity:debt ratio is 5:2
The yield on Bplc's debt, which is assumed to be risk frr, is 11%. B plc's equity
beta is 1.10. The average return on the stock market is 16% Thecorporation tax
rate is 30%
Required:
Answer
Degear the equity beta of the company in the nwe industry and find the busines
s risk asset beta of the new project/industry.
Ve
asset equity
Ve Vd (1 T )
=1.59x(2/(2+1(1-0.3)))
=1.18
Calculate the equity beta of the nwe project, by regearing:
incorporate the financial risk of our company using our gearing ratio(5:2)
Ve
asset equity
Ve Vd (1 T )
1.18= e X [5/(5+2(1-0.3))]
1.18=0.78 e
=1.51
Ke=22%+1.51(16%-11%)=18.55% Kd=11%(1-0.3)=7.7%
WACC=18.55%X5/7+7.70X2/7=15.45%
The method used to gear and degear betas is based on the assum
ption that debt is perpetual. This overvalues the tax shield where d
ebt is finite.
Basic principle
The APV method evalueates the project and the impact of financin
g separately. Hence, it can be used if a new project has a different
financial risk (debt-equity ratio) from the company
project project
tax reliefs
As all financing cash flows are low risk they are discounted
at either:
the Kd or
Grossing up
A firm will know how much finance is required for the investment.
Issue costs of finance will usually be quoted on top. It will therefore
be necessary to gross up the funds to be raised.
Equity (x)
Debt (x)
Example
Rounding plc is a company currently engaged in the manufacture of
baby equipment. It wishes to diversify into the manufacture of snowboards
The investment details
The company's equity beta is 1.27 and is 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 an average debt to equity ratio of 30:70
Assume that the debt is risk frr, that the risk free rate is 10% and that
the expected return from the market porfolio is 16%
The new projct will invove the purchase of new machinery for a cost of
800,000(net of issue cost), which will produce annual cash inflows of
450,000 for 3years. At the end of this time it will have no scrap value.
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3.The adjusted present value(APV) technique
Example
Corporation tax is payable in the same year at rate of 33%. The
machine will attract writing down allowances of 25% pa on a reducing
balance basis, with a balancing allowance ata the end of the project life
when the machine is scrapped.
The issue costs are 4% on the gross equity issued and 2% on the
gross debt issud , Assume that the debt issue costs are tax deductible.
Answer
The investment element
βa=0.92
The next task is to determine base case discount rate for the project.
E(Rf)=Rf + (E(Rm)-Rf) βa
=10%+(16%-10%)0.92
=15.52%(round to 16%)
Answer
(1) Base case NPV calculation($000)
Time 0 1 2 3
Receipts 450 450 450
Corporation tax (149) (149) (149)
@33%
Tax relief on capital allowance(W1) 66 50 149
Initial outlay ( 800)
Net cash flow (800) 367 351 450
Discount rate@16% 1 0.862 0.743 0.641
Present value (800) 316 261 288
Base case NPV 65
Answer
(W1)Capital allowances computation W1
Investment 800
Y1 WDA (200) 66 T1
600
Y1 WDA (150) 50 T2
450
Y1 WDA 0
Answer
Answer
C. PV of Tax shield
Answer
Equity (20,000)
Debt (4,376)
APV 67,424
Financially viable.
Calculate the PV of the tax shields and the PV of the cheap loan.
Although the cheap loan has a cost of 6% it has the same risk as a
normal loan ,therefore the appropriate discount rate is 10%pa
0 1 2 3 4 5 6
Annuity PV of the interest saved x x x x x
Deferred PV of the tax relief lost . . (x)(x)(x)(x)(x)
annuity
Interest saved tax relief lost
Annual amount
300,000 x (0.1-0.06) = 12,000
12,000 x 0.3= 3,600
Annual factor for 5 yrs@10% 3.791 3.791
Discount factor for 1 yr@10% 0.909
PV of the tax shield 45,492 (12,406)
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3.The adjusted present value(APV) technique
Burung Co (6/14)
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:
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.
(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 subsidised 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)
Answers:
(1) Cash flows are inflated and the nominal rate based on Lintu Co's
all-equity financed rate is used (see below). Where different cash flows
are subject to different rates of inflation, applying a real rate to non-
inflated amounts would not give an accurate answer because the effect of
inflation on profit margins is being ignored.
(3) The approach taken to exclude depreciation from the net present
value computation is correct, but capital allowances need to be taken away
from profit estimates before tax is calculated, reducing the profits on which
tax is payable.
The impact of debt financing and the subsidy benefit are then
considered. In this way, Burung Co can assess the value created from its
investment activity and then the additional value created from the manner
in which the project is financed.
It is assumed that all figures used are accurate and any estimates
made are reasonable. Burung Co may want to consider undertaking a
sensitivity analysis to assess this.
It is assumed that the initial working capital required will form part of the
funds borrowed but that the subsequent working capital requirements will
be available from the funds generated by the project. The validity of this
assumption needs to be assessed since the working capital requirements
at the start of years 2 and 3 are substantial.
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