P4 Advanced Investment Appraisal

2 2 Section C: Advanced Investment Appraisal C1. Discounted cash flow techniques and the use of free cash flows C2. Application of option pricing theory in investment decisions C3. Impact of financing on investment decisions and adjusted present values Designed to give you the knowledge and application of:

3  Assess the impact of financing upon investment decisions of: i. pecking order theory ii. static trade-off theory iii. agency effects and capital structure  Adjusted present value technique to the appraisal of investment decisions that entail significant alterations in the financial structure  Macaulay Duration with impact of convexity  Assess the firm's exposure to credit risk, including: i. Role and the risk assessment models used by, the principal rating agencies. ii. Credit spread over risk free. iii. Firm's current cost of debt capital using the appropriate term structure of interest rates and the credit spread. C3: Impact of financing on investment decisions and adjusted present values Learning Outcomes

4 Pecking order theory Well defined order of preference of sources of capital  First preference: internal finance  Second preference: external finance - debt finance (bank borrowings, corporate bonds)  Third preference: external finance – equity finance  This financial preference results in the minimisation of the amount of new equity capital raised Financing decisions Static trade-off theory Optimum debt equity level of firm is determined by balancing:  benefit derived from the income-tax shield of debt and;  expected costs of financial distress  Overall cost of capital decreases with additional debt  Optimal level of gearing is achieved when level of marginal costs of financial distress = marginal benefits of income tax shield  It minimises the WACC and maximises the value of the firm The different capital structure theories discuss the combination of debt and equity that maximises the market value of the firm. Continued …

5 Financial distress  Occurs when company faces difficulties in honouring its obligations to its lenders  Extreme form: insolvency. Company required to sell its assets at distress prices and incur legal and administrative costs. Financial distress costs reduce the value of a firm. Value of a levered firm: Value of levered firm (VL) = Value of unlevered firm (VU) + PV of interest tax shield – PV of financial distress costs Types of financial distress costs Direct financial distress costs: related to the bankruptcy of a company. Examples of these costs are legal charges, insolvency charges, etc. Indirect financial distress costs : related to the loss of key employees, damaged relationships with customers and suppliers, etc. Optimum level of gearing  Overall cost of capital decreases with additional debt until certain point, beyond which it is not advantageous to employ further debt  At this level, marginal costs of financial distress = marginal benefits of the interest tax shield Continued …

6 Agency effects Agency theoryAgency problemAgency costs Management is agent & owners are principals Decisions taken by management inconsistent with maximising shareholder wealth Costs of monitoring managers’ performance Agency costs classification:  agency costs of debt, (e.g. bankruptcy costs, increased interest, loan covenants, reorganisation costs)  agency costs of equity (e.g. monitoring costs, management bonuses)  Agency costs will be minimised at the optimum mix of debt and equity Agency effects

7 Adjusted present value (APV) technique 1.Weighted average cost of capital (WACC)  overall compensation for the average risk of projects that the firm may undertake in the near future  WACC is used as the discount rate to determine the project’s NPV Drawback: WACC for project will change, and may change each year of the project’s life. This problems can be resolved by using APV method. APV = NPV of project assuming it is entirely equity financed + Present value of financing effects APV method can cover different types of real-world financing situations such as:  tax rates that change each year,  increases or decreases in the amount of debt each year  government subsidies  new debt issued involving flotation costs and increased debt capacity V e V d WACC = K e K d (1 – T) V e + V d V e + V d where K o = Overall cost of capital K e = Cost of equity K d = Cost of debt V e = Market value of equity V d = Market value of debt T = Corporate taxation Formulae Continued …

8 2. Market gearing measure of the company’s gearing based on its market value of debt and equity D E + D where, D is the market value of debt E is the market value of equity Formulae 3. Asset beta  Beta is project’s total systematic risk i.e. business risk and financial risk.  Asset beta = weighted average of firm’s equity beta(β e ) and debt beta(β d ) E Asset Beta = Equity beta x E + D (1 – t) Equity beta = Asset beta x E Where E is market value of equity, D is market value of debt and t is the tax rate. Formulae Continued …

9 4. Value of levered company (V L ) market value of an entirely equity-financed company (V u ) (unlevered) plus the present value of interest tax shield (TD) less the present value of financial distress costs. V L = V u + TD – PV (Financial distress) Formulae Cost of equity of a levered company can be calculated using CAPM Continued …

10 Steps for calculating APV 1 2 Calculation of base NPV by taking cost of equity as discount rate using asset beta & CAPM Calculation of present value of financing side effects / tax shield 3 Calculate present value of issue costs of debt & equity 4 Calculate present value of expected bankruptcy costs Defines value of levered firm as value of an identical but unlevered firm plus the value of any “financial side effects” due to leverage. Adjusted present value (APV) APV = base case NPV (all-equity financed) + PV financing benefits – PV issue costs Formulae

11 Steps for adjustments 1 2 Identify comparable company in same industry Calculate beta of comparable company 3 Calculate comparable company’s beta by adjusting beta for leverage & tax 4 Calculate equity beta by levering asset beta as calculated in step 3 Adjustments required to be made for leverage before using beta of a comparable firm Levering (gearing) and unlevering (degearing) the beta

12 Duration is a measure of how rapidly the prices of a debt security change as the rate of interest changes Macaulay duration Is the measure of the price volatility and interest rate-sensitivity of a fixed income debt security such as bonds, debentures and time taken by the cash flows from a debt security to repay that debt security. Macaulay Duration with impact of convexity Benefits of duration  speculate on change in the interest rates  invest according to the risk appetite  create a portfolio consisting of debt instruments Calculation Macaulay duration is the weighted average term to maturity of the cash flows from a debt security. Continued …

13 Continued … Step 1: Calculate the coupon on the bond. Step 2: Calculate the present value of the coupon and redemption value. Step 3: Add all the present values of cash flows Step 4: Multiply the present value of the coupon and the redemption valuewith the weights i.e. their respective years. Step 5: Add all the values obtained in step 4 Step 6: Divide the values obtained in step 3 with values obtained in step 5. Present value of cash flows from a bond.

14 Convexity Convexity is the measure of the curvature of a debt instrument’s price to market interest rate relationship. Relationship between convexity and duration Convexity can also be used to compare debt instruments with same duration with different convexity. The price change in value of debt instruments due to change in market interest rate will be different because of convexity

15 Firm’s exposure to credit risk Credit risk  Risk that a borrower will not repay the loan as called for in the original loan agreement, thus resulting in default  Primary risks in bank lending Credit losses  Results from the inability and unwillingness of the borrower to repay credit  Ability of firm to repay credit is dependent on its ability to generate cash flows which is in turn dependent on macroeconomic factors and company-specific factors. Definition of default Probability of default (PD) Exposure of default Loss given default (LGD) Expected loss (EL) Measuring credit losses Complexities & peculiarities of credit risk Continued …

16 Mitigation of credit risk Factoring i.e. selling debts at discount to debt factor Credit risk insurance Credit rating  Measures future ability of borrower to repay principal & interest on loan  Reflects probability of timely repayment by borrower  Rating agency reviews rating periodically High credit rating: greater possibility of borrower making timely payments Low credit rating: lower possibility of borrower making timely payments Functions of the credit rating agencies Assign credit ratings to debt issuers Provide independent, easy-to-use measurements of relative credit risk Raise funds for start-up companies Increase range of investment alternatives Reduce cost for borrowers & lenders Address possibility that financial obligation will not be honoured as promised Continued …

17 Effects of credit ratings on bond yield Higher ratings- lower yield on bonds Rating Yield Rating Lower ratings- higher yield on bonds Credit spread over risk-free Credit spread reflects additional net yield that the lender can earn from a debt with a higher credit risk, relative to the one with a lower credit risk Credit spread = Yield on corporate debt + Risk-free rate. Cost of debt capital = (Credit spread + Risk-free rate) (1 – Tax rate) Formulae

18 Recap  Assess the impact of financing upon investment decisions of: i. pecking order theory ii. static trade-off theory iii. agency effects and capital structure  Adjusted present value technique to the appraisal of investment decisions that entail significant alterations in the financial structure  Macaulay Duration with impact of convexity  Assess the firm's exposure to credit risk, including: i. Role and the risk assessment models used by, the principal rating agencies. ii. Credit spread over risk free. iii. Firm's current cost of debt capital using the appropriate term structure of interest rates and the credit spread.