Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk

Project Appraisal Techniques: Advanced Adjusted Present Value (APV) APV states that total project value is the value of the project with all equity financing plus the present value of side effects (commonly interest tax shields) associated with financing of the project. Simply (ignoring cost of financial distress etc.) For Perpetuities: APV = (CF/Unlevered Cost of Equity) + Tax Rate x Debt For Non-perpetuities: APV = PV (CFs in each period) + NPV (Debt) Remember: APV is not a substitute for NPV as a capital budgeting decision criterion. Rather, it is an approach to computing NPV that is sometimes simpler, more accurate, or more informative than using the WACC. APV is sometimes referred to as “valuation in parts” or “valuation by components TOPIC 1: Capital Investment Appraisal

Project Appraisal Techniques: Advanced Example (Perpetuity) CF0 = Rs. 475,000 Debt = Rs. 126,230 (remaining equity financed) After tax Cash flows = Rs. 92,400 in perpetuity Tax Rate = 34% Ungeared cost of equity = 20% Target Debt Ratio = 25% Interest Rate = 10% WACC = 18.3% (will see later how is it calculated) NPV (using WACC) = [92,400/0.183] – 475,000 = 29,918 NPV (using APV) = [(92,400/.20) + (126,230 x 0.34)] – 475,000 = 29,918 TOPIC 1: Capital Investment Appraisal

Project Appraisal Techniques: Advanced Example (Non-Perpetuity) NPV using WACC and NPV using APV method give different results when Debt is non-perpetual (or debt levels change every year). TOPIC 1: Capital Investment Appraisal

Modified Internal Rate of Return (MIRR) IRR assumed re-investment (of intermediate CFs) at IRR which is unrealistic and we saw how re-investment rate changes the rate of return on a project. In order to remove this deficiency of IRR and make it more realistic Modified version of IRR is used. MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. TOPIC 1: Capital Investment Appraisal

Project Appraisal Techniques: Advanced Modified Internal Rate of Return (MIRR) - Example A project has following CFs Calculation of MIRR (WACC is 10%) TOPIC 1: Capital Investment Appraisal

NPV and Stock Price (Firm Value) In theory, a positive NPV project should cause a proportionate increase in a company's stock price. Example: Relationship between NPV and Stock Price Value Conscious Corporation is investing 300 million in new printing equipment. The present value of the future after-tax cash flows resulting from the equipment is 750 million. Value Conscious Corporation currently has 100 million shares outstanding, with a current market price of 45 per share. Assuming that this project is new information and is independent of other expectations about the company, calculate the effect of the new equipment on the value of the company and the effect on Value Conscious Corporation’s stock price. TOPIC 1: Capital Investment Appraisal

NPV and Stock Price (Firm Value) Answer:   NPV of the new printing equipment project = 750 million - 500 million = 250 million. Value of the company prior to new equipment project = 100 million shares x 45 per share = 4.5 billion. Value of the company after new equipment project = 4.5 billion + 250 million =4.75 billion. Price per share after new equipment project = 4.75 billion / 100 million shares = 47.50 The stock price should increase from 45.00 per share to 47.50 per share as a result of the project. TOPIC 1: Capital Investment Appraisal

NPV and Stock Price (Firm Value) In reality, however, the impact of a project on the company's stock price is more complicated than the example above. A company's stock price is a function of the present value of its expected future earnings stream. As a result, changes in the stock price will result more from changes in expectations about a project's profitability. If a company announces a project for which managers expect a positive NPV but analysts expect a lower level of profitability from the project than the company does, the stock price may actually drop on the announcement. In another example, a project announcement may be taken as a signal about other future capital projects, resulting in a stock price increase that is much greater than what the NPV of the announced project would justify. TOPIC 1: Capital Investment Appraisal

Further reading Read the Harvard Business School Note on APV for further information. Concentrate on the comparison between APV and WACC and situations where APV will give better results.

TOPIC 2:COST OF CAPITAL Reference: Chapter 10 of the Book

TOPIC 2:COST OF CAPITAL Reference: Chapter 10 of the Book INTRODUCTION   In Topic on Capital Investment Appraisal Techniques, we discussed the discounting of the cash flows of potential projects. We showed how the discount rate is used to discount the cash flows and arrive at their present value. This discount rate is often called the required rate of return for the project or the opportunity cost for the funds that may be used to invest in the or project. The cost of capital represents the required rate of return. In this topic, you will learn how to calculate the cost of each source of capital and the overall cost of capital for a company (project). UNIT OBJECTIVES After you successfully complete this unit, you will be able to: Calculate the cost of debt, preferred stock, and common stock (equity) Calculate the weighted average cost of capital Understand different concepts related to Cost of Capital

2.1 SOURCES OF CAPITAL AND THEIR COSTS   The firm must decide how to raise the capital to fund its business or finance its growth, dividing it among common equity, debt, and preferred stock.  Each of these sources of capital has a cost associated with it. The mix that produces the minimum overall cost of capital will maximize the value of the firm (share price) Some companies can borrow capital at lower rates than other companies because of different risks associated with the companies. Likewise, because of risks involved in their business, some companies have a lower cost associated with preferred stock or common stock than other companies.

2.1.1 Cost of Debt   The cost of debt is usually the easiest to calculate. There are two points to consider when calculating the cost of debt. a) The appropriate cost of debt is the incremental cost - not the historical cost. Suppose that a company is considering investing in a project and is planning to issue corporate bonds to pay for part of the investment. The cost of debt is the market interest rate (YTM) that the company will pay on the new bonds. The rate of interest currently being paid on outstanding bonds is not the appropriate cost of debt. b) Interest payments may be tax deductible In these cases, the appropriate cost of debt to use is the after-tax cost of debt.

Expected Tax Rate (not historical) Cost of Debt Formula   kd* = kd x (1 - T) Where: kd* = After-tax cost of debt kd = Marginal cost of debt T = Marginal (expected) Tax rate of company For example, a company can borrow at 8% and its tax rate is 35%, the appropriate after-tax cost of debt would be: kd* = 8% x (1 - 0.35) kd* = 5.2% Important: Tax Deductibility Expected Tax Rate (not historical)

Estimating cost prior to pricing of bond issue   There are times when a potential new bond issue has not yet been priced. In this case, the cost of debt can be estimated by substituting the YTM on bonds already issued by the company for the Marginal cost of debt (kd) in the formula. Remember YTM = IRR (on the bond) so you can use a financial calculator to calculate YTM (If any one wants I will provide you the relevant notes for detailed calculations) Estimating cost when debt is not publicly traded If a market YTM is not available because the firm's debt is not publicly traded, the rating and maturity of the firm's existing debt can be used to estimate the before- tax cost of debt. For example a firm's (non traded) debt carries a single-A rating and has an average maturity of 15 years, you can use the yield curve for single -A rated (publically traded) debt to determine the current market rate for debt with a 15 year maturity.

Further Comments on Cost of Debt If any characteristics of the firm's anticipated debt would affect the yield (e.g., covenants or seniority), you should make the appropriate adjustment to estimated before-tax cost of debt. For firms that primarily employ floating-rate debt, the longer-term cost of the firm's debt should be estimated using the current yield curve (term structure) for debt of the appropriate rating category.  

Recall perpetuity formula 2.1.2 Cost of (Non-Callable, Non-Convertible) Preferred Stock   To estimate the cost of preferred stock as a source of capital, we use the dividend rate that the shares will pay and the price of the shares. The flotation cost is the amount charged by investment bankers to find investors for the shares. Once again, these represent future figures, not historical ones. The formula is: kp = Dp / Sp Where: kp = Cost of preferred stock Dp = Annual dividend paid per share of preferred stock Sp = Price per share of preferred stock Note that the equation kp = Dp / Sp is just a rearrangement of the preferred stock valuation model Sp = Dp/ kp, where Sp is the market price. Recall perpetuity formula

Will see the adjustment for floatation costs later in the topic. Example   Suppose that Mega Company plans to issue new preferred stock to raise capital for a project. The investment bankers indicate that Mega may issue stock with a par value of $100 per share that pays a 9% dividend. The cost of the preferred stock can be estimated as follows: kp = Dp / Sp kp = 9 / 100 kp = 0.090 or 9% The 9% preferred stock means that the company will pay a $9 dividend (Dp). Will see the adjustment for floatation costs later in the topic.