17 The Adjusted Present Value

Question 1

How should non financial factors be considered with APV

Answer 1

• We are looking at it from a financial perspective
• But must not loose sight of how qualitative factors can affect that financial advice
• Might not be able to quantify but need to bring to attention
• For instance, when you bring in a model state the assumptions of the model and how these might affect the outcomes it produces
• To inform the user of any limitations

Question 2

How do you calculate the after tax cost of capital and what does it show

Answer 2

• The after tax cost of capital for a project appraisal is given by the following formula
  KOt = KUt (1 - (Dt / (D + E)))
• KUt – The equivalent return a ungeared company would demand in the world of tax
• This says that the overall cost of capital is the same as the cost of capital of an ungeared company in a world of tax less the tax shield
• This formula separates out the business and finance risks
• The use of this formula combines information about the discount rate for the level of business risk, and the tax shield DT due to debt finance
• By using this formula for project evaluation we automatically incorporate the effect of any advantageous financing for the project.
  The investment and the financing decision have become interdependent.

Question 3

What are the assumptions under Modigliani and Miller

Answer 3

1. The cash flows are level perpetuities. That is that a project’s after tax cash flows are the same every year until eternity. Clearly very few projects have such a pattern cash flows.
2. The projects risk is the same as that of the firm. Under WACC we are concerned with total risk .
3. The debt to equity ratio remains constant throughout the life of the project. This is unlikely to be true for a number of reasons:
   a. The term on which debt is raised. i.e. whether the loan is repaid at the end of the project or annually.
   b. The present value of the project will decline the closer you get to the end of the project. Thus the total amount of debt a project can support must decline.
   c. Dividend policy will affect the debt equity ratio.
   d. The NPV of the project itself will change the debt equity ratio, and therefore K. Because the NPV is attributable to equity and hence E will rise if the NPV of the project is positive

Question 4

Along with the assumptions of Modigliani and Miller what other factors must be taken into account

Answer 4

• In addition to problems caused by the assumptions underlying the MM model, there are other factors that should be taken into account:
  1. Issue costs. There may be different issue cost associated with raising different types of finance.
  2. Special financing. The government may offer special low cost finance to encourage companies to undertake specific projects
• All these factors should be considered and taken into account in any investment / financing decision.
• They cannot necessarily be captured in the simple after tax WACC formula.

Question 5

What is Adjusted Present Value

Answer 5

• Looks to separate out the investment and financing decisions
  o Rather than evaluating an investment decision in one step using WACC
• Firstly have to create a base case
  o This evaluates the project as if it is all equity financed
  o Only considering business risk
• Doing this looks at the investment decision in isolation to the way it is financed
  o This is called the base case present value
• After this is done it is necessary to see the effect of tax relief on debt interest
  o Could also consider other factors such as the value of the subsidised loan, or the effect of issue costs
  o Making sure to discount at appropriate discount factor
   Then add or subtract from the NPV found in the base case PV

Question 6

What does APV tell you

Answer 6

• This tells us that even if the project is financed in the way suggested it is still not a worthwhile project.
• This approach helps to separate out the investment from financing decision.
• Provides useful information
• Aids in the decision making process

Question 7

What are other reasons to use APV

Answer 7

The project may be differ from current operations because:
* It has a different risk profile
* It is to be financed differently