APV Oyly Study Hub

Hi Tutor,

I have a question regarding the calculation of Oyly Co as below, it’s in Chapter 6 Study hub ACCA

Oyly Co is a listed major oil company contemplating a $500m investment in renewable energy. Oyly Co plans to borrow 100% of the funds needed for this project.

Project information

Oyly Co’s finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:

Year 1 2 3 4
$m $m $m $m
Post-tax operating cash flows 100.0 130.0 140.0 150.0
Realisable value 100.0
Working capital of $25m, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.

Predicted rates of inflation are as follows:

Year 1 2 3 4
3% 4% 3% 4%
The finance director has proposed the following finance package for the new investment:

$m
Bank loan, repayable in equal annual instalments over the project’s life,
interest payable at 6% per year 200
Subsidised loan from a government loan scheme over the project’s life
on which interest is payable at 2.5% 300
500
Issue costs of 2% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.

Financial information

Oyly Co pays tax at an annual rate of 20% on profits in the same year in which profits arise.

Oyly Co’s asset beta is currently estimated at 0.88. The current return on the market is estimated at 10%. The current risk-free rate is 1.5% per year.

I want to ask
(1) when calculating NPV base case, we always assume the initial investment is equity financed and include the full $500m in the cash flow to calculate NPV?
(2) in case of (let’s say) 50% is equity financed ($250m), 50% ($250m) is borrowings, then we still include the $500m in full to calculate NPV base case, but it will affect our calculation of financing effect, wont it?
(3) Why they take the bank loan to discount for the financing effect, can we take the weighted average rate between the bank loan and subsidised loan ?
(4) Why we use annuity factor to find the equal repayment for bank loan?

Thank you and appreciate your time