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Question regarding example 2 in chapter 12. Do i understand it correctly that we will have the same results when calculating the APV as shown in Chapter 12 example 2 for question b and if we would solve the queston at the same why as earlier in chapter 10 (by finding the new equity beta and new cost of equity using CAPM and the WACC).
You would, but it would be complicated because the problem is that any gain from the project would increase the market value of the equity, which in turn would change the gearing. It therefore requires a lot of algebra!
Don’t waste your time – the question will make it clear if it wants APV and if it does then you do APV
Thanks for a well explained lecture:)
Sir in example2 partB shareholder’s required return should change due to gearing as before it was all equity financed now it is 70% equity and 30% debt ????
should we regerar beta and than calculate shareholders return
Best is to use an APV approach (as in the answer at the back of the notes) in which case you discount the project at the return required were there no gearing and then add on the tax benefit of the debt.
An alternative would be to calculate a new cost of equity for the project (by regearing the beta) and then a WACC for the project, and then discount at that rate. The problem is that any gain from the project would go to the equity and so the gearing would end up different from 70%/30% which would change things. That would either mean keep redoing the exercise with the new gearing (an interative approach) or else use lots of algebra
in APV approach we assume npv is all equity financed so gearing will not effect the cost of equity ????
We calculate the NPV as though it was all equity financed and then calculate the tax benefit separately (whereas appraising at the WACC effectively deals with both things at the same time).
APV is a better approach if there are significant changes in the gearing.
thank you very much sir
“The problem is that any gain from the project would go to the equity and so the gearing would end up different from 70%/30% which would change things.”
What do u mean by this?
As you will know from this chapter (and previous ones), we measure gearing using the total market values of equity and debt.
If we invest in a project with a positive NPV, then it means it is giving more than the required return, and the benefit of this will go to equity (debt get fixed interest and so they are not affected). This will mean that the market value of the equity will change, which will change the gearing ratio.
my WACC ends up to be 19% if i regear the beta. Can you please tell why does this happen?
I have not checked your arithmetic (the WACC is not relevant in this question) but it is not surprising that it is lower than the WACC if it was all equity financed. M&M prove that with tax the WACC will fall with higher gearing.
PS When you did calculate the WACC, I assume you took the cost of debt to be 3.5% (5% less tax)?
The APV cuts a lot of hussle! i think Moffat you trully handled this one well. the APV i almost overlooked it when studying now this question made me re read it a bit. Nicely done. it had given me head aches just think about how complex it can be the minute debt is said to be reedemable to get IRR rate.
John I agree with yenuar, I have calculated using the alternative method and the NPV is not 28.64 for part b! Please could you post the alternative solution steps in narrative as i understand posting a new video maybe cumbersome, but just a brief narrative so I can understand possibly I am missing something in the calculations I am doing!
I do need to change the lecture because it will not come to exactly the same result. The reason is that that the project is only lasting 5 years – if it lasted for perpetuity then it would be the same.
However, it will be clear in the question if they want you to take and APV approach.
John, if it’s possible, could you please post the alternative solutions to parts b) and c). I’ve tried to work them out but my answers are different from those calculated using the APV…
Or should we just use the APV approach whenever possible?
The question will make it clear if they want APV and if so then you should obviously use that approach.
In Part C of Example 2, why is the tax saving 0.45m for year 1-5 if it is redeemable debt. If redeemable, surely the outstanding balance of debt after 1 year will not be $30m any more, but only $24.5m and interest in the second year will be only $1.2m with tax saving of $0.36m. The outstanding amount of debt reduces each year, thus interest paid and the tax saving will become less as the debt are repaid each year.
I get a total NPV tax saving on interest over 5 to be 1.23m
@jurgenshniek, the $30m is paid back at the end of 5 years. I have never seen this in real practice.
With redeemable debt, only interest is paid each year and the full amount of the principal is repaid at the end of the period (in this case after 5 years).
This is standard for traded debt (and remember we are talking about traded debt)!
@johnmoffat – the lecturer also states that the new WACC is approx 18% (actual is 18.2%), which is what andypandy, garlyliu and I calculated. However, this discount rate gives an NPV of $24.52.
Any idea of where we went wrong?
Anyone to help pls?
I tried part B using WACC and NPV = $24.52M (?equity=1.95 and WACC=18.2%). Has anybody else tried to do part B using WACC? If yes, what is your result?
@andypandy, i tried and got the same answer as yours. anybody knows which part goes wrong?
@andypandy, The problem is this……although the finance for the project is being raised in the ratio 70%/30%, any gain from the project will go to the shareholders and will therefore increase the market value of the equity.
As a result, the gearing will end up being different that 70%/30% (and also the cost of equity will change because of the gearing).
To be able to use WACC you would need to know what the gearing ratio ended up at, and what the cost of equity ended up being.
(You can check is because we have calculated the gain using APV and you can use the M&M formula to get to the new cost of equity)
i get lost failed to follow from e.g 1, bcz it cuts whn we started part b.
Thanks very much. I have got a better understanding. When I read the question first time, I thought we will work out a NPV and then use WACC to discount on solution b and c.
Adjusted Present Value approach is much easier to use in this case.
I think I’m comfortable with gearing and identifying APV versus WACC questions. The problem is the scenarios given and how the information is presented.
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