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d) JBC could adopt a constant dividend payout percentage. Annual earnings would be
multiplied by this percentage to identify total cash dividends for the year. Per-share
dividends would be this total amount divided by the number of shares outstanding.
Under this policy, per-share dividends fluctuate from year to year, with earnings.
Shareholders do not have the stable cash flows they receive under the current
constant-dollar dividend policy.
JBC could also adopt a residual dividend payout policy. Dividends would then be
paid only after all positive NPV projects had been undertaken. That is, only residual
funds are paid out and the rest is retained in the firm for reinvestment. Under this policy, annual dividends fluctuate with annual investment opportunities, with given levels
of earnings. Again, shareholders are unlikely to have the stability of dividends that they
enjoy under the current policy.
CHAPTER SIX
Qualitative Questions
Question 1
■
■
■
■
Sponsors guarantee that the project will be completed on time and will meet certain
specifications or quality tests.
Sponsors guarantee the supply of raw materials to the project during or after completion.
Sponsors guarantee purchasing part or all of the output from or services of a project.
Sponsors effectively guarantee the project against default.
Question 2
■
■
■
Calculate the cash flows obtained from the project assuming the project will be financed
with all equity (unlevered project).
Determine the cost of capital assuming an all-equity firm.
Discount the unlevered cash flows by the unlevered cost of equity.
Question 3
■
■
■
■
■
■
Calculate the base-case NPV (all equity).
Calculate the incremental cash flows obtained if the firm uses a source other than equity
to finance the project.
Determine the after-tax cost of debt for the firm.
Determine the interest tax shield.
Discount the present value of incremental cash flows at the after-tax cost of debt.
Add the present value of the finance-related benefits and costs to present value from the
base-case NPV.
Question 4
■
■
■
■
Leasing uses up the firm’s debt capacity in the same manner as debt.
Lease payments magnify the variability of the net cash flows to shareholders.
Leasing allows the lessee to avoid the investment outlays that would be required to
purchase.
Leasing requires periodic cash outflows similar to those required to service debt.
Question 5
■
■
■
The entire periodic lease payment can be claimed as a tax-deductible expense.
Lessees cannot claim capital cost allowances on the leased equipment.
The lessee loses the advantages derived from the asset’s residual value.
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Question 6
■
■
■
■
■
Identify the costs and benefits of leasing as opposed to those of borrowing to buy.
Discount the incremental costs and benefits of leasing at the after-tax cost of debt or a
higher rate, depending on risk.
Identify an equivalent loan that exactly commits the firm to the same cash outflows that
the lease would.
Leasing is preferable to borrowing if the amount of the equivalent loan is less than the
initial investment outlay saved under the lease.
A positive net present value of leasing means the firm should lease rather than borrow
to buy.
Question 7
■
■
■
■
In the case of an operating lease, the lessor is entitled to claim capital cost allowance for
the equipment.
The leased equipment provides more security than a mortgage, enabling risky customers
to qualify for leasing.
Costs of leasing may be lower than borrowing.
Leasing may allow a company to finance the acquisition of equipment in spite of restrictive
covenants included in the firm’s loan agreements or bond indentures.
Question 8
■
■
■
■
The production cost per unit decreases, allowing the firm to decrease its price.
A firm may acquire component manufacturers that cannot afford to invest in technological
improvements.
Creditors are more willing to lend to bigger companies than to medium or small ones.
The cost per dollar of new funds decreases with the size of the issue, as some costs
are fixed.
Question 9
■
■
■
■
Identify cases in which acquired companies or assets are similar to the target firm or
assets.
Calculate ratios based on the offer price.
Determine for each ratio the lowest and highest value it took during past mergers.
Identify an offer price that falls within the common range.
Question 10
■
■
■
■
■
Buyers commit very little capital and borrow the balance.
The target company’s assets serve as security for the loans taken out by the acquiring firm.
Buyers hope to achieve quick improvement in operations and higher residual cash
flows.
High leverage enables the owners, if successful, to gain substantial wealth from improving
the operating performance of their firms.
If the owners are unsuccessful in improving operating performance, the LBO will have
difficulty servicing its debt and may go bankrupt.
Question 11
■
■
■
■
56
LBOs require very little capital and large amounts of debt by pledging the acquired
company’s assets as collateral.
Senior debt is provided by financial institutions.
Subordinated debt is provided by life insurance companies or by special funds, such as
pension plans.
Preferred shares are used when a firm exhausts its ability to use interest tax shields.
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Qualitative Multiple Choice Questions
Question 1
i) A firm that uses well-known, mature production technology
Question 2
i) The main disadvantage of the APV method is that it discounts the cash flows that will
be used to pay debtholders at the rate required on the unlevered firm’s equity.
Question 3
i) Vertical mergers are attractive if the activity is complex and difficult to define under
conventional legal contracts.
Question 4
iii) The WACC method assumes that the debt-to-equity ratio will be constant over time.
Question 5
i) A horizontal merger
Question 6
iv) Diversification
Question 7
iii) Some leases require the lessor to handle all maintenance and servicing.
Question 8
i) Operating leases enable the lessor to claim the investment tax credits and tax deductions associated with ownership.
Question 9
i) Creating a class of shares with superior voting powers, such as 10 votes per share
Quantitative Multiple Choice Questions
Question 1
i) The appropriate discount rate is the after-tax cost of debt = 6%(1 - 0.35) = 3.9%.
Question 2
iv) $70,000 × [1 + PVIFA(15%, 4 years)] - $70,000(0.35) × PVIFA(15%, 5 years)
This includes the annuity due of payments, which start immediately at the beginning of each
period, less the tax shields on these payments, which do not occur until the end of each period.
Question 3
iii)
D
b L = b U + (1 - T )a b b U
E
1.35 = b U + (1 - 0.4) a
bU =
0.5
b b = 1.6b U
0.5 U
1.35
= 0.84375
1.6
b Lnew = 0.84375 + (0.6)a
0.33
b (0.84375) = 1.093
0.67
Required return on the new project, using CAPM = 0.04
+ 1.093(0.11 - 0.04)
= 11.7%
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Quantitative Problems
Problem 1
a) Analysis of investment proposal:
APV
Initial investment
$ (10,000,000)
If the project is financed with all equity, the PV
of the operating cash flows is:
(revenues - variable costs)
(1 - tax rate) × PVIFA (15%, 15 years)
= (4,000,000 - 2,500,000)(1 - 0.4)(5.847)
= $900,000(5.847)
5,262,300
PV of CCA tax shields:
{8,500,000(0.2) (0.4) / [2(0.2 + 0.15)]}
× (2.15/1.15)
= 971,429(1.87)
1,816,572
PV of operating cost subsidies after tax:
250,000(1 - 0.4) × PVIFA(6% (1 - 0.4), 15 years)
= 150,000 × PVIFA(3.6%, 15 years)
= 150,000(11.436)
1,715,400
PV of flotation costs, after tax:
350,000 - 350,000
(0.4)
* PVIFA(3.6%,5 years)
5
(223,944)
= 350,000 - 28,000 * 4.502 = 350,000 - 126,056
PV of interest tax shields:
5,000,000(0.06)(0.4) × PVIFA(3.6%, 15 years)
120,000(11.436)
1,372,320
PV of expected salvage value for land and building:
1,500,000 × PVIF(3.6%, 15 years) = 1,500,000(0.588)
APV
882,000
$
824,648
As the APV is positive, the investment proposal should be accepted.
b) The tax deductibility of interest is accounted for differently in the APV and WACC capital
budgeting methods. In the APV method, the present value of the interest tax shield is added
to the base-case NPV. When calculating NPV under the WACC method, the tax deductibility of interest expense is accounted for by averaging the cost of equity and the after-tax cost
of debt to obtain the WACC. That is, the cost of debt is calculated on an after-tax basis.
Problem 2
This question involves an adjusted present value (APV) analysis of an investment proposal that
has financing side effects.
a) The cost of equity for SIGMA without the plant expansion is calculated using the unlevered beta and the capital asset pricing model:
Cost of equity = 6% + 1.1(10% - 6%) = 10.4%
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The plant expansion proposal involves a change in capital structure, including debt financing. The levered beta will be:
1.1 + (1 - 0.35) a
25
b (1.1) = 1.1 + 0.24 = 1.34
75
So the cost of equity, if the plant expansion proposal is accepted, will be:
6% + 1.34(10% - 6%) = 11.4%
b) Without the plant expansion, SIGMA is 100% equity financed, so the weighted average
cost of capital equals the unlevered cost of equity for SIGMA, or 10.4%.
With the plant expansion, SIGMA is financed 25% with debt and 75% with equity. The
weighted average cost of capital is:
WACC = 0.25(7.5%)(1 - 0.35) + 0.75(11.4%) = 9.8%
The rate with the plant expansion is lower than the unlevered cost of equity. This is a result
of the after-tax cost of debt financing.
c)
d)
Note that the market rate of interest and the levered cost of equity are used in this calculation.
Reasons that APV is more appropriate than NPV in this case are:
■ The project qualifies for a subsidized loan.
■ The project has a different capital structure than the firm as a whole.
■ The project has partial debt financing, which provides SIGMA with interest tax
shields.
Base-case NPV is calculated using the unlevered cost of equity as the discount rate:
Investment outlay = $600,000
PV of incremental operating revenues = 120,000(1 - 0.35) × PVIFA(10.4%, 7 years)
= 78,000(4.80496)
= $374,787
PV of CCA tax shields =
2.104
$600,000(0.2)(0.35)
*
2(0.2 + 0.104)
1.104
= 69,079(1.90579)
= $131,650
Base-case NPV = $(600,000) + 374,787 + 131,650
= $(93,563)
e)
For APV, add the PV of the two side effects, using the after-tax cost of debt at the market rate for SIGMA as the discount rate 7.5%(1 - 0.35) = 4.875%.
PV subsidy = 2.5%(600,000)(1 - 0.35) × PVIFA(4.875%, 7 years)
= $56,673
PV interest tax shield = 5%(600,000)(0.35) × PVIFA(4.875%, 7 years) = $61,033
PV side effects = 56,673 + 61,033 = $117,706
APV = base-case NPV + PV side effects = $(93,549) + 117,706
= $24,157
The APV is positive so the project is acceptable.
Problem 3
The equity residual method is to be used to assess the investment project proposal. Under
this method, the cash flows from operations are those that can be distributed to shareholders after paying interest, taxes, and principal payments on the debt.
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Background Calculations:
Debt financing at start of project = (0.75) ($15,000,000) = $11,250,000
Debt principal repaid at end of each year =
$11,250,000
= $2,812,500
4
Schedule of debt payments—annual interest and principal repayments:
Year
Interest
Interest + principal
repaid
Remaining
principal
1
0.06(11,250,000) = $675,000
$3,487,500
$8,437,500
2
0.06(8,437,500) = 506,250
3,318,750
5,625,000
3
0.06(5,625,000) = 337,500
3,150,000
2,812,500
4
0.06(2,812,500) = 168,750
2,981,250
0
NPV Calculations:
Present value of operating earnings, discounted at levered cost of equity of 16%:
(7,000,000 - 1,220,000) × (0.5) × PVIFA(16%, 4 years)
= $2,890,000(2.7982) = $8,086,798
Present value of principal payments to debt holders:
2,812,500 × PVIFA(16%, 4 years)
= 2,812,500(2.7982) = $7,869,938
Present value of interest payments, after tax:
Year
Interest
Interest, after tax
PV factor
PV
1
$675,000
$337,500
0.8621
$290,959
2
506,250
253,125
0.7432
188,123
3
337,500
168,750
0.6407
108,118
4
168,750
84,375
0.5523
46,600
Total PV = $633,800
Present value of CCA tax shields:
$15,000,000 e
(0.3)(0.5)
2.16
fc
d
[2(0.3 + 0.16) 1.16
= $2,445,652(1.86207) = $4,553,975
Present value of CCA tax shields lost on salvage:
[$2,500,000 × PVIF(16%, 4 years)] c
(0.3)(0.5)
d
(0.3 + 0.16)
= $2,500,000(0.5523)(0.32609) = $450,249
Present value of salvage value:
$2,500,000 × PVIF(16%, 4 years)
= $2,500,000(0.5523) = $1,380,750
NPV = -15,000,000 + 11,250,000 + 8,086,798 - 7,869,938 - 633,800
+ 4,553,975 - 450,249 + 1,380,750 = 1,317,536
The NPV is positive. This project should be undertaken.
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Problem 4
a) NVL = initial investment outlay - equivalent loan
Equivalent loan = PV(after-tax lease payments) - PV(operating costs) + PV(CCA tax
shields) + PV(salvage value)
Discount rate = 10%(1 - 40%) = 6%
Because the series of lease payments occur at the beginning of the year, the present value
of the annuity due is calculated as follows:
$28,000 × PVIFA(6%, 10 years) × 1.06 = $218,447
The tax shield due to the lease payment each year:
$28,000 × 0.40 = $11,200
The present value of the tax shield due to lease payments at the after-tax cost of debt:
$11,200 × PVIFA(6%, 10 years) = $82,433
The present value of the lease payments
on an after-tax basis:
$218,447 - $82,433
$136,014
The present value of after-tax operating costs for
the owning alternative:
$1,000(1 - 40%) × PVIFA(6%, 10 years)
(4,416)
The present value of CCA tax shield available on
purchase of the asset:
200,000(30%)(40%)[1 + 0.5(6%)]
20,000(30%)(40%)
(30% + 6%)(1 + 6%)
(1 + 12%)10(30% + 6%)
62,634
The present value of the salvage value lost by
leasing would be:
$20,000
6,439
(1 + 12%)10
Equivalent loan
$200,671
NVL = $200,000 - $200,671 = $(671) < 0
Since the net value to leasing is negative, LaSalle should not lease the asset.
b) The firm will be indifferent between leasing and buying if NVL = 0.
Initial investment outlay = equivalent loan = PV(after-tax lease payments)
- PV(after-tax operating costs) + PV(CCA tax shields)
+ PV(salvage value)
PV(after-tax lease payments) = initial investment outlay
+ PV(after-tax operating costs)
- PV(CCA tax shields) - PV(salvage value)
= $200,000
+ $4,416 - $62,634 - $6,439
= $135,343
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Let X = pre-tax annual lease payment:
X * PVIFA(6%,10)(1.06) - X (0.4) * PVIFA(6%, 10) = $135,343
X = $27,862
Problem 5
Sudbury Corporation
Analysis of Project Proposals
Evaluating the Project as a Single Project
Unlevered beta for the comparable company:
D
bL = bU + (1 - T ) bU
E
1.2 = bU + (1 - 0.4)
bU =
0.5
b
0.5 U
1.2
= 0.75
1.6
The levered beta for the new project is:
bL = 0.75 + (1 - 30%) a
30%
b (0.75) = 0.975
70%
Using the CAPM, the required rate of return on the new project is:
r = rf + bL(rm - rf) = 5% + (0.975)(10% - 5%) = 9.875%
The expected return on the new project is 11%, which exceeds the risk-adjusted required
rate of return. Therefore, the new project should be accepted on its own merits.
Evaluating the Project in Relation to Our Portfolio
We also need to consider whether adding the new project would increase the risk of our
whole portfolio.
The total risk of the portfolio after adding the new project is:
1/2
7 2
2 2
7 2
s P = c a b (2%)2 + a b (3%)2 + 2 a b a b (0.9)(2%)(3%) d
9
9
9 9
= 2.175%
The expected rate of return on the portfolio after adding the new project is:
a
200,000
700,000
b(10%) + a
b(11%) = 10.22%
900,000
900,000
The coefficient of variation of the portfolio after adding the new project is:
CV =
2.175%
= 0.2128
10.22%
After adding the new project, the degree of risk of the whole portfolio increases
marginally from 0.2 to 0.2128.
Summary
In general, if a firm has a well-diversified portfolio of projects, any new project should
be evaluated on its own merits. In other words, only the market risk of a new project
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represented by beta should be taken into account. However, if a firm is not welldiversified and/or there is a high correlation between the returns from the firm’s existing
portfolio of projects and the new project, as exhibited in this case, the financial manager
should consider the total risk of the portfolio.
Cases
Case 1: Victoria Corp.
a)
This minicase involves integrating material learned in Chapters 1, 2, and 6. This capital
budgeting problem involves more than one asset class, CCA effects of salvage value,
various capital budgeting techniques, and also the option of leasing one of the two assets
under consideration.
PV of costs of purchasing and operating Brand X equipment:
Initial outlay = $700,000
Annual operating and maintenance costs = $35,000 per year for 4 years
Salvage value = $100,000
PV = 700 + 35 × 0.55 × PVIFA(12%, 4) - 100 × PVIF(12%, 4) - PV(CCA tax shields)
= 700 + 35 × (0.55)(3.0373) - 100(0.6355) - PV(CCA tax shields)
= 700 + 58.47 - 63.55 - PV(CCA tax shields)
= 694.92 - PV of CCA tax shields
The pool continues to have assets and a positive balance after salvage, so salvage value is
deducted from costs and remaining CCA tax shields forgone are added to costs, as follows:
= 694.92 -
(0.45)
700(0.2)(0.45) 2.12
a
b + 100 * PVIF(4,12%)(0.2)
[2(0.2 + 0.12)] 1.12
(0.2 + 0.12)
= 694.92 -
63
* 1.893 + 100(0.6355)(0.28125) = 694.92 - 186.3 + 17.9
0.64
= $526,520
PV of costs of purchasing and operating Brand Y equipment:
PV = 550 + 52(0.55) × PVIFA(12%, 4) - 80 × PVIF(12%, 4) - PV(CCA tax shields)
= 550 + 52(0.55)(3.0373) - 80(0.6355) - PV(CCA tax shields)
= 550 + 86.87 - 50.8 - PV(CCA tax shields)
= 586.07 - PV(CCA tax shields)
Since the pool has no other assets in this class, depreciation must be calculated for this
individual asset each year, and then salvage value must be compared with UCC at time of
salvage to determine residual tax effects. The detailed calculations shown here were not
required for marks.
CCA for Brand Y equipment:
In year 1, =
0.25
(550,000) = $68,750
2
In year 2, = 0.25(550,000 - 68,750) = 0.25(481,250) = $120,313
In year 3, = 0.25(481,250 - 120,313) = 0.25(360,938) = $90,234
In year 4, would be 0.25(360,938 - 90,234) = 0.25(270,704) = $67,676
UCC at time of salvage would be $203,028 but the actual salvage value is only $80,000.
There is a terminal loss of $203,028 - $80,000 = $123,028.
PV(costs) = 586.07 - 68.750(0.45) × PVIF(12%, 1) - 120.313
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(0.45) × PVIF(12%, 2) - 90.234(0.45) × PVIF(12%, 3) - 67.7(0.45)
× PVIF(12%, 4) - 123.0(0.45) × PVIF(12%, 4)
PV(costs) = 586.07 - 30.9(0.8929) - 54.1(0.7972)
- 40.6(0.7118) - 30.5(0.6355) - 55.4(0.6355)
PV(costs) = 586.07 - 27.6 - 43.1 - 28.9 - 19.4 - 35.2 = 431.87
The present value of costs for Brand X is higher than for Brand Y. Brand Y should be
selected. The present value of CCA tax shields would have to exceed 586.07 - 526.52 =
$59.55 for Y to have lower costs than X.
b) If there is a leasing alternative for Brand Y, its costs must be calculated and compared with
the purchase cost for Brand Y.
PV of costs of leasing include lease payments, after-tax, plus annual operating costs, aftertax. There are no maintenance costs as these are included in the lease payment. There are
no salvage value or CCA effects as these are captured by the owner of the asset.
PV(leasing costs) = $347 × [1 + PVIFA(12%, 3)]
- 0.45(347) × PVIFA(12%, 4) + 40(1 - 0.45)
× PVIFA(12%, 4)
= 347(1 + 2.4018) - 156(3.0373) + 22(3.0373)
= 1,180.4 - 473.8 + 66.8 = 773.4 or $773,400
The Brand Y equipment is the most expensive under the leasing alternative. Leasing Y
costs more than buying either X or Y.
Brand Y should be selected and the equipment should be purchased. The leasing alternative did not change the decision.
Case 2: Saskatoon Industries
a)
b)
A firm has decided to acquire a major piece of equipment and must now decide whether
to purchase or lease it. The problem involves an investment tax credit, an uncertain salvage value, and differences in who bears the costs of maintenance and insurance under
the two financing alternatives.
WACC = 0.5(7%)(1 - 0.4) + 0.5(14%) = 2.1 + 7 = 9.1%
■ The after-tax cost of debt is 7%(1 - 0.4) = 4.2%.
■ The required return on equity is 14%.
■ The firm is financed 50/50 with debt and equity and is assumed to stay this way.
There will be two discount rates used in the analysis.
Certain items, like contractual debt or lease payments and their tax shields, will be discounted at the after-tax cost of debt of 4.2%.
c)
Uncertain items, in this case the salvage value, will be discounted at the weighted-average cost
of capital of 9.1%. This rate will be used both to take the present value of the salvage value,
and to calculate the impact on the CCA tax shields of salvaging the asset for this amount.
The net value to leasing has several components, as follows:
Initial investment outlay = purchase price - investment tax credit
= 0.95(purchase price) = 0.95($690,000) = $655,500
Equivalent loan = PV(lease payments)
- PV(tax shields on lease payments)
- PV(maintenance and insurance costs saved, after tax)
+ PV(CCA tax shields if buying the asset and keeping
it indefinitely)
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- PV(CCA tax shields lost on salvage)
+ PV(expected salvage value)
+ PV(investment tax credits lost under the lease option)
+ PV(lease payments)
= $200,000[1 + PVIFA(4.2%, 4 years)] = $200,000(1 + 3.613)
$922,600
- PV(tax shields on lease payments)
= 0.4($200,000) × PVIFA(4.2%, 5 years) = $80,000(4.427)
(354,160)
- PV(maintenance and insurance costs saved, after tax)
= $40,000(1 - 0.4) × PVIFA(4.2%, 5 years) = $24,000(4.427)
+ PV(CCA tax shields if buying the asset and keeping it
$655,500(0.2)(0.4) 2.042
da
b
indefinitely) = c
2(0.2 + 0.042)
1.042
(106,248)
212,327
- PV(CCA tax shields lost due to salvage)
= $200,000 * PVIF(9.1%, 5 years) * c
(0.2)(0.4)
d
(0.2 + 0.042)
= $200,000(0.647)(0.331)
(42,831)
+ PV(expected salvage value) = $200,000(0.647)
129,400
+ PV(lost investment tax credits) = 0.05($690,000)
34,500
Equivalent loan
$795,588
Net value to leasing = initial outlay - equivalent loan
= $690,000 - 795,588 = $(105,588)
d) A summary should include:
■
■
■
■
description of project under consideration
explanation of type of analysis that was conducted (NVL)
summary of numerical results
explanation of results and implication for the decision
The conclusion is that the lease alternative displaces $795,588 of conventional debt, so it
is too costly. The borrowing to purchase alternative is less expensive.
It is recommended that the firm finance its equipment acquisition by borrowing.
Case 3: East Travel Ltd.
a) Jane should buy ET shares on January 16, 2007, the dividend-on date.
b) ET should take the following factors into account when it determines how much cash to
c)
pay out as dividends:
■ Investment requirement: ET should put aside sufficient cash to invest in new projects.
■ Signalling effect: ET should set the cash dividend at a level that can be supported by
its expected future earnings so that it won’t send a negative message by cutting cash
dividend in the future.
■ Clientele effect: ET should review the composition of its shareholders and whether its
different shareholders would prefer cash dividend or capital gain due to their tax profile.
■ Legal restrictions may be imposed by legislative authorities.
■ Investors may impose restrictive constraints in the form of protective covenants
included in debt and preferred share contracts.
Share repurchase from the market may be the most appropriate substitute for cash dividends in this particular situation.
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From the perspective of the company, ET’s share price must have been depressed as its
industry was in a downturn. Now is a good time to repurchase the shares to provide support for the share price.
d)
e)
From the perspective of the shareholders, a share repurchase gives them greater tax efficiency:
with cash dividends, they have to pay tax, now at a higher tax rate than that for capital gains;
with a share repurchase, they are taxed only if they sell their shares and realize a capital gain.
This is an example of horizontal merger.
Any two of the following:
■ Operating economies of scale and/or scope to lower operating costs
■ Strategic motives to eliminate a competitor
■ Market power and control over pricing policies
■ Faster growth to be a dominant player in the industry
f)
Solution Case Exhibit 6-1
Ranges of Possible Offer Prices for WT Shares
Minimum
Level of
item considered
Share price
Maximum
Prior
WT item
Offer
ratio
Prior
price
Offer
ratio
Price
$35
20.00%
$42.00
45.00%
$50.75
Earnings per share
5
9.50
47.50
20.00
100.00
Cash flow per share
6
7.50
45.00
12.50
75.00
Book value per share
25
1.95
48.75
3.00
75.00
Replacement cost per share
30
1.35
40.50
2.00
60.00
A reasonable range of share price should be $48.75 to $50.75.
Case 4: Asian Auto Co.
a) The adjusted present value (APV) method separates the cash flows of a project into two
b)
sets. The first set contains the cash flows that would be obtained from the project if it were
unlevered; that is, financed with all equity. The second set contains the incremental cash
flows that would be obtained if the firm were to use a source of funds other than equity
to finance the project. Each cash flow is discounted at a rate that reflects its inherent risk.
The traditional weighted average cost of capital method is used to incorporate the
finance-related effects into investment analysis.
The equity residual method is a valuation method that first determines the cash flows
that can be distributed to shareholders after paying operating costs, financing costs, and
debt repayments, and then calculates the present value of these cash flows by discounting at the cost of equity.
In this particular case, at the beginning, AA will finance the project with equity, and this
excludes the weighted average cost of capital method. Then the government financial incentives play an important role in AA’s decision to locate the assembly in Ontario. Only the adjusted
present value method can determine the value of the government financial incentives.
The discount rate should be the rate of return required by shareholders; that is, the cost
of equity, as AA will use equity capital to finance this project.
We apply the CAPM model to estimate the cost of equity based on the information in
the problem. In the following equation:
E(R) = Rf + b [E(RM) - Rf] = 4% + b (5%)
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b is unknown and calculated as follows:
From the industry leveraged bL = 1.2857, we get the industry unleveraged bU:
bU =
bL
1.2857
D
1 + (1 - T )a b
E
=
50%
1 + (1 - 50%) a
b
50%
= 0.8571
Applying AA’s debt ratio and tax rate to the industry unleveraged bU, we get AA’s leveraged bL:
D
40%
b = 1.2
b L = b U + (1 - T )a b b U = 0.8571 + 0.8571(1 - 40%) a
E
60%
The discount rate = 4% + (1.2)(5%) = 10%.
The initial investment for the U.S. location is just the cost of equipment; that is,
$800 million. For the Ontario location, there is additional investment in a building; thus,
the total initial investment will be $800 million + $200 million = $1,000 million.
The annual after-tax operating income (cash flow) = 100,000($30,000)(6%) =
$180 million for the U.S. location. The present value of the 10-year after-tax operating
cash flow = $180 million × PVIFA(10%, 10) = $1,106 million.
For the Ontario location, the annual after-tax operating cash flow =
100,000($30,000)(6.6%) = $198 million. The present value of the 10-year after-tax operating cash flows = $198 million × PVIFA(10%, 10) = $1,216.6 million.
The present value of the CCA tax shields from the equipment over the 10 years equals:
a
$800 million * 40% * 20% 2 + 10%
ba
b = $203.64 million
2(10% + 20%)
1 + 10%
This is also the present value of the total CCA tax shields for the U.S. location. For the
Ontario location, there is also the present value of the CCA tax shields from the building:
a
$200 million * 40% * 4% 2 + 10%
ba
b = $21.82 million
2(10% + 4%)
1 + 10%
The total present value of the CCA tax shields for the Ontario location is:
$203.64 million + $21.82 million = $225.46 million
The net present value of the plant in the U.S. location is:
$1,106 million + $203.64 million - $800 million = $509.64 million
For the plant in the Ontario location:
NPV = $1,216.6 million + $225.46 million - $1,000 million
= $442.06 million
c)
As $509.64 million > $442.06 million, AA should choose the U.S. location.
The after-tax market interest rate 6%(1 - 40%) = 3.6% is used to calculate the present value of the governments’ financial incentives.
The present value of the federal government’s low-interest loan subsidy is:
$100 million - $100 million (4%)(1 - 40%)PVIFA(3.6%, 10)
- $100 million × PVIF(3.6%, 10)
= $100 million - $19.86 million - $70.21 million
= $9.93 million
The present value of the provincial government’s operating subsidies is:
$25 million(1 - 40%) × PVIFA(3.6%, 5) = $67.53 million
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Taking the financial incentives from the governments into account, the NPV of the plant
in the Ontario location will be:
$442.06 million + $9.93 million + $67.53 million = $519.52 million
As $519.52 million > $509.64 million, AA should choose the Ontario location.
CHAPTER SEVEN
Qualitative Questions
1.
2.
What types of interest rate risk may a treasury risk manager face?
■ The risk that interest on a planned investment or loan deviates from the expected rate
■ The risk that realized net income deviates from expected income because of changes
in interest rates
■ The risk that the value of an asset or liability changes adversely because of changes in
interest rates
What other types of risk can a treasury risk manager face?
■ The risk that net income deviates from expected income because of changes in the
prices of key commodities
■ The risk that net income deviates from expected income because of changes in foreign
exchange rates
3.
How is duration used to measure risk?
■ The volatility of a security’s value depends upon the security’s duration.
■ The longer the duration of a security, the more volatile its value will be in response to
changes in interest rates.
■ The duration of a portfolio is a weighted average of the durations of the assets and
liabilities that make up the portfolio.
■ The duration of a portfolio measures the sensitivity of the portfolio’s value to changes
in interest rates.
4.
How is gap analysis used to measure interest-rate risk in financial institutions?
■ Gap analysis attempts to identify gaps between assets and liabilities that expose the
■
■
■
■
5.
institution to interest-rate risk.
An asset is interest rate sensitive if the asset is repriced when rates change.
The gap is equal to rate-sensitive assets less rate-sensitive liabilities.
If the gap is negative, net income decreases if rates rise and increases if rates drop.
The magnitude of the potential decrease or increase in net income is proportional to
the size of the gap.
How are gap analysis and duration calculations used to create basic hedges?
■ Determining the gap between rate-sensitive assets and rate-sensitive liabilities allows
management to create a basic hedge by narrowing the gap.
■ Gap analysis will not eliminate risk because a true matching of asset rates and terms
with liability rates and terms is unlikely.
■ The duration calculation allows management to match asset duration to liability duration.
■ Matching durations is a form of hedging known as portfolio immunization.
6.
What are the general approaches to risk management?
■ The opportunistic approach relies on management to have a superior ability to fore-
cast financial or commodity prices, which will enable the firm to benefit from the
changes.
■ The passive approach ignores risk and relies on the company riding out changes,
assuming that gains or losses will balance out.
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