Chapter 13

Special Decision Situations

Uniform Annual Equivalent

PV of costs of machine A :
12,000
75,000 +

12,000
+

(1.12)

12,000
+

(1.12)2

12,000
+

(1.12)3

12,000
+

(1.12)4

= 118,260
(1.12)5

PV costs of machine B :
15,000
50,000 +

15,000

15,000

+
(1.12)

Machine A: UAE

+
(1.12)2

Machine B: UAE

(1.12)3

= 118,260
PVIFA12%,5

= 86,030
118,260

= 86,030
PVIFA12%,3 =

3.605

= 32,804

86,030
2.402

= 35,816

Illustration for APV

Investment

: Rs. 5 million

Net cash inflow

: Rs.1 million per year for 8

years

Opportunity cost of capital : 15 percent

Issue cost of equity

: 5 percent

Debt available

: Rs.2.4 million at 14 percent

Repayment of debt

: 8 equal annual instalments.

First instalment will be paid at
the end of first year

Tax rate

: 40 percent

Illustration
Base case NPV:
8

1,000,000

-5,000,000 +
t=1

-512,700

(1.15)t

The base-case NPV has to be adjusted for two factors: (i)

issue cost, and (ii) tax-shield associated with debt.

Illustration
Out of the total financing requirement of the project
Rs.2,600,000 will come from the equity sources and
Rs.2,400,000 will come in the form of debt finance. As the net
equity finance required by the project is Rs.2,600,000 and the
issue costs would absorb 5 per cent of the gross proceeds of the
issue, the firm will have to issue Rs.2,736,842 (Rs.2,600,000 /
0.95) of equity stock in order to realise a net amount of
Rs.2,600,000. The difference of Rs.136,842 is the cost of
underwriting, brokerage, printing, and other issue related
expenses. The APV after adjustment for issue cost is :
APV
= Base-case NPV Issue cost
= -Rs.512,700 Rs.136,842
= -Rs.649,542

Illustration
Now we consider the adjustment for the tax shield associated
with debt finance. The present value of tax shield associated with
Rs.2,400,000 of debt finance is calculated. From this we find that
the debt finance associated with the project brings a stream of
tax shields which has a present value of Rs.403,385. If we make
adjustment for this also, we get :
APV

= Base case NPV Issue cost + Present

value of tax shield
= -Rs.512,700 Rs.136,842 + Rs.403,385
= -Rs.246,157

Calculation of the Present Value of Tax Shield

Year

1
2
3
4
5
6
7
8

Debt outstanding
at the beginning

2,400,000
2,100,000
1,800,000
1,500,000
1,200,000
900,000
600,000
300,000

Interest

Tax shield

336,000
294,000
252,000
210,000
168,000
126,000
84,000
42,000

134,400
117,600
100,800
84,000
67,200
50,400
33,600
16,800

Present value of
tax shield
(at 14% discount rate)

117,869
90,552
68,040
49,728
34,877
22,982
13,440
5,897
Total Rs.403,385

Adjusted Cost of Capital

Example 1 A firm is considering a project for setting up a captive
power plant for which the following information has been gathered.
Investment outlay
Annual post-tax savings
Life of the project
Debt capacity of the project
Interest rate of debt
Nature of debt
Tax rate of the firm
Opportunity cost of capital

:
:
:
:
:
:
:
:

Rs. 50 million
Rs. 5 million
Perpetual
Rs. 25 million
10 percent
Perpetual
40 percent
12 percent

The adjusted cost of capital as per Modigliani-Miller formula is :

r* = r (1-TL) = 0.12 (1- 0.4 x 0.5 ) = 0.096 or 9.6%
The adjusted cost of capital as per Miles and Ezzell formula is :
1+r
1.12
r* = r L rD T
= 0.12 0.5 x 0.10 x 0.4 x
= 0.100 or 10.0%
1+ rD
1.10