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Chapter No- 11 Eg. – 2
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: (kk Tk k V V (1 )( –)ee i e i d d e y and 30% from debt redeemable in 5 years time.
Sir I have two concerns with your explanation :-
1. is the solution given supported the M&M proposition of change cost of equity due to increased gearing . Because you have used the same rate of 20% for calculated the basic NPV ($19.64). But why M&M proposition is not used ?
20+(.70)(20-5)*(30/70)=24.50
WACC= (24.50*.70)+(5*.30) = 18.65%..
Why the increased risk factor is ignored due to the increase in gearing ?
2. The irredeemable , How we can consider the Tax sheild on interest as infinite ? As the project is only for 5 years , is it rationale considering the benefit beyond 5 years ? Also how we can assume this fund will be properly used after the project ?
You are referring to chapter 12, not chapter 12 🙂
This is an example of APV, and with APV we discount at the cost of equity as if it was all equity financed and then add the tax shield on the debt separately. The answer is perfectly correct and is applying M&M. APV is the best approach when there is a large change in gearing. (The problem with using a WACC for the project is that the gain from the project (the NPV) will increase the value of the equity, therefore change the gearing, therefore change the WACC.)
It the debt is irredeemable then there is interest payable indefinitely and therefore a tax benefit indefinitely. It has nothing to do with how the funds will be used after the five years. However, part (c) is more likely in the exam where the funds are raised purely for the life of the project.
It would seem that you have not watched the free lectures. The notes should not be used without watching the lectures – they are lecture notes not a study text, and it is in the lectures that I explain and expand on the notes. If you are not watching the lectures for any reason then you should not use the notes and should study instead from a study text from one of the ACCA approved publishers.
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