Adjusted present value

Wadia Haddaji February 20, 2008

 Topics: 1. Adjusted present value. Readings: 1. Brealey, Myers and Allen, section 20.4.

The Adjusted-Present-Value Rule Recall that we can write the value of a levered rm as the value of an otherwise identical all-equity rm and the value of its nancing decisions: V = VU +NPV(nancing decisions). It is then obvious to dene the APV of a project as the sum of its NPV to an all-equity rm and the PV of the associated nancing decisions: APV = NPV(unlevered project) + NPV(nancing decisions) Separating the APV of a project into its NPV to an all-equity rm and the value of the associated nancing decisions should be generally useful for the nancial manager.

A Comparison of WACC and APV Features/advantages of WACC. 1. WACC accounts for tax shield benet of interest in discount rate. 2. WACC is widely adopted by practitioners and is easy to use. 3. WACC is applicable when D/E remains essentially constant through project life. 4. WACC is most appropriate when the project is typical of the rms traditional businesses (i.e., same risk), or scale enhancing. Features/advantages of APV. 1. APV accounts for tax shield benet of interest in cash ows (not discount rate). 2. APV was introduced by academics and is slowly being adopted in practice. 3. 11% of rms always or almost always use it. APV often requires/accomodates knowledge of a particular debt repayment schedule. APV (as opposed to WACC) is suited for situations where the debt to equity ratio is changing signicantly over time (capital intensive projects and LBOs). APV can handle side eects: tax shield, issue costs, bankruptcy costs, etc.
3

Adjusted Present Value: Example Suppose the rm is evaluating a project requiring a $10 million investment and oering an after-tax free cash ow of $1.8 million per year for 10 years. The rm has a 30% target debt-to-book ratio; that is the rm will use 30% (3 million) debt and 70% (7 million) equity to nance the project. What is the APV of the project? The rst step is to do the usual NPV computation. If we assume that the opportunity cost of capital, reecting the projects risk, is 12%, then N P V = 10, 000, 000 +
10 1,800,000 t=1 (1.12)t

= 170, 401.

The second step is to determine the NPV of the change in capital structure. Since the rm has a target 30% debt-to-book ratio, the project would result in $3 million of additional debt. If we assume that, at this level of debt, bankruptcy and agency costs are negligible, then the NPV of the change in capital structure equals the present value of the tax shield minus any issue costs.

Adjusted Present Value: Example (contd) For example, assume that the rm is issuing the additional $3 million debt at a rate of 8% and that issue costs equal 1.5% of the debt value, or $45, 000. Assuming that tc = 20%, the annual tax shield is tc rD 3, 000, 000 = (0.20)(0.08)(3, 000, 000) = 48, 000, and the NPV of the change in capital structure can be computed as N P V (nancing) = 45, 000(1 0.20) + Therefore, the APV of the project is $170, 401 + $286, 084 = $456, 485.
48,000 (1 0.08

1 ) (1.08)10

= 286, 084.

Adjusted Present Value: Example (contd) Why is it that the interest payments on the debt (8% $3 million) never appear as cash ows? 1. Because capital markets are ecient (the debtholders get what they pay for), we know that the NPV of this transaction is zero: N P V (loan) = 3M (.08)(3M )[ 1(1.08) ] .08
10

3M (1.08)10

= 0.

What would change if the government subsidized this loan? For example, suppose that it oered the $3 million at 6%. 1. The yearly tax shields are smaller than before, (0.20)(0.06)(3, 000, 000) = 36, 000 < 48, 000, so that 1 N P V (taxshield) = 45, 000(1 0.20) + 36,000 (1 (1.08)10 ) = 241, 563. 0.08 2. However, the loan itself now has a positive NPV: check N P V (loan) = 3M (0.06)(3M )[ 1(1.08) ] .08
10

3M (1.08)10

= 402, 605.

Adjusted Present Value: Example (contd) The APV can accommodate debt repayment schedules. For example, suppose instead that the rm intends to raise $5 million in debt nancing for the project. 1. The principal will be repaid in equal installments over the next 10 year. 2. The interest rate is 8%.

Adjusted Present Value: Example (contd) The debt repayment schedule (in 000s) is as follows: End of Year C1 C2 ... 4,500 4,000 ... 400 360 ... 500 500 ... 900 860 ... 80 72 ...

Debt outstanding Interest payment Principal payment Total payment on the debt Interest tax shield

C0 5,000

C9 500 80 500 580 16

C10 0 40 500 540 8

We can now discount the tax shield to nd N P V (nancing) =

80,000 1.08

72,000 (1.08)2

+ ... +

16,000 (1.08)9

8,000 (1.08)10

= 328, 992,

for an adjusted present value of AP V = 170, 401 + 328, 992 = 499, 393.

The Full Picture: An Example Stare E.O. (SEO) is a producer of electronics equipment located on the west coast. The rm is currently all-equity nanced. The rm is not publicly traded. Sounds Good Inc. (SG), also a producer of electronics equipment with operations on the east coast only, is considering acquiring SEO. In particular, Sounds Good is interested in knowing the maximum price that it should consider bidding for SEOs assets and operations. Sounds Good is publicly traded. It is currently nanced with 800,000 shares, each worth $65 (i.e., $52 million of equity), and $15 million worth of debt. A regression of Sounds Goods last 60 monthly stock returns on the market returns yields an estimated beta of 1.8. The beta of its debt is 0.2. The expected risk premium of the market is currently 8%, and the yield on a 10-year treasury bond is 5%. The corporate tax rate is 34%.

The Full Picture: An Example (contd) Sounds Goods chief nancial ocer estimates that the expected for SEO will be as follows. End of Year C1 C2 C3 C4 (1)Operating income 2,620 3,436 3,671 3,976 (2)Tax on operating income 891 1,168 1,248 1,352 (3) After-tax operating income 1,729 2,268 2,423 2,624 (4)+ Depreciation 449 475 475 475 (5) Capital expenditures 522 512 525 538 (6) Change in working capital -203 -275 200 225 (7)+ Proceeds from asset sales 3,545 1,805 (8)After-tax free cash ows 5,404 4,311 2,173 2,336 after-tax cash ows C5 4,336 1,474 2,862 475 551 250 2,536

The CFO also estimates that these cash ows will grow at an annual rate of 3% after year 5.

10

The Full Picture: An Example (contd) Let us assume for now that, after the acquisition, Sounds Good will try to maintain its debt/equity ratio around its current value. Suppose also that SEOs operations are similar to those of Sounds Good. Given this, Sounds Goods chief nancial ocer decides that the rms WACC should be used to discount the after-tax free cash ows. First, we can calculate rD = rf + (rm rf )D = 0.05 + 0.08(0.2) = 6.6%; rE = rf + (rm rf )E = 0.05 + 0.08(1.8) = 19.4%. The weighted average cost of capital is then W ACC =
D V

(1 tc )rD +

E V

rE =

15 (1 15+52

0.34)(0.066) +

52 (0.194) 15+52

= 16.0%.

11

The Full Picture: An Example (contd) Under this set of assumptions, the maximum bid that Sounds Good should consider is PV =
5,404 1.160

4,311 (1.160)2

2,173 (1.160)3

2,336 (1.160)4

2,536 1 0.1600.03 (1.160)4

= 21, 275.

12

The Full Picture: An Example (contd) In order to get a clearer picture of SEOs value, Sounds Goods CFO decides to calculate the adjusted present value in two parts: the value of SEOs unlevered assets plus the value of the expected tax shields that the new debt will bring to Sounds Good. She also decides to be more precise about the exact nature of the extra debt capacity resulting from the acquisition. To nance the acquisition, Sounds Good will be able to borrow $8 million at 7.5% for the acquisition of SEO. The rest will be nanced in cash using last years earnings. The debt contract is a ve-year contract, during which Sounds Good is expected to repay the bank in ve equal end-of-year installments of x=
8,000 1 (1 (1.075)5 )

1 0.075

= 1, 977.

Under this scenario, the CFO conservatively assumes that Sounds Good will not be able to take on more debt.

13

The Full Picture: An Example (contd) Check this First the value of SEOs assets is obtained by discounting the after-tax cash ows at the appropriate rate for the risk. Since SEO is not publicly traded, the CFO decides to use the expected rate of return for Sounds Goods assets (i.e., the rate at which we would discount the rms assets if it were all-equity nanced). We know from the previous lecture (this is often a useful shortcut) that rA = W ACCU = so that NP V =
W ACCL D 1tc V

0.160 15 10.34 15+52

= 17.3%,

5,404 1.173

4,311 (1.173)2

2,173 (1.173)3

2,336 (1.173)4

2,536 1 0.1730.03 (1.173)4

= 19, 688.

We need to add the present value of the expected tax shields generated by the new debt.

14

The Full Picture: An Example (contd) We need to gure out the interest payment on the debt each year. This is done in the following table, where the initial debt outstanding is 8,000 (and so the rst interest payment is 7.5% 8, 000 = 600). End of Year C2 C3 C4 5,142 3,550 1,839 1,977 1,977 1,977 497 386 266 1,481 1,592 1,711 169 131 91

Debt outstanding Payments on the debt Interest paid Principal paid Interest tax shield

C1 6,623 1,977 600 1,377 204

C5 0 1,977 138 1,839 47

The present value of the tax shield is therefore P V (tax shields) =

204 1.075

169 (1.075)2

131 (1.075)3

91 (1.075)4

47 (1.075)5

= 542,

so that AP V = N P V + P V (tax shields) = 19, 688 + 542 = 20, 230.

15

The Full Picture: An Example (contd) Upon further consideration, the CFO decides that SEOs operations are actually somewhat dierent from those of Sounds Good. 1. First, the west coast electronics market tends to be more aected by swings in the business cycle. 2. Furthermore, SEOs operations being smaller than Sounds Goods, they do not benet from the same economies of scale (and wont, even after the acquisition). Instead, SEOs operations are deemed more comparable to another west coast rm, White Noise, which is publicly traded. 1. White Noise is currently nanced with $18 million of equity and $5 million of debt. 2. The beta of White Noises equity is 2.1, and that of its debt is 0.3.

16

The Full Picture: An Example (contd) First we need to unlever White Noises equity beta to get its asset beta:
WN +( D ) E E WN WN (1tc )D
(1tc )
5 2.1+( 18 )(10.34)0.3 5 1+( 18 )(10.34)

WN
A

1+( D ) E

WN

= 1.82.

The CFO now assesses that Sounds Goods debt capacity will increase by a fraction of about 30% of SEOs value (i.e., 30% of the projects value). So, using the A from White Noise, she relevers the asset beta for the project:
p p E = A + D p (1 E p p tc )(A D ) = 1.82 + 0.30 (1 0.70

0.34)(1.82 0.2) = 2.28.

17

The Full Picture: An Example (contd) Using the CAPM, the CFO then calculates the cost equity for the project (we already know rD = 6.6%):
p p rE = rf + E (rm rf ) = 0.05 + (2.28)(0.08) = 23.2%.

The projects weighted average cost of capital is therefore W ACC = (0.30)(1 0.34)(0.066) + (0.70)(0.232) = 17.5%. The value of SEOs assets for Sounds Good is then PV =
5,404 1.175

4,311 (1.175)2

2,173 (1.175)3

2,336 (1.175)4

2,536 1 0.1750.03 (1.175)4

= 19, 462.

18