Week 7 Flashcards

1
Q

What is the APV approach?

A

The adjusted present value approach (APV).
This incorporates financing aspects into capital budgeting, and is essentially the value of a project to an unlevered firm (NPV_All equity) plus the present value of financing side effects (NPVF).

APV = NPV_all equity + NPVF

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2
Q

What are the four potential side effects of financing in APV?

A

The tax subsidy to debt, the costs of issuing new securities, the costs of financial distress, subsidies to debt financing.

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3
Q

What is a flotation cost?

A

A flotation cost is incurred by a publicly-traded company when it issues securities and incurs expenses as a result.

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4
Q

What is the net present value of a loan under APV?

A

The net present value of a loan is the amount borrowed - the present value of after tax interest payments - the present value of the principal repayment. This is the same as the present value of the interest tax shield.

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5
Q

How do we treat flotation costs under the adjusted present value approach?

A

Under the adjusted present value approach the net present value of a flotation cost is given by the flotation cost + the present value of the resulting tax shield. The tax shield comes from the amortization of the flotation costs over the life of the loan.

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6
Q

What do subsidies to debt financing mean for the value of a project?

A

Subsidies to debt financing occur when the firm can borrow at a rate lower than the market, in these cases the project will have a higher net present value as a result of a lower discount rate.

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7
Q

How does the flow to equity approach work? What are the three steps?

A

The flow to equity approach discounts the cash flow form the project to the equity holders of the levered firm at the cost of levered equity capital, R_S.

The three steps are:

  1. Calculate the levered cash flows.
  2. Calculate the cost of levered equity capital R_S.
  3. Value the levered cash flows at R_S.
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8
Q

What do the adjusted present value, WACC, and flow to equity approach both act to do?

A

The APV, FTE, and WACC approaches all act as a way to evaluate investment decisions in the presence of debt financing.

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9
Q

How do we calculate the levered cash flows to equity?

A

Take the unlevered cash flows and remove the financing costs, e.g interest or principal repayments.

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10
Q

How does the WACC method work?

A

The WACC represents the discount rate applicable to all capital providers, so it reflects the cost of debt and the effect of debt on the cost of equity.

We simply discount the unlevered cash flows (so cash flows before financing costs), at the WACC.

The WACC is calculated as (The proportion of equity * the cost of levered equity R_S) + (The proportion of debt * the cost of debt*(1- corporate tax rate)).

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11
Q

Will the adjusted present value and cash flow to equity method give the same result?

A

No, the adjusted present value and cash flows to equity approached can give different net present value results, but they will be the same sign.

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12
Q

When should we use WACC, flow to equity, or the APV methods?

A

We should use the WACC or flow to equity approaches if the firm’s target debt-to-value ratio applies to the project of the life of the project(constant), we should use the adjusted present value approach if the project’s level of debt is known over the life of the project. In the real world the WACC is the most widely used.

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13
Q

What are the initial investment, cash flows, discount rates, and present value of financing effects used in APV, WACC, and FTE?

A

In the adjusted present value approach the all the initial investment is used, the cash flows are unlevered, the discount rate is the unlevered cost of equity, and it considered the present value of financing effects.

The WACC considers all the initial investment, uses unlevered cash flows, uses the WACC discount rate, and does not consider the present value of financing effects.

The flow to equity approach only considered the equity portion of the initial investment, uses levered cash flows, uses the levered cost of equity as the discount rate, and doesn’t consider the present value of financing effects.

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14
Q

What is a scale-enhancing project? Why are they easy to work with?

A

A scale enhancing project is one where the project is similar to those of the firm’s existing assets. For these we can use the APV, WACC, or FTE to get a good discount rate.

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15
Q

What can we do if we have a non-scale-enhancing project with regards to discount rate?

A

For non-scale-enhancing projects (projects in different activities or industries to normal) there are no exact formulas, so we must select a higher than normal discount rate for firms in that industry, or identify a pure-play.

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16
Q

What is a pure-play? Why can it be useful for non-scale-enhancing projects?

A

A pure-play firm is a single segment business, or as close as possible, if this pure-play is listed, its beta coefficient can be used as a proxy for project risk, but needs to be adjusted for the leverage differences.

17
Q

What are some other terms for beta of assets? What about for beta of (levered) equity?

A

Beta of assets: Beta_unlevered, or beta_assets, or beta_0.

Beta of (levered) equity: beta_equity or beta_S.

18
Q

What is the relationship between beta_asset and beta_equity in a world with riskless corporate debt and no corporate taxes?

A

Beta_asset = (equity/asset) * beta_equity.

This occurs as a result of beta_debt being 0.

19
Q

What is the relationship between beta_asset and beta_equity in a world with risky corporate debt but no corporate taxes?

A

Beta_asset = (debt/asset)*beta_debt + (equity/asset) * beta_equity).

20
Q

What is the relationship between beta_asset and beta_equity in a world with riskless corporate debt and corporate taxes?

A

beta_equity = (1+(debt/equity)(1-corporate tax rate))beta_unlevered firm).

As a result of this, beta_equity must be higher than beta_unlevered firm when debt is riskless and there are corporate taxes

21
Q

What is the relationship between beta_equity and beta_unlevered-firm in a world with corporate taxes and risky debt?

A

Beta_equity = beta_unlevered-firm + (1-corporate tax rate)*(beta_unlevered firm - beta_debt) * (debt/equity)

22
Q

What should a firm in industry A do when considering a non-scale-enhancing project in Industry B?

A
  1. Select a comparison firm (pure play) in industry B.
  2. Un-lever (de-lever) the pure play’s beta_equity to get beta_unlevered for the pure play, using the debt ratio of the pure play.
  3. Re-lever the beta unlevered identifies to get the beta_equity for the project, using the debt ratio of the project firm.
  4. Use CAPM to determine the cost of levered equity for the project.

Or, they could use the pure play’s beta equity and CAPM to get its levered cost of equity, then Solve for the pure play’s unlevered cost of equity using its debt ratio, then use the pure play’s unlevered cost of equity and the debt ratio of the project firm to solve for the project’s levered cost of equity.