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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© Larry A. Wood and Peggy L. Hedges, February, 2021 3. Interest Rate Subsidies Subsidized loans provide a positive NPV (saving on the interest paid) and an interest tax shield on the interest paid. A disadvantage (in a financial sense) is that by accepting a subsidized loan, the company foregoes the opportunity to take an unsubsidized loan with a higher interest tax shield. If k sub < k market then the value of interest savings or NPV sub loan = PV amt borrowed –PV(P+I repayment ) Using the same example what happens of the company borrows from the Government at 5% (instead of the market 8%). a) If the company makes blended payments, what is the NPV of the subsidized loan and the value of the interest tax shield? Annual subsidized payment = $1,410,059 NPV sub = 5,000,000 – 1,410,059(PVIFA 8,4 ) = 329,705 What does this mean? As the company saved 3% per year on the loan, this cash flow could go to other uses (an opportunity). The difference between what was borrowed, and what was repaid (valued at the market rate of interest) is the PV of this benefit. The PV of the interest tax shield uses the same process as before, but the interest rate is changed for calculating the interest payment. Yr Princ. outst. Begin yr Interest due @ 5% Tax shield @ 36% PVTS @ 8% (r D ) Principal payment Princ. outst. end yr 1 5,000,000 250,000 90,000 83,333 1,160,059 3,839,941 2 3,839,941 191,997 69,119 59,258 1,218,062 2,621,879 3 2,621,879 131,094 47,194 37,464 1,278,965 1,342,914 4 1,342,914 67,146 24,172 17,767 1,342,913 Ø Total PVTS 197,823 b) If the repayment is on a constant decline basis, what is the NPV of the subsidized loan and the value of the interest tax shield? The process is not so straightforward in this case. The annual principal payment remains the same but the interest bill reduces. The easiest solution - change the amortization table slightly so that both the PV of the total payments and the PV of the interest tax shield can be calculated. Yr Princ. outst. Begin yr Interest due @ 5% Tax shield @ 36% PVTS @ 8% (r D ) Princ. + Int paid (P + I) PV of P + I @ 8% 1 5,000,000 250,000 90,000 83,333 1,500,000 1,388,889 2 3,750,000 187,500 67,500 57,870 1,437,500 1,232,425 3 2,500,000 125,000 45,000 35,722 1,375,000 1,091,519 4 1,250,000 62,500 22,500 16,538 1,312,500 964,727 Total PVTS 193,463 Tot. PV (P+I) 4,677,560 NPV sub = 5,000,000 – 4,677,560 = 322,440

© Larry A. Wood and Peggy L. Hedges, February, 2021 c) If the repayment is on a balloon basis (straight bond), what is the NPV of the subsidized loan and the value of the tax shield? As the bond has a constant interest payment, the NPV of the subsidized loan is simply the present value of the bond today subtracted from its face amount or P 0 = 250,000(PVIFA 8,4 ) + 5,000,000(PVIF 8,4 ) = 4,503,181 NPV sub = 5,000,000 – 4,503,181 = 496,819 And the interest tax shield = 250,000(.36)(PVIFA 8,4 ) = $298,091 If a subsidized loan is available the Net benefit subsidy = NPV sub loan + PVTS sub loan - PVTS unsub loan foregone as a result of taking sub loan Continuing with the same example, what is the net benefit of the three different repayment types, if the company chooses to go with a government subsidy? a) Blended payments: 329,705 + 197,823 – 320,528 = 207,000 b) Repayment on a constant decline basis: 322,440 + 193,463 – 309,543 = 206,360 c) Repayment on a balloon basis (straight bond): 496,819 + 298,091 – 476,946 = 317,964 Summarizing: APV = NPV base case - PV aftertax issue costs + PVTS excess unsubsidized loans + NPV subsidized loan + PVTS subsidized loan Note: Calculation of the PVTS foregone on any unsubsidized loan is only required if you are asked for the net benefit of the subsidized loan: Net Benefit subsidized loan = NPV subsidized loan + PVTS subsidized loan - PVTS foregone on any unsubsidized loan If simply calculating APV, this term always cancels and can be ignored (saving time in exams!) Notice on the summary the tax shield on the unsubsidized loans is included and then subtracted when calculating the net benefit of the subsidized loan. It is important to recognize that sometimes not all the borrowing can using a subsidized loan. Other Considerations: If the company is trying to maintain a constant debt ratio, it will have to be careful when raising new debt or equity as issue costs will throw the ratio out, and target debt ratios are based on book values for debt - debt does not remain constant over time.

© Larry A. Wood and Peggy L. Hedges, February, 2021 Another practice problem As Chief Financial Officer for Hedgewood Manufacturing Inc. (HMI), you have been asked to look into the following project: The expansion project requires the immediate purchase of $600,000 of equipment. The NPV base case for the 3 year project is $0. Financing information: HMI wants to maintain their target debt ratio of 30%. The company is eligible for a maximum government loan of $185,000 at an interest rate of 5.00% p.a. The loan would be structured as a constant decline of principal loan. An identical loan from the bank would have cost 7.00% p.a. and it too would have been a constant decline of principal loan. The government will charge a 2% floatation cost on the loan. The government has agreed to allow you to finance this cost by merely borrowing additional funds from them. This means that the subsidized loan flotation costs are externally financed. Any equity to be issued would come from issuing common shares. The shares include a floatation cost of 3% to be paid externally as well (additional shares will be sold to finance the floatation costs). Additional Information: The current return demanded by the HMI’s shareholders is 15%. When the company had no debt, common shareholders demanded a 11% rate of return. The corporate tax rate is 33% and taxes are paid at the end of the year. Since the issue costs are externally financed the company is aware that the stated target debt ratio (after being adjusted for issue costs) may not be precisely 30%. They are willing to make adjustments for this at a later time. 1. To the nearest whole dollar, what is the APV for this project? ($470) 2. To the nearest whole dollar, what is the present value of the after-tax issue costs? ($11,524) 3. To the nearest whole dollar, what is the NPV of the subsidized loan? ($6,572) 4. To the nearest whole dollar, what is the present value of the after-tax interest tax shield on the subsidized loan? ($5,422)

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