Study notes 45 Paper F3 Financial Strategy

If your company is considering an investment expected return on an average market portfolio is project in a completely new industry to it, 15 per cent. Corporation tax is set at 30 per cent. beware of using its current WACC to discount the Let’s consider three project evaluation methods: post-tax operating cash flows of that project using the current WACC as a discount rate; using an adjusted WACC as a discount rate; and using the adjusted present value (APV) approach. By Andrew Howarth Content specialist at Kaplan Publishing and a marker 1 The current WACC as a discount rate for paper F3 X’s current WACC is: [kd x 0.8] + [kd(1 – t) x 0.2] = [(10% + 1.8{15% – 10%}) x 0.8] + [(10%{1 – 0.3}) x 0.2] = 16.6%. But we’d be wrong to use this to discount inancial managers have traditionally the post-tax operating cash flows of the project. appraised new investment projects by The first reason is that the current WACC is based discounting the after-tax cash flows to on X’s existing business risk: that of the food present value at an entity’s weighted- industry. The plastics project entails a different F average (WACC). The risk, so it should be evaluated at an appropriate formula for calculating it is as follows: discount rate. Second, the asso- WACC = ke[VE ÷ (VE + VD)] + kd(1 – t)[VD ÷ (VE + VD)]. ciated with the plastics division differs from X’s This formula shows that an entity’s existing existing capital structure, so the weightings used in WACC reflects its current capital structure, repre- this calcu lation aren’t relevant to the new project. sented by VE and VD, and level of business risk, With regard to business risk, we need to derive a reflected in the shareholders’ required rate of return suitable cost of equity for the project based on share- (ke). The entity’s existing WACC is appropriate for holders’ expectations of the new risk of the plastics use as a discount rate only if the business risk and project. Since no beta factor yet exists for this, let’s capital structure associated with the new invest- use a proxy figure based on the plastics industry to ment are likely to remain the same as before. approximate the risk and hence (using the capital Let’s work through the following example, asset pricing model) the adjusted cost of equity of which will show the options available when an the new project. The given plastics industry beta is entity’s business risk and capital structure change. geared, so we first need to degear this in order to A US firm called X is looking to diversify its opera- remove the impact of industry-average gearing. The tions away from its main business (manufacturing ungeared beta (ßu) can be expressed as the geared food) by setting up a plastics division. Its first beta (ßg) x [VE ÷ (VE + VD{1 – t})]. Putting the figures potential project entails buying a moulding into the equation, we obtain 1.368 x [5 ÷ (5 + 1{1 – 0.3})] machine for $100,000. This is expected to produce = 1.2 as the ungeared beta for the plastics industry. net post-tax annual operating cash flows of $15,000 With regard to capital structure, the assumption into perpetuity. The project’s assets will support is that the new project represents the formation debt finance of 40 per cent of its initial cost. The ‘Using the of a new division whose future capital structure loan will be irredeemable and carry an annual adjusted will be 40 per cent debt and 60 per cent equity (in interest rate of 10 per cent. The balance of finance present value common with the initial financing of the project). will come from a placing of new equity (assume method In this case there are two options: that no issue costs will be associated with this). means that less ● The ungeared beta we have calculated can be The plastics industry has an average geared recalculation is regeared to this new level of capital structure and (equity) beta of 1.368 and a debt-to-equity ratio of required if used to find an adjusted WACC for discounting 1:5 by market values. X’s current geared (equity) assumptions (see method 2, next page). beta is 1.8, and 20 per cent of its long-term capital about capital ● The adjusted present value (APV) method can is represented by debt that’s generally seen as risk- structure be applied, whereby the ungeared beta is used free. The risk-free rate is 10 per cent a year and the change’ to find an ungeared cost of equity, which is 4646 Study notes Paper F3 Financial Strategy used for discounting the project cash flows before ‘Both the this accurately reflects the risk associated with the impacts of financing are tackled separately adjusted WACC the debt cash flows and hence the tax relief. The (see method 3). method and the debt interest is: 10% x (40% x $100,000) = $4,000 APV approach a year. So the tax relief is: $4,000 x 30% = $1,200 2 An adjusted WACC as a discount rate do not deal with a year. The present value of tax relief at 10% is First we need to regear the ungeared beta (1.2) to the increased therefore: $1,200 ÷ 0.10 = $12,000. reflect the 40 per cent debt to 60 per cent equity financial risk The plastics project’s APV is the sum of the base- gearing ratio associated with the plastics project: that comes with case NPV and the . In this case it’s: ßg = 1.2 ÷ [0.6 ÷ (0.6 + 0.4{1 – 0.30})] = 1.76. increasing $12,000 – $6,250 = $5,750. Now we can use the capital asset pricing model gearing’ Methods two and three give different results for to derive a risk-adjusted cost of equity, which can the project appraisal: $6,534 and $5,750 respec- be inserted into the WACC formula along with the tively. This is because the amount of debt in the new 40:60 capital structure level to give a risk- APV calculation ($40,000) represents 40 per cent adjusted WACC for discounting. With a cost of of the initial investment, while the risk-adjusted equity of: 10% + 1.76(15% – 10%) = 18.8%, the WACC WACC calculation also incorporates the tax benefit for the new project is: [(VE ÷ {VE + VD}) x 18.8%] + on the additional debt capacity generated by the [(VD ÷ {VE + VD}) x 10%(1 – t)] = 14.08%. project’s positive NPV. If the APV calculation had The new project’s (NPV) at a used this higher level of debt capacity, the two WACC of 14.08 per cent, therefore, would be: methods would have given the same answer. [$15,000 ÷ 0.1408] – $100,000 = $6,534. Note that, The risk-adjusted WACC method has the fol- when discounting the project flows using the lowing relative advantages: WACC, you need to use the post-tax cash flows ● The concept is easier to understand. before financing charges. This is because financ- ● It requires the calculation of a single hurdle rate, ing charges are incorporated in the calculation of which can be used for different projects and to WACC, so deducting them as part of the cash flows compare with other businesses. would mean double-counting their impact. The APV method has the following advantages: ● It can handle other financing side-effects, such 3 The adjusted present value approach as subsidies on loans, in a more transparent way. Adjusted present value (APV) is known as a “divide ● Using APV means that less recalculation is and conquer” approach. To follow it, we first evalu- required if assumptions about capital structure ate the project as if an all-equity company were change. The base-case NPV is calculated inde- considering it, so we ignore financing side-effects pendently of any financing issues. such as the tax shield on debt. This gives us the But both methods share two limitations: so-called base-case NPV. The second step is to find ● They do not deal with the increased financial the present value of the financing side-effects and risk that comes with increasing gearing. Adjusting add this to the base-case NPV. The resulting figure the beta for gearing simply recognises the impact is the APV, which shows the net effect on share- of the change in capital structure on the cost of holder wealth of accepting the project. capital (because of the tax shield on debt). It does So for X we first compute a suitable (ungeared) not deal with the U-shaped graph of WACC under cost of equity for the new project, based on the the traditional view of gearing that is more appli- ungeared beta (1.2) we calculated previously: cable in the real world. required return of project = 10% + [1.2 x (15% – ● They assume that cost of capital stays constant 10%)] = 16% a year. Then we discount the project into perpetuity, whereas in practice the various cash flows at this figure to give a base-case NPV input components may well fluctuate. as follows: [$15,000 ÷ 0.16] – $100,000 = -$6,250. Despite these limitations, both methods can be The next step is to calculate the financing side- used to give a useful insight into the viability – or effects. In X’s case they comprise the tax relief on otherwise – of a potential investment project. As the debt interest. The present value of this element long as we bear these in mind, we can ensure that needs to be computed as follows, using the pre-tax any marginal projects are also evaluated using cost of debt (10 per cent) as a discount rate, because other methods before a final decision is made.

Further reading J Ogilvie, Financial Strategy – CIMA Official Learning System, CIMA Publishing, 2009.