Advanced financial management revision question and answer

CPA-Advanced-Financial-Reporting-Section-6

The managers of Strayer plc are investigating a potential Sh.25 million investment. The investment would be a diversification away from existing mainstream activities and into the printing industry. Sh.6 million of the investment would be financed internal funds, Sh.10 million a rights issue and Sh.9 million long term loans. The investment is expected to generate pre-tax net cash flows of approximately Sh.5 million per year, for a period of ten years. The residual value at the end of year ten is forecast to be Sh.5 million after tax. As the investment is in an area that the government wishes to develop, a subsidized loan of Sh.4 million out of the total Sh.9 million is available. This will cost 2% below the company‟s normal cost of long-term debtfinance, which is 8%.

Strayer‟s equity beta is 0.85, and its financial gearing is 60% equity, 40% debt value. The average equity beta in the printing industry is 1.2, and average gearing 50% equity, 50% debt market value.

The risk free rate is 5.5% per annum and the market return 12% per annum.

Issue costs are estimated to be 1% for debt financing (excluding the subsidized loan), and 4% for equity financing. These costs are not tax allowable.

The corporate tax rate is 30%.

Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed investment

(b) Comment upon the circumstances under which APV might be a better method of evaluating a capital investment than Net Present Value (NPV).
ANSWER
(a) Assuming the risk of companies in the printing industry is similar to that of Strayer‟s new investment, the beta of the printing industry will be used to estimate the discount rate for the base case NPV. Ungearing the beta of the printing industry:


Financing side effects relate to the tax shield on interest payments, the subsidized loan, and issue costs associated with external financing.

Tax relief:
Sh.5 million 8% loan. Interest payable is Sh.400,000 per year, tax relief is Sh.400,000 x 0.3 = Sh.120,000 per year
Sh.4 million subsidized loan. Interest is Sh.240,000 per year, tax relief Sh.72,000 per year. Total annual tax relief Sh.192,000 per year.
The present value of this tax relief, discounted at the risk free rate of 5.5% per year is: Sh.192,000 x 7.541 = Sh.1,447,872
(The tax relief on interest payments allowed government is assumed to be risk free. The mid-point between 5% and 6% in annuity tables is used. N.B. discounting at a rate higher than the risk free rate could be argued, especially if the company might be in a non taxpaying position in some years.)

Subsidy:
The company saves 2% per year on Sh.4,000,000 or Sh.80,000, or Sh.80,000 x (1 – 0.30) = Sh.56,000 after tax.
As this is a government subsidy it is assumed to be risk free and will be discounted at 5.5% per year. Sh.56,000 x 7.541 = Sh.422,296

The adjusted present value is estimated to be:
(Sh.1,562,500) + Sh.1,447,872 + Sh.422,296 – Sh.450,000 = (Sh.142,332)

Based upon these estimates the project is not financially viable.

(b) APV may be a better technique to use than NPV when:
• There is a significant change in capital structure as a result of the investment.
• The investment involves complex tax payments and tax allowances, and/or has periods when taxation is not paid.
• Subsidized loans, grants or issue costs exist.
• Financing side effects exist (e.g. the subsidized loan) which require discounting at a different rate than that applied to the mainstream project.

(Visited 32 times, 1 visits today)
Share this on:

Leave a Reply

Your email address will not be published. Required fields are marked *