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Hi there, as per your lecture I decide to do part b using an alternative method. I added the gearing to the beta, recalculated the return on equity and then used WACC. However I did not come back to the same answer. Can you please explain where I have gone wrong?
b) 70% from equity and 30% from irredeemable debt.
1.5=(0.70/(0.70+0.3X0.7))Beta
B = 1.95
Ke = 0.05 + 1.95(0.15 – 0.05)
Ke = 24.5%
WACC = (0.7 X 0.245) + ((0.3 X (0.08 X 0.7))
WACC = 18.83%NPV@19% = (40 M X 3.058) – 100 M = 22.32M
As per your method in the book you have gotten 28.64M why do the two different methods give a different result, it is to my understanding that they should be exactly the same because the debt in this question is irredeemable?
The real problem is that the NPV you have got of 22.32 is the gain that will go to the shareholders.
That will mean that the gearing does not end up being 70% equity and 30% debt (that was how the money was raised, but the equity will end up being higher and therefore you would need to rework on the new ratios (then the gain will be different, which would mean reworking again, and so on – you would never be required to do this 🙂 )The other problem is that discounting at the WACC over the project life of 5 years is effectively only dealing with the interest (and tax saving) over the 5 years. However part (b) is assuming that even though the project lasts only 5 years, doing the project enables us to raise more debt and give us the tax saving in perpetuity (which means a bigger gain).
Hi John, thank you for the prompt response. Now I am even more confused :). As per the question does it not state calculate the gain to the shareholders if the project is to be financed (b) 70% from equity and 30% from irredeemable debt?
“The real problem is that the NPV you have got of 22.32 is the gain that will go to the shareholders.”
A company is considering a project that has the following after-tax flows:
0 (100M)
1 – 5 40M p.a.
The ? of the project has been calculated as 1.5.
The market is giving a return of 15% and the risk free rate is 5%.
The rate of corporation tax is 30%
Calculate the gain to shareholders if the project is to be financed:
(a) entirely from equity
(b) 70% from equity and 30% from irredeemable debt
(c) 70% from equity and 30% from debt redeemable in 5 years time.Secondly, “That will mean that the gearing does not end up being 70% equity and 30% debt (that was how the money was raised, but the equity will end up being higher and therefore you would need to rework on the new ratios (then the gain will be different, which would mean reworking again, and so on – you would never be required to do this ? )”
so what you are saying above is that the ratio of debt and equity (gearing) is the debt and equity in the company. This is not necessarily the ratio that this specific project was financed with it is instead gearing is the overall ratio of debt and equity. So to put it more simply when looking at a question because it says the project if financed using 70% from equity and 30% from debt we would perform the calculation your way in the answer. If the question said the company will finance the project using a RATIO of 70% equity and 30% debt then is would be calculated the way I did it?
I think why I am getting so confused is if we look at Chapter 10 example 9, “Xplc is an oil company” the calculation is done my way and to provide a return to the shareholder the next step in example 9 would be to an NPV cal if the cash flows were given.
So I guess what I am asking is in the exam how do I know which calculation route to take. is the clue that in example 2 chapter 12 it does not say using a ratio of 70% and 30%?
It is not the gearing of the company that matters, but the gearing for the project.
Although the project is financed using gearing of 70:30, the project makes a gain (the NPV) and is therefore worth more than the original amount invested. That gain goes to the shareholders and therefore the ratio of equity to debt in the project will change.
That is what creates the problem.Don’t worry about it for the exam, because the question will make it clear whether they want an APV approach, or whether they want you to discount the flows at the WACC for the project 🙂
(But that is why your answer ends up different)
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