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ACCA AFM · Guided practice (Show me how)

Chapter 12: The Impact of Financing

Adjusted present value - base case plus the tax shield

A company is considering a project costing $100 million now, with after-tax operating cash flows of $40 million a year for 5 years. Its asset beta is 1.5. The market return is 15% and the risk-free rate is 5%. Corporation tax is 30%, with relief on interest in the same year.

Calculate the gain to shareholders with (a) equity alone; (b) 70% equity and 30% irredeemable debt; and (c) the same mix with debt redeemable at the end of the project. Assume debt interest is paid at the risk-free rate and discount its tax relief at that same rate.

Published annuity factors for the stated life: at the risk-free rate 4.329; at 10%, 3.791; at 15%, 3.352; at 20%, 2.991. All values are in $m; report each component present value to two decimal places before combining it.

  1. (a) The base case: all equity

    Calculate the all-equity required return and the base-case NPV.

  2. (b) Irredeemable debt

    Calculate the present value of the perpetual debt tax relief and the adjusted present value.

  3. (c) Debt redeemable in five years

    Calculate the present value of the finite debt tax relief and the adjusted present value, and identify the financing with the greatest gain.

Opening this exercise…