ACCA AFM Syllabus B. Advanced Investment Appraisal - Adjusted present value - Notes ^{18 / 19}

This can be quantified and added as an adjustment to the PV of a project.

If a question shows an investment has been funded entirely by debt or asks for project appraisal using ‘the adjusted present value method’, you must

1. Step 1

   Calculate the NPV as if ungeared i.e. Kei

2. Step 2

   Add the PV of the tax saved as a result of the debt used in the project

3. Step 3

   Subtract the cost of issuing new finance

Illustration 1

Cow plc is considering a project that would involve investment of $8 million now and would yield $2m per annum (after tax) for each of the next five years.

The project will raise Cow’s debt capacity by $25 million for the duration of the project at an interest rate of 8%.
 
The costs of raising this loan are estimated at $100,000 (net of tax).

The company’s existing Ke is 16% and corporation tax is 20%.

Cow currently has a ratio of 1:2 for market value of debt to market value of equity.

Required

By calculating the APV, recommend whether Cow should accept this project with the proposed financing.

Solution

Ke =  Kei + (1-T)(Kei-Kd)xVd/Ve

   16 = x + (1-0.20)(x-8)x1/2
   16 = x + 0.4 (x-8) 
   16 = x + 0.4x – 3.2 so 
19.2 = 1.4x
  X = 19.2 / 1.4 = 13.7% this is the cost of equity ungeared. 

Round this up to 14% to use the discount tables.

Step 1 -Base case NPV ($m)

Step 2

Interest payable = $25,000,000 x 8% = $2,000,000 and tax saved = $2,000,000 x 20% = 400,000 or 0.4m 

Discount at cost of debt 8% over 5 years = 3.993

PV of tax shield (3.993 x 0.4) = $1.5972

Step 3

Issue costs = $0.1m

APV ($m) = -0.966 + 1.5972 – 0.1 = +$0.5312m  

Therefore  - Accept