More on APV and financing side effects

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© Larry A. Wood and Peggy L. Hedges, February, 2021 More on APV and financing side-effects (adapted from FNCE 317 lecture notes 2003-2004, Chapter 14, by Larry A. Wood and Peggy L. Hedges) Using an adjusted WACC to discount a projects cash flow results in an NPV that takes into account one financing side effect - the value of the interest tax shields. Some practitioners feel other financing side effects should be taken into account when determining WACC however, trying to reflect other financing side effects in the discount rate is difficult. For example, flotation (or issue) costs are often quite substantial. Adjusting WACC to reflect issue costs There are a number of ways to approach the cost of financing, one method is to calculate the project NPV using adjusted WACC, and then subtracting the floatation or issue costs (f). For example, a company needs to raise $500,000 for a project with perpetual after-tax cash flows of $60,000 per year. The debt to equity ratio is 1, Tc = 40%, k E = 18% and f E is 6%, k D = 8% and f D = 2% What is the total APV for the project taking into account externally raised issue costs? ADJ WACC = 0.5(8)(1-.4) + 0.5(18) = 11.4% NPV = -500,000 + (60,000/.114) = +26,316 so accept if floatation costs are ignored In dollar terms, flotation (issue) costs: IC Debt = (250,000/(1 - .02)) - 250,000 = $5,102 after tax = 5,102*(1-.4) = 3,061 IC Equity = (250,000/(1 - .06)) - 250,000 = $15,957 after tax = 15,957*(1-.4) = 9,574 APV = 26,316 – 3,061 – 9,574 = +$13,681 accept but at a lower return than first thought Adjusting WACC for corporate taxes is sufficient, if the only financing side effect is the interest tax shield on any debt financing and the cost of debt and debt ratio are expected to remain constant over time. APV is more useful when there are other financing side effects including the impact of different repayment types, subsidized financing, and flotation costs. In the lesson we discounted the financing side effects using the unadjusted WACC, to demonstrate that both the APV and tax adjusted WACC approaches lead to the same result. In practice, the financing side effects are often discounted at the cost of debt – they are considered less risky. The value additivity principle should hold – APV is the value contributed by the investment and the financing decision. Steps 1. Determine the project NPV as if it were all equity financed

© Larry A. Wood and Peggy L. Hedges, February, 2021 2. Determine the NPV or PV of the various financing side effects: - issue costs - interest tax shields from addition of debt - subsidies 3. Sum: APV = NPV base case +/- NPV financing decisions caused by project acceptance Issue costs - If issue costs are incurred, they affect the overall desirability of the project. Issue costs may be generated: Externally: issue cost is a % of gross proceeds IC external = amount needed - amount needed (1 - f) where f are the issue costs as a percent Internally: issue cost is a % of net proceeds IC internal = amount needed (f%) Total IC = IC external + IC internal Usually issue or flotation costs are tax deductible. For simplicity, assume the full issue costs can be claimed in the same year as they were incurred. 1 PV after-tax issue costs = IC - { IC(T c ) / (1 + r D ) } Why discount the issue cost tax shield? Normally issue costs are paid up front but generate the tax shield at the end of the year, when the tax return is prepared. 2. Interest Tax Shield From Debt Tax shields are generated by the tax deductibility of interest payments. A few cautions: i. the tax shield is often assumed to be a perpetuity (T c D). Usually projects (and payments toward the loan) have a limited life. Therefore, the diminishing value of the tax shield must be recognized. ii. we assume the company will be able to use the tax shield generated 1 This is a simplifying assumption. For a more detailed treatment consider taking Acct 421.

© Larry A. Wood and Peggy L. Hedges, February, 2021 Example: A company borrows $5 mm to finance a project and will repay the loan in four years. The cost of debt is 8% and the corporate tax rate is 36%. a) If the company makes blended payments, what is the value of the interest tax shield? Annual payment = $1,509,604 Yr Princ. outst. begin yr Interest due @ 8% Tax shield @ 36% PVTS @ 8% (r D ) Principal payment Princ. outst. end yr 1 5,000,000 400,000 144,000 133,333 1,109,604 3,890,396 2 3,890,396 311,232 112,044 96,059 1,198,372 2,692,024 3 2,692,024 215,362 77,530 61,546 1,294,242 1,397,782 4 1,397,782 111,823 40,256 29,590 1,397,782 0 Total PVTS 320,528 b) If repayment is on a constant decline (also called principal decline) basis, what is the value of the interest tax shield? Constant decline refers to the treatment of principal. Principal PLUS interest is paid yearly (or more frequently). Annual principal payment = 5,000,000/4 =$1,250,000 Yr Princ. outst. Begin yr Interest due @ 8% Tax shield @ 36% PVTS @ 8% (r D ) Principal payment Princ. outst. end yr 1 5,000,000 400,000 144,000 133,333 1,250,000 3,750,000 2 3,750,000 300,000 108,000 92,593 1,250,000 2,500,000 3 2,500,000 200,000 72,000 57,156 1,250,000 1,250,000 4 1,250,000 100,000 36,000 26,461 1,250,000 0 Total PVTS 309,543 c) If the repayment is on a balloon basis (straight bond), what is the value of the tax shield? Yr Princ. outst. Begin yr Interest due @ 8% Tax shield @ 36% PVTS @ 8% (r D ) Principal payment Princ. outst. end yr 1 5,000,000 400,000 144,000 133,333 0 5,000,000 2 5,000,000 400,000 144,000 123,457 0 5,000,000 3 5,000,000 400,000 144,000 114,312 0 5,000,000 4 5,000,000 400,000 144,000 105,844 5,000,000 0 Total PVTS 476,946 2 2 Or more easily – as the bond has a constant interest payment, the interest tax shield will also be constant (it is an annuity). PVTS = Interest Payment(T c )(PVIFA 8,4 ) = $476,946

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