accaspaceaccaspace.com/upload/acca_p4/ppt/p4_chapter_04_risk... · 2016-04-05 · accaspace...

ACCAspace

Provided by ACCA Research Institute

Copyright © ACCAspace.com ACCAspace 中国ACCA特许公认会计师教育平台

ACCA P4

Advanced Financial Management (AFM)

高级财务管理

ACCA Lecturer: Lily Wang

Copyright © ACCAspace.com ACCAspace 中国ACCA特许公认会计师教育平台 2

1

3

Introduction

The adjusted present value(APV) technique

P4 Chapter 4 Content

2

4

The risk adjusted WACC

Analysis of Comprehensive Example


Chapter Summary

Beta revisited

• Asset beta-relfects pure systematic business risk

• Equity beta-reflects business and gearing risk

• Betas can be geard and ungeard:

Investment Appraisal

Adjusted present value model

Two-part approach:

• Find base NPV

• PV of project flows using asset

beta in the CAPM

• Find PV of financing

• PV of issue costs on equity

• PV of issue costs on debt

• PV of tax relief

Problems with the risk-adjusted WACC

• Can't cope if gearing ratio changed by

project

• Over-values tax shield where debt

not pernament

• Ignore costs of raising finance

)1( TVV

V

de

eequityasset


1.Introduction

Alternatives to the use of existing WACC as a discount rate in

project appraisal

We have now established that the existing WACC should only be

used as a discount rate for a new investment project if the

business risk and the capital structure (financial risk) are likely to

stay constant. Alternatively,

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)


1.Introduction

If the capital structure (financial risk) is expected to change when the new

project is undertaken

The simplest way of incorporating a change in capital structure is to

recalculate the WACC using the new capital structure weightings.

This is appropriate when the chanage in capital structure is not significant,

or if the new investment project can be effectively treated as a new

business, with its own long term gearing level.

If the capital structure is expected to change significantly ,the APV method

of project appraisal should be used. This method separates the investment

element of the decision from the financing element and appraises them

independently. APV is generally recommended when there are complex

funding arrangements.


2.The risk adjusted WACC

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

Calculating a risk-adjusted WACC

Find the appropriate equity beta from a suitable quoted company.

Adjust the available equity beta to convert it to an asset beta-degearit.

Readjust the asset beta to reflect the project gearing levels-regear the beta

Use this beta in the CAPM equation to find Ke

Use this Ke to find the WACC

Evaluate the project



Example

B plc is a hot air balloon manufacturer whose equity:debt ratio is 5:2

The company is considering a waterbed-manufacturing project.B plc will finance

the project to maintain its exisitng capital structure.

S plc is a waterbed-manufacturing company. I t has an equity beta of 1.59 and

a Ve:Vd ratio of 2:1

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:

Calculate a suitable cost of capital to apply to the project.



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.

=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)

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%

)1( TVV

V

de

eequityasset

)1( TVV

V

de

eequityasset



Using the risk-adjusted WACC

TWO other issues also need to be considered:

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.

Issue costs on equity are ignored


3.The adjusted present value(APV) technique

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

APV consists of two different elements:

APV = Base case NPV + Financing impact

(3) Value (1)Value of an all (2)Present value of

of a geared equity financed financing side effects

project project



The investment element (Base case NPV)

The projct is evaluated as though it were being undertaken by an

all equity company with all financing side effects ignored. The fina

ncial risk is quantified later in the second part of the APV analysis.

Therefore:

• ignore the financial risk in the investment decision process

• use a beta that reflects ust the business risk, i.e.β

Find the project β

Calculate the base case discount rate=Keu

by putting the βasset in the CAPM formula

Calculate the base case NPV



The financing impact

Financing cashflows consist of :

issue cost

tax reliefs

As all financing cash flows are low risk they are discounted

at either:

the Kd or

the risk free rate



APV exam tricks

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.

• e.g. the finance required for a planned investment is 2m (net of

issue costs), Issue costs are 3%. And the finance raised will

also have to cover the issue costs. What are the issue costs

and what sum will need to be raised altogther?

• 2m is 97% of the amount to be raised:

• therefore,2m/0.97=2,061,856 will be needed.

• Issue costs are 3% 3%x2061856=61,856



APV exam tricks

PV of debt issue costs

Method:

issue costs at T0 (X)

tax relief at the CT rate(issue costs x CT rate) X

PV of the tax relief(RTQ for timing of tax flows) X

PV of the issue costs X

(issue costs-PV of tax relief)

Equity issue costs

Not tax deductible Are tax deductible-

RTQ for timing of tax flows

Equity issue costs



APV exam tricks

PV of the tax relief on interest payment

The PV of the tax relief on interest payments is also known as the

PV of the tax shield .

The method adopted depends on the information given:

Simple scenario: Debentures- interest paid at a fixed amount

each year

Annual tax relief= total loan x interest rate x tax rate (X)

Annuity factor for n years X

Year one discount factor(if tax is delayed one year) X

PV of the tax shield X



APV exam tricks

Calculation of APV( in detail)

The base case NPV is used as a starting point. The costs and benefits

of the financing are then added to find a final adjusted present value.

Base case NPV x

PV of the issue costs

Equity (x)

Debt (x)

PV of the tax shield x

Adjusted Present Value 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.



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 financing details:

The new investment will be financed as follows:

Debentues(redeemble in three years time ) 40%

Rights issue of equity 60%

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.

Calculate the APV



Answer

The investment element

Firstly,COMPUTE the asset beta of the project. This is achieved by de

gearing the equity beta from the snow board indutry average.

βa=1.19 x (70/(70+30(1-0.33)))

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%)

)1( TVV

V

de

eequityasset



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

W.D.A Tax relief@33% Timing

Investment 800

Y1 WDA (200) 66 T1

600

Y1 WDA (150) 50 T2

450

Y1 WDA 0

Balancing allowance 450 149 T3



Answer

(2) The financing impact

lay out the financing package.

Equity- 60%x 800,000 480,000 issue cost 4%

Debt - 40% x 800,000 320,000 issue cost 2%

A. PV of issue cost on equity

Equity issue cost 480,000x4/96=(20,000)

B. PV of issue cost on debt

Debt issue cost: 320,000x 2/98=(6,531)

Tax relief@33% 2,155

PV of the issue cost on debt 4,376



Answer

(2) The financing impact

C. PV of Tax shield

Total amount raised by loan- don't forget to add the issue

costs=320,000+6,531=326,531

Annual tax relief=326,531 x 0.10 x 0.33=10,776

AFfor 3 yrs 2.487

PV of the tax shield 26,800

(3) The APV calculation



Answer

(3) The APV calculation

Base case NPV 65,000


Equity (20,000)

Debt (4,376)

PV of the tax shield: 26,800

APV 67,424

Financially viable.



Additional Factors regarding the APV method

Additional factors-subsidised/cheap loans

If the loan is cheap ,the interest cost is lower. However, the benefit is

reduced since the tax shield will also be lower:

PV of the cheap loan (opportunity benefit):

PV of the interest saved x

Less: PV of the tax relief lost (x)

PV of the cheap loan x





Example: A plc requires 1million in debt finance for 5years

It has borrowed 700,000 in the form of 10% debentures redeemablein

5years and the remainder under a government subsidised loan scheme

at6%. The tax rate is 30%. Assume that tax is delayed one year.

Calculate the PV of the tax shields and the PV of the cheap loan.

(a) PV of the tax shields

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





Answers: (a) PV of the tax shields

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

Normal loan Cheap loan

Annual tax relief=total loan x

interest rate x tax rate

700,000 x 0.1x 0.3 21,000

300,000 x 0.6x 0.3 54,000

Annual factor for 5 yrs@10% 3.791 3.791

Discount factor for 1 yr@10% 0.909 0.909

PV of the tax shield 72,366 18,609





Answers: (b) PV of the cheap loan

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)

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





The APV calculation is therefore amended as follows:

Base case NPV X/(X)


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)

APV X/(X)



Advantages and disadvantages of APV

Advantages Disadvantages

• Step-by-step approach gives Based on M&M with-tax theory.

clear understanding of the Ignores:

element of the decision * bankruptcy risk

* tax exhaustion

* agency costs

• Can evaluate any type of Based on M&M with-taxt theory

financing package Assumes:

* debt is risk free and irredeema

ble

• More straightforward than

adjusting the WACC which can

be complex


Analysis of Example

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:


Analysis of Example

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.


Analysis of Example

(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.


Analysis of Example

(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.


Analysis of Example

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.


Analysis of Example

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)


Solution of Example

Answers：


Solution of Example


Solution of Example

(b) Corrections made to the original net present value

(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.

(2) Interest is not normally included in the net present value

calculations. Instead, it is normally imputed within the cost of capital or

discount rate. In this case, it is included in the financing side effects.


Solution of Example

(b) Corrections made to the original net present value

(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.

(4) The impact of the working capital requirement is included in the

estimate as, although all the working capital is recovered at the end of the

project, the flows of working capital are subject to different discount rates

when their present values are calculated


Solution of Example

(b) Approach taken (relates to errors 5 & 6)

The value of the project is initially assessed considering only the

business risk involved in undertaking the project. The discount rate used is

based on Lintu Co's asset beta which measures only the business risk of

that company. Since Lintu Co is in the same line of business as the project,

it is deemed appropriate to use its discount rate, instead of 11% that

Burung Co uses normally.

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.


Solution of Example

(b) Assumptions made

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.


Solution of Example

(b) Assumptions made

It is assumed that Lintu Co's asset beta and all-equity financed

discount rate represent the business risk of the project. The validity of this

assumption also needs to be assessed. For example, Lintu Co's entire

business may not be similar to the project, and it may undertake other lines

of business. In this case, the asset beta would need to be adjusted so that

just the project's business risk is considered.

It is also assumed that there are no adverse side-effects of taking on

the extra debt eg a worsening credit rating which could impact Burung's

trading position.

ACCAspace

Provided by ACCA Research Institute

accaspaceaccaspace.com/upload/acca_p4/ppt/p4_chapter_04_risk... · 2016-04-05 · accaspace...

Documents