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Hello sir! there were a few sentences related to the theoretical points of WACC that is did not understand at all. I will go through them and hopefully you can clear up my confusion.
Reference: text chap 07, page no 231.
”The degearing and regearing procedure is a product of the M&M 1963
position. To use these equations debt must be perpetual and risk free.
If it is not perpetual, to ignore that it is for a shorter period will overvalue
the tax shield on debt.'”
My thoughts from this were that we Degear and regear to calculate the cost of equity and then to calculate the WACC to appraise projects which contains both cost of both equity and debt. Is it saying that if the project’s life is longer than the maturity of the debt used to finance the project, and when we use the WACC to discount the whole of project it would overstate NPV as the WACC would go up most likely after the maturity of debt because now the lower cost of debt should not be included in the WACC calculation. This seems like a stupid understanding of this from me, but I really do not know what else it means can u please clarify.
“The value Ve + Vd used in the WACC equation should represent market
values of debt and equity after the project has been adopted (i.e. the
equity value should include the NPV of the project). ”
This really confused me because why would we use the market value of equity in the WACC calculation after the project is completed and besides in order to calculate the NPV we need the WACC in the first place so how could we increase the value of equity by NPV if we do not have a WACC calculated. Is it saying that we should calculate the NPV based on the current market values and then increase the market value of equity by the NPV and recalculate the WACC to appraise the project is it so why do we need to do this, I understand I couldn’t possibly be required to do this in the exam, but this is just giving me headache.
lastly “If the project has a positive NPV the calculation will assume that borrowing is proportional to the present value of future cash flows rather than the initial value of the asset.” this just went over my head I could not understand what it is referring to when it says that assuming that borrowing is proportional to the PV of future flows.I have no idea which study text you are referring to!
However……
For the first statement, the formula all stem from Modigliani and Millers proposition and one of their assumptions is that debt is irredeemable. As you will have seen from my lectures on APV, the tax shield is the PV of the tax saving on the interest payments. If the debt is not irredeemable then the tax saving will be for a shorter period, therefore the tax shield (PV for the tax savings) will be smaller than it would be were the debt irredeemable.
For the second statement, we need to use the gearing after adoption of the new project because different gearings will affect the risk and the overall cost of borrowing. In this sort of question we will be using CAPM to determine the discount rate (and would be told the gearing ratio after adoption of the project) or, more likely, would be expected to take an APV approach.
I am not completely certain what the last statement is saying, because I need to see the context in which it is written.
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