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Sir i have a doubt reagarding the treatment of Issue cost in the qn. Here we have given the issue cost of $400k which is included in the total investment required ($5.4m). But we only took $5m as investment for Base case NPV calculation and included the 400k in Financing side effect.
My logic is if we only consider equity CF’s for Base case NPV and so we can exclude the issue cost for debt ($100k). But why have we excluded both equity’s and debts issue costs from investment for Base case NPV…
Two things:
Firstly it doesn’t really matter whether the issue costs are subtracted in the calculation of the base case NPV or later. The APV resulting is the same.
Secondly, although with APV we first calculate the NPV as though all equity financed, we are not ignoring the fact that the financing is partly from debt. Adding the tax shield on the debt raised is applying Modigliani and Miller to deal with the effect of using debt finance and is a better approach than calculating the NPV at the WACC when there is a significant change in the gearing. Given that we are still raising debt and are accounting for the debt, we still bring in all of the issue costs.
So will we get marks even if we forget to reduce the issue cost and taking the full investment cost in base case NPV.
Thanks in advance…..
Taking the costs in the calculation of the base case NPV instead of showing them later will not lose marks.
I do not know what you mean about reducing the issue cost. The total issue costs should appear as in the examiners answer. If you reduce them then you would lose a mark or two.
What i mean by that was if i take the entire $5.4m (including issue costs) as cost of investment to find base case NPV and then reduce the issue costs as financing CF’s will that be correct.
Examiner only took $5m as cost for Base case NPV and then reduced the issue cost as financing CF’s.
The examiner has subtracted $5m when arriving at the base case NPV and has then subtracted $0.4m as a financing expense when getting the APV.
If instead you subtracted $5.4m when arriving at the base case NPV (and did not subtract the $0.4m later) then you would arrive at the same APV and would not lose any marks.
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