1. Other topics: Adjusted Present Value & Preferred Stock MF 807: Corporate Finance Professor Thomas Chemmanur

2. 2 2 Adjusted Present Value When we studied capital budgeting, we studied formulae for the cost of capital:  (1) The weighted average cost of capital  (2) Asset beta method. Both these methods took into account the effect of the debt tax shields, by adjusting the discount rate for the effect of the deductibility of interest payments from corporate tax. However, if other market imperfections, like the costs of financial distress, issue costs, and asymmetric information costs are also significant, it is useful to take market imperfections into account using the Adjusted Present Value Approach (instead of adjusting the discount rate).

3. 3 3 Adjusted Present Value The following steps are involved in using APV for capital budgeting: Step (1): Compute the "base case NPV" of the project, using as the discounting rate, the expected return on the assets of the firm, r A.  For example, if we are using the asset beta method, plug the asset beta into the CAPM to get r A. If you are using the weighted average cost of capital, use r A = (E/V) * r E + (D/V) * r D.  Unlike in the adjusted discount rate method we learned earlier, do not make any adjustments to the discount rate at this stage for the effect of the debt tax shield.

4. 4 4 Adjusted Present Value Step (2): Adjust the NPV computed above for the impacts of market imperfections: e.g.: tax shield effects, effects of the costs of financial distress, asymmetric information costs, issue costs: APV of the project = Base Case NPV + Present Value of incremental debt tax shield due to project - Present value of incremental bankruptcy costs - Asymmetric information and issue costs etc. Step (3): Accept the project only if APV greater than zero: i.e., make sure that the project increases the value of the firm after taking into account the effect of financing. To decide on the right form of financing the project, compute firm value using several alternative scenarios, and pick that financing mix that maximizes the value of of equity in the firm (in other words, pick that financing mix that gives the highest APV for the project).

5. 5 5 Adjusted Present Value - Example Consider a project lasting 1 year only. The initial outlay is $1000 and the expected inflow is $1200. The opportunity cost of capital is r A = 20%. The borrowing rate is r D = 10%, and the net tax shield per dollar of interest is T* = 0.20.  (a) What is the project's base case NPV?  (b) What is its APV if the firm borrows 30% of the project's required investment? (Assume that the remainder is equity financed: asssume no cost to equity financing at this stage).  (c) How will your answer to (b) change if 10% of equity proceeds goes toward flotation costs? (Assume that the amount raised has to be enough to pay this flotation cost as well).

6. 6 6 Adjusted Present Value - Example Solution: (a) Base Case NPV = -1000 + 1200/1.2 = 0 (b) PV of Tax Shield  Amount Borrowed = 0.3 * 1000 = $300  Interest Payments = 0.1 * $300 = $30  PV of debt tax shield (1 yr debt) = 30 * 0.2 / 1.1 = 5.45  APV = 0 + 5.45 = 5.45 [(+)  accept project] (c) Assuming that the amount raised has to be enough to meet floatation costs as well,  Amount raised = 1000 * 0.07 / 0.9 = 777.777  Floatation Coasts = 10% of 777.777 = 77.77  APV = 0 + 5.45 – 77.777 = -72.32 [(-)  reject project]

7. 7 7 Cost of capital under alternative financing Let us now integrate what we have learned about financing under capital market imperfections with what we know about the cost of capital. Under perfect capital markets, the financing mix doesn't matter: the cost of capital to be used in evaluating a project is then r A :  the required return for the firm (if all projects equally risky), or  the required return for the particular risk level of the specific project (if different projects are in different industries). Thus, the cost of internal financing is also r A (internal financing is not free, as some people seem to think)! What happens to the cost of capital if we introduce market imperfections? We can still use r A as the cost of capital, provided we incorporate the effects of financing.

8. 8 8 Cost of capital under alternative financing This is what we are doing when we compute the APV.  If the APV is higher than the base case NPV, the effective cost of capital applicable to this project (inclusive of financing effects) is lower than r A,  If APV is less than the base case NPV (as is often the case), then, the effective rate of return required from this project is higher than r A. Thus, by making the APV the criterion for accepting/rejecting this project, we are in effect applying a cost of capital to the project which incorporates the effect of market imperfections. Thus, the APV method allows us to discount project cash flows at a cost of capital corresponding to the riskiness of the project, except that we are also taking into account the effects of costs imposed on the firm by market imperfections, which in turn depend on how the project is financed.

9. 9 9 Internal vs. External Financing: Trend SOURCESOF LONG-TERM FINANCING (%) Data are derived from Value Line Selection and Opinion. “Industrial Composite Financial Results” (February 13,1987) and Board of Governors of the Federal Reserve System, Division of Research and Statistics. Flow of Funds Accounts. Internal financing comes from internally generated cash flow and is defined as net income plus depreciation minus dividends. External financing is new long-term bond and new shares of equity net of buy-backs Internal Financing76.578.777.370.278.796.183.586.8 External Financing Net new long-term borrowing 0.03.34.59.66.013.3-4.119.8 Net new stock issues 23.518.018.220.215.3-9.420.6-6.6 Total100

10. 10 Preferred Stock Institutional Features:  Fixed dividends, if possible.  However, firms cannot be forced into bankruptcy for non- payment (unlike debt). Protections:  Common shareholders must forgo dividends if dividends to preferred shareholders are deferred.  Preferred shareholders get voting rights. Difference from debt:  Preferred dividend is not deductible for corporate tax purposes.  When held as an asset, 80% of dividend amount is exempt from corporate taxation Still a next tax disadvantage to issuing preferred stock.

11. 11 Preferred Stock So then why do companies issue preferred stock? (i)Certain companies, such as regulated utilities, benefit because they can pass off the disadvantage to their customers. (This is how pricing formulas are set up in regulatory environments). So, consumers pay the return on preferred stock. (ii)No threat of bankruptcy, so bankruptcy costs are avoided (iii)The required return is low. E.g. 9% < Required Return on Debt. Why? Most preferred stock is owned by corporations. Corporate income (from preferred or common stock dividends) enjoys an 80% tax exemption, which can substantially lessen the tax disadvantage of preferred stock