Lecture 11: Internnational Capital Budgetinng: APV and Cost of Capital

Question 1

Why is APV suited to international capital budgeting?

Answer 1

Due to its flexibility.

• Allows unique feature to be more easily built into the model.
• Allows an analyst to more easily see where the project value comes from.
• Allows for more ready adjustment of different debt levels and nnegotiation for subsidies.

Question 2

What are the 3 main groups of CFs involved in APV?

Answer 2

1. The investment decision CFs discounted at the required rate of returns.
2. Debt financing package - tax saving discounted by required rate of return for debt.
3. Subsidiaries or pennalties recieved from local governments - discounted at requiredd rate of return for debt.

Question 3

How do you find the required rate of return on equity?

Answer 3

It is unobservable but it can be given by CAPM.

*There are 2 problems with this;

1. project betas are rarely observable - solved by finding a comparable firm (C)
2. most projects an firms are financed partly by debt - solvedd by de-levering firrm C’s equity beta

Question 4

What is the 4 step procedure to estimating k*?

Answer 4

1. Find a listed firm (C) that specialise in that kind of project.
2. Estimate Firm C’s equity beta
3. ‘De-lever’ the estimate of Firm C’s equity beta
4. Use the CAPM formula to estimate k*

Question 5

What are the ideal conditions for the first step in calculating k*?

Answer 5

It is ideal that the comparable firm C operates in the same country as the proposed project.

*This is hard to do in practice.

Question 6

What are the ideal conditions in the second step in calculating k* (calculating beta)?

Answer 6

To estimate Firm C’s equity beta it is optimal to use a regression with past data. An issue with this is that the data may not be availible, another issue is that even if the data is readily availible betas are time-period specific (unstable).

Question 7

What are the ideal conditions in the third step in calculating k* (de-levering beta)?

(Explain why it needs to be done and its implications)

Answer 7

Due to most firms having borrowed funds (some assumed level of debt), the effects of this must be recognised on the equity beta.

Borrowing leads to higher financial risk which then leads to a higher required rate of return.

Question 8

How do you de-lever the equity beta of a firm?

Answer 8

Question 9

Why do NPV and APV differ?

Answer 9

They differ because the comparisons were not made on the same basis (they use different WACC).

The APV uses the de-levered beta assuming a linear relationship between leverage and financial risk (proven by MM)