Dear Sir, regarding APV, I have got a few questions which I hope you could help me with. Suppose a company has been quoted a price of around £1m to acquire an asset which will be used for a 5 year project. The company is likely to finance the project through borrowing bearing annual interest payment, the loan is priced at 12M LIBOR rate (1.77%) plus 2%, the issue costs are expected to represent 2% of the total funds raised. My questions are:

1. When calculating the interest payment for tax shield, should we take (1.77% + 2%) x £1m or we need to take into account the issue costs and take (1.77% + 2%) x £1m x 100/98, ie. are the issue costs already included in £1m or we need to add it into £1m to get the amount of total funds raised?

2. When calculating NPV, should we use £1m as an initial investment or £1m x 100/98? In other words, should the issue costs be included in initial investment or it is treated differently to the amount necessary for the project (£1m)?

3. If we don’t include the issue costs when calculating NPV (if we only use £1m as the initial investment), why do we need to to deduct the issue costs at the end when we calculate the APV?

1. It depends on the wording of the question. If it is not clear then state your assumption and you will get the marks.

2 and 3 The issue costs are effectively an extra cost of doing the project and so need subtracting when getting the NPV. It wouldn’t make any difference to the final answer whether you subtracted them from the base case NPV or separately at the end, but we subtract them at the end because they related to the method of financing rather that to the project itself.

Thank you for your answer but I am a bit confused, if we assume that £500 is needed for the investment and the issue costs (say £100) are paid out of total finance raised, yes we have to pay interest on £600 but when calculating base NPV, what is the initial investment, £500 or £600 and why? Could you please help me clarify? Thank you Sir.

For the base case NPV the investment in the project is $500.

However in total it did end up costing us $600, and we show the extra $100 issue costs in arriving at the adjusted PV (we take the base case NPV, add on the tax saving on the interest, and subtract the $100 issue costs).

I have a question regarding example 2 of chapter 16.

First, why the cash flow of the combined companies is 35, 42, 47, 52, and 207?

It’s my understanding that, including synergy benefit of 10 p.a, it should be 38, 45, 50, 55, and 210 instead.

Another question is related to the comment saying that “Nairobi will therefore gain 4.” I don’t know where this conclusion comes from. Please explain to me the detail and the rational.

Note that it is in Chapter 16 THE VALUATION OF ACQUISITIONS AND MERGERS, whose video podcast is not available.

It is assumed that the synergy benefit is pre-tax, and so after tax will be 7 per year.

The gain should be 7 not 4 – thank you for spotting the typing error, I will have it corrected.

(Incidentally, although there are no lectures for Chapter 16 because the techniques involved are covered in other chapters, I have recorded a lectures working through a few Question 1’s from recent exams. The problem is more one of approach than extra technical knowledge and I try to deal with this in the lectures. They are linked from the main P4 page.)

Your reply is so earlier than expectation that I couldn’t believe it. I’m really delighted with your short and concise explanation; it’s really helpful to me.

Hi, after Minute 9, should we have not converted the ungeared asset beta of 1.57 to a geared(as per oil company gearing) beta to be used in CAPM of part a)’
Thanx

No, because at that point we are considering the situation when the project is all equity financed. In which case the equity beta will be the same as the asset beta. The lecture does go on to explain this.

In relation to part b where the project is financed by equity and debt in a ratio 50:50, I understand that this will change the gearing of the company and so the financial risk of the company will change.
I thought that we use APV method where the financial risk of the company changes as a result of taking up a project.
Please explain the reason the WACC method has been used in this question and not APV.

Many thanks for all your lectures, they are invaluable source of knowledge.

There is no rule about when to use APV rather than discount at the WACC.

However it is regarded as being a better approach when the gearing of the company as a whole is changing significantly (not just the gearing of the project).

These days, the examiner tells you if he wants you to use the APV approach 🙂

Please what if we are are an Oil company and we were going to invest in a Ship project, hence which means the business risk may be different from that of the company. The project will be all Equity financed and the current WACC is 10%. We were also given a similar company’s data in the shipping business. BUT Finally, the examiner drops a bomb and say after careful analysis, the company found out that taking on the project will not change the existing risk of the company.

In this case above, what should be the discount factor to use?

It would be impossible for the examiner to do this. The only way that the existing risk would not change would be if oil carried the same risk as ships. If that were the case then using the asset beta for ships would still be the right approach (because the asset beta for oil would be the same)

If you see a question and you think he is doing this, then I really would read again very carefully 🙂

PS If you are asking questions of me, then it is better to ask in the Ask the ACCA tutor forum for P4. It is not always possible to check all the comments made below lectures – there are so many lectures – but questions in the Ask ACCA Tutor forums are always checked and answered.

I HAVE UNDERSTOOD THOUGH I MUST ADMIT ONE THEN NEEDS TO PAY PARTICULAR ATTENSION TO THE GEARING RATIO. That you need to understand like in the example above that when he says gearing ratio (debt to equity) of 0.4, it doesn’t mean 40% debt and 60% equity. I mean that was my initial confused assumption Admin. which would have also been in the exam too!

I’m not sure about one thing…In Example 11 the asset beta equals to 1.57, equity beta is 1.80. What about the difference of 0.23? What does it represent if we assume that debt beta is 0?

Gearing makes the shares more risky and therefore the equity (share) beta is greater than the asset beta (which is the risk if there was no gearing). The fact that we assume the debt beta to be zero is irrelevant in that more gearing will always make a share more risky.
There is no special significance attaching to the difference of 0.23.

I am a bit confused about the using the asset beta in part a. as the question asked, “100% equity financed”, where I thought only equity beta has to be used. It got further confusing when equity beta was used to calculate the equity holders return in part b and c.

my question is, why equity beta was used for calculation of equity holders required return in part b and c; why not in part a?

If there is no gearing, then the equity beta will be the same as the asset beta. (More gearing makes share more risky and therefore when there is gearing the equity beta is higher than the asset beta. However, when there is no gearing the equity beta is equal to the asset beta.)

Since the equity beta measures the risk to shareholders, it is always the equity beta that determines the return required by shareholders. The equity beta was used in part (a) – it is equal to the asset beta since is is 100% equity (i.e. no gearing).

the lecture is great but i wonder why we don’t consider tax effect on culculating wacc? why not culculate wacc as:[ve/(ve+vd)]*ke+[ve/(ve+vd)]*0.75*6%?

cyh says

hi Sir, do we need to know more about Adjusted present value (APV)?

John Moffat says

What is in our lectures is enough for APV (as long as obviously you are practising all of the questions in your Revision Kit).

Dino says

Dear Sir, regarding APV, I have got a few questions which I hope you could help me with. Suppose a company has been quoted a price of around £1m to acquire an asset which will be used for a 5 year project. The company is likely to finance the project through borrowing bearing annual interest payment, the loan is priced at 12M LIBOR rate (1.77%) plus 2%, the issue costs are expected to represent 2% of the total funds raised. My questions are:

1. When calculating the interest payment for tax shield, should we take (1.77% + 2%) x £1m or we need to take into account the issue costs and take (1.77% + 2%) x £1m x 100/98, ie. are the issue costs already included in £1m or we need to add it into £1m to get the amount of total funds raised?

2. When calculating NPV, should we use £1m as an initial investment or £1m x 100/98? In other words, should the issue costs be included in initial investment or it is treated differently to the amount necessary for the project (£1m)?

3. If we don’t include the issue costs when calculating NPV (if we only use £1m as the initial investment), why do we need to to deduct the issue costs at the end when we calculate the APV?

Thank you so much Sir.

John Moffat says

1. It depends on the wording of the question. If it is not clear then state your assumption and you will get the marks.

2 and 3 The issue costs are effectively an extra cost of doing the project and so need subtracting when getting the NPV. It wouldn’t make any difference to the final answer whether you subtracted them from the base case NPV or separately at the end, but we subtract them at the end because they related to the method of financing rather that to the project itself.

Dino says

Dear Sir,

Thank you for your answer but I am a bit confused, if we assume that £500 is needed for the investment and the issue costs (say £100) are paid out of total finance raised, yes we have to pay interest on £600 but when calculating base NPV, what is the initial investment, £500 or £600 and why? Could you please help me clarify? Thank you Sir.

John Moffat says

For the base case NPV the investment in the project is $500.

However in total it did end up costing us $600, and we show the extra $100 issue costs in arriving at the adjusted PV (we take the base case NPV, add on the tax saving on the interest, and subtract the $100 issue costs).

Dino says

Thank you so much Sir, that indeed solved my question.

John Moffat says

You are welcome 🙂

nounrattanak says

Hi, P4 lecturer!

I have a question regarding example 2 of chapter 16.

First, why the cash flow of the combined companies is 35, 42, 47, 52, and 207?

It’s my understanding that, including synergy benefit of 10 p.a, it should be 38, 45, 50, 55, and 210 instead.

Another question is related to the comment saying that “Nairobi will therefore gain 4.” I don’t know where this conclusion comes from. Please explain to me the detail and the rational.

Note that it is in Chapter 16 THE VALUATION OF ACQUISITIONS AND MERGERS, whose video podcast is not available.

I am looking forwards to seeing your explanation.

Thanks,

John Moffat says

It is assumed that the synergy benefit is pre-tax, and so after tax will be 7 per year.

The gain should be 7 not 4 – thank you for spotting the typing error, I will have it corrected.

(Incidentally, although there are no lectures for Chapter 16 because the techniques involved are covered in other chapters, I have recorded a lectures working through a few Question 1’s from recent exams. The problem is more one of approach than extra technical knowledge and I try to deal with this in the lectures. They are linked from the main P4 page.)

nounrattanak says

Thank you very much, Mr. Moffat.

Your reply is so earlier than expectation that I couldn’t believe it. I’m really delighted with your short and concise explanation; it’s really helpful to me.

With regards,

Rattanak

John Moffat says

You are welcome 🙂

fass239 says

Hi, after Minute 9, should we have not converted the ungeared asset beta of 1.57 to a geared(as per oil company gearing) beta to be used in CAPM of part a)’

Thanx

John Moffat says

No, because at that point we are considering the situation when the project is all equity financed. In which case the equity beta will be the same as the asset beta. The lecture does go on to explain this.

Ania says

Dear Sir,

In relation to part b where the project is financed by equity and debt in a ratio 50:50, I understand that this will change the gearing of the company and so the financial risk of the company will change.

I thought that we use APV method where the financial risk of the company changes as a result of taking up a project.

Please explain the reason the WACC method has been used in this question and not APV.

Many thanks for all your lectures, they are invaluable source of knowledge.

John Moffat says

There is no rule about when to use APV rather than discount at the WACC.

However it is regarded as being a better approach when the gearing of the company as a whole is changing significantly (not just the gearing of the project).

These days, the examiner tells you if he wants you to use the APV approach 🙂

anonymous says

Awesome Lecture!!

sogan0 says

im grasping so far thanx Lecturer

lakeside says

Dear Tutor,

Please what if we are are an Oil company and we were going to invest in a Ship project, hence which means the business risk may be different from that of the company. The project will be all Equity financed and the current WACC is 10%. We were also given a similar company’s data in the shipping business. BUT Finally, the examiner drops a bomb and say after careful analysis, the company found out that taking on the project will not change the existing risk of the company.

In this case above, what should be the discount factor to use?

John Moffat says

It would be impossible for the examiner to do this. The only way that the existing risk would not change would be if oil carried the same risk as ships. If that were the case then using the asset beta for ships would still be the right approach (because the asset beta for oil would be the same)

If you see a question and you think he is doing this, then I really would read again very carefully 🙂

PS If you are asking questions of me, then it is better to ask in the Ask the ACCA tutor forum for P4. It is not always possible to check all the comments made below lectures – there are so many lectures – but questions in the Ask ACCA Tutor forums are always checked and answered.

lakeside says

Thanks John, I will post future questions in the Ask ACCA Tutor forums.

Many Thanks really for this

rmracca says

Hi Tutor ,

Where can I find lectures relating to Valuations of mergers and acquisitions – Type 1,2,3 acquisition ?

Many thanks,

RMR

John Moffat says

There are no lectures on this yet. However the course notes contain all you need.

rmracca says

Thanks for a great lecture.

But was wondering where can I find lecture relating to the alternative way mentioned at the end of lecture?

John Moffat says

The alternative way is adjusted present value, which is dealt with in chapter 12.

rmracca says

Thank you 🙂

John Moffat says

You are welcome 🙂

questforknowledge says

opetuition tutors are great but you are marvellous: but where is the section for the alternative way

tinashe says

I HAVE UNDERSTOOD THOUGH I MUST ADMIT ONE THEN NEEDS TO PAY PARTICULAR ATTENSION TO THE GEARING RATIO. That you need to understand like in the example above that when he says gearing ratio (debt to equity) of 0.4, it doesn’t mean 40% debt and 60% equity. I mean that was my initial confused assumption Admin. which would have also been in the exam too!

naveed says

dont b panic .its simply means debt is 40 % of equity ultimately equity is 100%

babarali47 says

Once again, Great lecture!….but, what is that alternative?

yenuar says

I’m not sure about one thing…In Example 11 the asset beta equals to 1.57, equity beta is 1.80. What about the difference of 0.23? What does it represent if we assume that debt beta is 0?

John Moffat says

Gearing makes the shares more risky and therefore the equity (share) beta is greater than the asset beta (which is the risk if there was no gearing). The fact that we assume the debt beta to be zero is irrelevant in that more gearing will always make a share more risky.

There is no special significance attaching to the difference of 0.23.

euxuph says

I am a bit confused about the using the asset beta in part a. as the question asked, “100% equity financed”, where I thought only equity beta has to be used. It got further confusing when equity beta was used to calculate the equity holders return in part b and c.

my question is, why equity beta was used for calculation of equity holders required return in part b and c; why not in part a?

John Moffat says

If there is no gearing, then the equity beta will be the same as the asset beta. (More gearing makes share more risky and therefore when there is gearing the equity beta is higher than the asset beta. However, when there is no gearing the equity beta is equal to the asset beta.)

Since the equity beta measures the risk to shareholders, it is always the equity beta that determines the return required by shareholders. The equity beta was used in part (a) – it is equal to the asset beta since is is 100% equity (i.e. no gearing).

bunnywong1986 says

the lecture is great but i wonder why we don’t consider tax effect on culculating wacc? why not culculate wacc as:[ve/(ve+vd)]*ke+[ve/(ve+vd)]*0.75*6%?

bunnywong1986 says

@bunnywong1986, oh sorry i see, 6% is after tax relief

asadxsiddiqui says

Awesome explanation !!

nuan says

HELP! I can’t see the rest of the ecture. It stops at around 21mins, after (Ke) for part b of the question

mwachilale says

This lecture has clarified most of the errors that I was making on this topic.

Thank you. I hope I will not repeat the same mistakes during exams.