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Hi,
I need to know how to identify when to use the following,
1. Company’s current WACC
2. Risk adjusted WACC
3. Adjusted present valuewhen doing a project appraisal.
Also if there is a reduction in gearing, for example, if funds for a project are raised through a rights issue, will that require APV to be used?
Thank you.
Hi, this is covered in detail in our lectures and notes, Chapter 9.
The short answer is:
1 If the new project is in the same type of business activity and gearing stays constant, use old WACC.
2 If the new project is of a different type of business, but the gearing stays constant, use Risk adjusted cost of capital
3 Any time gearing changes use APV (but see below).
When a rights issue is made more equity shares are issued so gearing decreases and APV would have to be used. However, this project is effectively equity financed so there would be no tax benefits flowing from the finance, so a risk adjusted discount rate could be used. Issue costs (after tax) could eat into the NPV and might need to be taken into accont.
Hi,
Thank you for the above explanation. I also need to know, how would it be if the questions says, only internally generated funds were used to fund a project (the company has both debt and equity currently)?
I’m assuming, internally generated means retained earnings (please correct me if im wrong)
Should APV be used since the gearing will increase due to retained earning going down?
But as per the above explanation, there aren’t any tax shields.
Thanks in advance.
You are correct: internally generated funds = equity.
Gearing does not increase: it decreases as the assumption is that is there were no project to spend money on then a bigger dividend would have been paid.
So, if no new project:
Dr Retained profits, Cr Cash (dividends) [if divis = all post tax earnings, gearing will stay the same as if was as equity, ie share capital + reserves, would stay constant]
If a new project:
Dr Non-current assets (project assets) Cr Cash [so there is more equity than previously].
Possibly no tax shields if financed by retained earnings in questions. However, higher equity and more assets might increase borrowing capacity.
The below questions stem from this quote from above: “…However, this project is effectively equity financed so there would be no tax benefits flowing from the finance, so a risk adjusted discount rate could be used…”
Do you mean that if the firm was fully equity financed before the project and the rights issue was done for the new project, then we use risk-adjusted WACC?
And if the firm had both debt+equity structure before the project and a rights issue was done for the new project,then we use APV?
Q1 You use teh risk adjusted cost of equity which, I suppose if there is no gearing is the risk adjusted WACC though this term isn’t much used.
Q2 The gearing has changed so we have to use APV. However, as there are no tax savings if only using using equity we effectively use the risk adjusted cost of equity as
APV = PV if all equity financed + PV of tax savings
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