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Respected Sir;
In this question company is making an investment of 150 million in Bahari country and due to subsidized loan it calculated APV of the project and added financing impact in the bihari project base case NPV.
But basic requirements of APV calculations are that business risk of the company must change as well as financial risk due to the project then APV should be calculated.
here business risk did not change and financial risk changed. He should have calculated new WACC based on new cost of equity which would have calculated by geared equity beta and value of debt 150 millon to calculate WACC.
Also he said in the answer that financial risk has changed for the company and cost of capital too.No. It is not a basic requirement that business risk should change.
The APV approach is used when there is a major change in the gearing, whether or not the business risk changes.
So what the examiner has done is correct.
The financial risk will certainly change if there is a significant change in the gearing, and because of this the WACC is bound to change.
that is why I am saying that he should have calculated WACC instead of taking financing impact and adding it to base case NPV.
If ever you increase the gearing, then the WACC will fall. The reason for this is because of the tax benefit associated with the debt, which is what APV is specifically looking at.
In fact, you could discount at the WACC and arrive at exactly the same answer as the APV, but it gets terribly messy because it requires an iterative approach (because any gain from the project goes to equity which it turn changes the gearing) – I do not suggest you waste your time checking me!! 🙂
Again, if there is a significant change in gearing (and we have the necessary information) then it is better to take an APV approach.
Hi sir,
May I know was the annuity discount factor used for the tax saving was 7% which is the Milia borrowing rate?
Similar APV question like Strayer PLC (Jun 02 Paper) and Fubuki Co(Dec 10) uses risk free rate to discount off for the annuity factor.
Please kindly advise.
Thank you very much in advanced =DIn theory the return on debt should be the same as the risk free rate (and then there would be no problem).
In practice the two are not the same and the examiner always allows you to use either – even though the final answer will be different, you will still get full marks for using either.
Noted Sir and thank you for your prompt reply. Understood.
Now I remembered my lecturer mentioned something like this..Thank you!
6 to 15 is a 10 year annuity. So you take the annuity discount factor for 10 years at 10%, and then multiply by the normal 5 year present value factor because the annuity starts 5 years late (it starts at time 6 instead of time 1).
Alternatively take the 15 year annuity factor and subtract the 5 year annuity factor – this will also give you the factor for 6 to 15.
Either way gives the same answer, apart from rounding difference, but rounding is irrelevant in the exam.
For more examples of this, watch my free Paper F2 lectures on discounting.
helo sir, can i know why then we calculated the ke of ungeared, why can we use the formulae of WACC(geared)= Ke(ungeared)*(1-(Debt*tax)/debt+equity))…
hi sir, i would like to ask for part c), right why ye assume the kd=9%?? why we dont find the kd using IRR method first??
sir, what is mean by the nominal value in this question, i tried to the npv method at first to calculate the value of unsecured debt, however it seems like it does not include the amount of par redeem at end of 10 year???
I don’t understand your first question or where you are quoted your formula from. The formula used for arriving at the ungeared cost of equity is the MM Proposition 11 formula that is provided in the exam.
For your second question, where are you finding this question? I am looking at the original exam question and there is no part (c) in it.
The nominal value of the unsecured bond is the value at which is appears in the SOFP. We have no choice here but to assume that this is also the market value (because no extra information is given). Always, if the redemption is of the same amount as the market value, then we do not need to calculate an IRR because the cost is simply the after tax interested rate.
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