Study notes

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Paper F3 Financial Strategy

If your company is considering an investment project in a completely new industry to it, beware of using its current WACC to discount the post-tax operating cash flows of that project By Andrew Howarth Content specialist at Kaplan Publishing and a marker for paper F3
expected return on an average market portfolio is 15 per cent. Corporation tax is set at 30 per cent. Lets consider three project evaluation methods: using the current WACC as a discount rate; using an adjusted WACC as a discount rate; and using the adjusted present value (APV) approach.

1 The current WACC as a discount rate

Xs current WACC is: [kd x 0.8] + [kd(1 t) x 0.2] = [(10% + 1.8{15% 10%}) x 0.8] + [(10%{1 0.3}) x 0.2] = 16.6%. But wed be wrong to use this to discount the post-tax operating cash flows of the project. The first reason is that the current WACC is based on Xs existing business risk: that of the food industry. The plastics project entails a different risk, so it should be evaluated at an appropriate discount rate. Second, the capital structure associated with the plastics division differs from Xs existing capital structure, so the weightings used in this calculation arent relevant to the new project. With regard to business risk, we need to derive a suitable cost of equity for the project based on shareholders expectations of the new risk of the plastics project. Since no beta factor yet exists for this, lets use a proxy figure based on the plastics industry to approximate the risk and hence (using the capital asset pricing model) the adjusted cost of equity of the new project. The given plastics industry beta is geared, so we first need to degear this in order to remove the impact of industry-average gearing. The ungeared beta (u) can be expressed as the geared beta (g) x [VE (VE + VD{1 t})]. Putting the figures into the equation, we obtain 1.368 x [5 (5 + 1{1 0.3})] = 1.2 as the ungeared beta for the plastics industry. With regard to capital structure, the assumption is that the new project represents the formation of a new division whose future capital structure will be 40 per cent debt and 60 per cent equity (in common with the initial financing of the project). In this case there are two options: l The ungeared beta we have calculated can be regeared to this new level of capital structure and used to find an adjusted WACC for discounting (see method 2, next page). l The adjusted present value (APV) method can be applied, whereby the ungeared beta is used to find an ungeared cost of equity, which is

inancial managers have traditionally appraised new investment projects by discounting the after-tax cash flows to present value at an entitys weightedaverage cost of capital (WACC). The formula for calculating it is as follows: WACC = ke[VE (VE + VD)] + kd(1 t)[VD (VE + VD)]. This formula shows that an entitys existing WACC reflects its current capital structure, represented by VE and VD, and level of business risk, reflected in the shareholders required rate of return (ke). The entitys existing WACC is appropriate for use as a discount rate only if the business risk and capital structure associated with the new investment are likely to remain the same as before. Lets work through the following example, which will show the options available when an entitys business risk and capital structure change. A US firm called X is looking to diversify its operations away from its main business (manufacturing food) by setting up a plastics division. Its first potential project entails buying a moulding machine for $100,000. This is expected to produce net post-tax annual operating cash flows of $15,000 into perpetuity. The projects assets will support debt finance of 40 per cent of its initial cost. The loan will be irredeemable and carry an annual interest rate of 10 per cent. The balance of finance will come from a placing of new equity (assume that no issue costs will be associated with this). The plastics industry has an average geared (equity) beta of 1.368 and a debt-to-equity ratio of 1:5 by market values. Xs current geared (equity) beta is 1.8, and 20 per cent of its long-term capital is represented by debt thats generally seen as riskfree. The risk-free rate is 10 per cent a year and the

Using the adjusted present value method means that less recalculation is required if assumptions about capital structure change

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Study notes

Paper F3 Financial Strategy

used for discounting the project cash flows before the impacts of financing are tackled separately (see method 3). Both the adjusted WACC method and the APV approach do not deal with the increased financial risk that comes with increasing gearing this accurately reflects the risk associated with the debt cash flows and hence the tax relief. The debt interest is: 10% x (40% x $100,000) = $4,000 a year. So the tax relief is: $4,000 x 30% = $1,200 a year. The present value of tax relief at 10% is therefore: $1,200 0.10 = $12,000. The plastics projects APV is the sum of the basecase NPV and the tax shield. In this case its: $12,000 $6,250 = $5,750. Methods two and three give different results for the project appraisal: $6,534 and $5,750 respectively. This is because the amount of debt in the APV calculation ($40,000) represents 40 per cent of the initial investment, while the risk-adjusted WACC calculation also incorporates the tax benefit on the additional debt capacity generated by the projects positive NPV. If the APV calculation had used this higher level of debt capacity, the two methods would have given the same answer. The risk-adjusted WACC method has the following relative advantages: l The concept is easier to understand. l It requires the calculation of a single hurdle rate, which can be used for different projects and to compare with other businesses. The APV method has the following advantages: l It can handle other financing side-effects, such as subsidies on loans, in a more transparent way. l Using APV means that less recalculation is required if assumptions about capital structure change. The base-case NPV is calculated independently of any financing issues. But both methods share two limitations: l They do not deal with the increased financial risk that comes with increasing gearing. Adjusting the beta for gearing simply recognises the impact of the change in capital structure on the cost of capital (because of the tax shield on debt). It does not deal with the U-shaped graph of WACC under the traditional view of gearing that is more applicable in the real world. l They assume that cost of capital stays constant into perpetuity, whereas in practice the various input components may well fluctuate. Despite these limitations, both methods can be used to give a useful insight into the viability or otherwise of a potential investment project. As long as we bear these in mind, we can ensure that any marginal projects are also evaluated using other methods before a final decision is made.

2 An adjusted WACC as a discount rate

First we need to regear the ungeared beta (1.2) to reflect the 40 per cent debt to 60 per cent equity gearing ratio associated with the plastics project: g = 1.2 [0.6 (0.6 + 0.4{1 0.30})] = 1.76. Now we can use the capital asset pricing model to derive a risk-adjusted cost of equity, which can be inserted into the WACC formula along with the new 40:60 capital structure level to give a riskadjusted WACC for discounting. With a cost of equity of: 10% + 1.76(15% 10%) = 18.8%, the WACC for the new project is: [(VE {VE + VD}) x 18.8%] + [(VD {VE + VD}) x 10%(1 t)] = 14.08%. The new projects net present value (NPV) at a WACC of 14.08 per cent, therefore, would be: [$15,000 0.1408] $100,000 = $6,534. Note that, when discounting the project flows using the WACC, you need to use the post-tax cash flows before financing charges. This is because financing charges are incorporated in the calculation of WACC, so deducting them as part of the cash flows would mean double-counting their impact.

3 The adjusted present value approach

Adjusted present value (APV) is known as a divide and conquer approach. To follow it, we first evaluate the project as if an all-equity company were considering it, so we ignore financing side-effects such as the tax shield on debt. This gives us the so-called base-case NPV. The second step is to find the present value of the financing side-effects and add this to the base-case NPV. The resulting figure is the APV, which shows the net effect on shareholder wealth of accepting the project. So for X we first compute a suitable (ungeared) cost of equity for the new project, based on the ungeared beta (1.2) we calculated previously: required return of project = 10% + [1.2 x (15% 10%)] = 16% a year. Then we discount the project cash flows at this figure to give a base-case NPV as follows: [$15,000 0.16] $100,000 = -$6,250. The next step is to calculate the financing sideeffects. In Xs case they comprise the tax relief on the debt interest. The present value of this element needs to be computed as follows, using the pre-tax cost of debt (10 per cent) as a discount rate, because

Further reading J Ogilvie, Financial Strategy CIMA Official Learning System, CIMA Publishing, 2009.