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Adjusted Present Value Method of Project Appraisal

The document provides information and examples for calculating a project's adjusted present value (APV). It discusses the APV method and decision rule, and provides three examples of calculating tax relief on debt interest and estimating the APV of projects. It also provides three practice questions asking to calculate the APV of investment projects and determine if they are worthwhile.

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Ahmed Raza
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331 views

Adjusted Present Value Method of Project Appraisal

The document provides information and examples for calculating a project's adjusted present value (APV). It discusses the APV method and decision rule, and provides three examples of calculating tax relief on debt interest and estimating the APV of projects. It also provides three practice questions asking to calculate the APV of investment projects and determine if they are worthwhile.

Uploaded by

Ahmed Raza
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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SMA ADJUSTED PRESENT VALUE (APV)

Adjusted Present Value Method of Project Appraisal

The decision rule for the APV method

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SMA ADJUSTED PRESENT VALUE (APV)

Example I

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SMA ADJUSTED PRESENT VALUE (APV)

Example II

Example III
$400,000 is to be borrowed for 3 years and repaid in equal installments.
The risk free rate is 10% and all debt is assumed to be risk free.

Required
Calculate the present value of the tax relief on the debt interest if the corporation tax
rate is 30%. Assume that tax is delayed 1 year.

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SMA ADJUSTED PRESENT VALUE (APV)

Practice Question
Question # 1

Rounding plc is a company currently engaged in the manufacturing of baby


equipment. It wishes to diversify into the manufacture of snowboards.

The investment details

The company’s equity beta is 1.27 and is current debt to equity ratio is
25:75, however the company’s gearing ratio will charge as a result of the
new project.

Firms involved in snowboard manufacture have an average equity beta of


1.19 and an average debt to equity ratio of 30:70.

The new project will involve the purchase of new machinery for a cost of
$800,000 (net of issue costs), which will produce annual cash inflows of
$450,000 for 3 years. At the end of this time it will have no scrap value.

Corporation tax is payable in the same year at a rate of 33%. The machine
will attract writing down allowances of 25% pa on a reducing balance basis,
with a balancing allowance at the end of the project life when the machine is
scrapped.

The financing detail:

The new investment will be financed as follows:

Debentures (redeemable in three years time)40%


Right issue of equity 60%

The issue costs are 4% on the gross equity issued and 2% on the gross debt
issued.

Required
Estimate the adjusted present value of the project

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SMA ADJUSTED PRESENT VALUE (APV)

Question # 2
Blades plc is considering diversifying its operations away from its main area
of business (food manufacturing) into plastics business. It wishes to evaluate
an investment project, which involves the purchase of a moulding machine
that costs $450,000. The project is expected to produce net annual operating
cash flows of $220,000 for each of the three years of its life. At the end of
this time its scrap value will be zero. The assets of the project will support
debt finance of 40% of the its initial cost (including issue casts).

The loan is to be repaid in three equal annual instalments. The balance of


finance will b provided by a placing of new equity. Issue costs will be 5% of
funds raised for the equity placing and 2% for the loan. Debt issue costs are
allowable for corporation tax.

The plastics industry has an average equity beta of 1.368 and an average
debt:equity ratio of 1:5 at market values. Blade’s current equity beta is 1.8
and 20% of its long term capital is represented by debt which is generally
regarded to be risk-free.

The risk free rate is 10% pa and the expected return on an average market
portfolio is 15%.

Corporation tax is at a rate of 30%, payable in the same year. The machine
will attract a 70% initial capital allowance and the balance is to be written of
evenly over the remainder of the asset life and is allowable against tax. The
firm is certain that it will earn sufficient profits against which to offset
allowances.

Required:
Calculate the adjusted present value and determine whether the project is
worthwhile?

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SMA ADJUSTED PRESENT VALUE (APV)

Question # 3
Fubuki Co, an unlisted company based in Megaera, has been manufacturing
electrical parts used in mobility vehicles for people with disabilities and the
elderly, for many years. These parts are exported to various manufacturers
worldwide but at present there are no local manufacturers of mobility
vehicles in Megaera. Retailers in Megaera normally import mobility vehicles
and sell them at an average price of $4,000 each. Fubuki Co wants to
manufacture
mobility vehicles locally and believes that it can sell vehicles of equivalent
quality locally at a discount of 37·5% to the current average retail price.

Although this is a completely new venture for Fubuki Co, it will be in addition
to the company’s core business. Fubuki Co’s directors expect to develop the
project for a period of four years and then sell it for $16 million to a private
equity firm. Megaera’s government has been positive about the venture and
has offered Fubuki Co a subsidised loan of up to 80% of the investment
funds required, at a rate of 200 basis points below Fubuki Co’s borrowing
rate. Currently Fubuki Co can borrow at 300 basis points above the five-year
government debt yield rate.

A feasibility study commissioned by the directors, at a cost of $250,000, has


produced the following information.
1. Initial cost of acquiring suitable premises will be $11 million, and plant
and machinery used in the manufacture will cost $3 million. Acquiring
the premises and installing the machinery is a quick process and
manufacturing can commence almost immediately.
2. It is expected that in the first year 1,300 units will be manufactured
and sold. Unit sales will grow by 40% in each of the next two years
before falling to an annual growth rate of 5% for the final year. After
the first year the selling price per unit is expected to increase by 3%
per year.
3. In the first year, it is estimated that the total direct material, labour and
variable overheads costs will be $1,200 per unit produced. After the
first year, the direct costs are expected to increase by an annual
inflation rate of 8%.
4. Annual fixed overhead costs would be $2·5 million of which 60% are
centrally allocated overheads. The fixed overhead costs will increase
by 5% per year after the first year.
5. Fubuki Co will need to make working capital available of 15% of the
anticipated sales revenue for the year, at the beginning of each year.
The working capital is expected to be released at the end of the fourth
year when the project is sold.

Fubuki Co’s tax rate is 25% per year on taxable profits. Tax is payable in the
same year as when the profits are earned. Tax allowable depreciation is
available on the plant and machinery on a straight-line basis. It is anticipated

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SMA ADJUSTED PRESENT VALUE (APV)

that the value attributable to the plant and machinery after four years is
$400,000 of the price at which the project is sold. No tax allowable
depreciation is available on the premises.

Fubuki Co uses 8% as its discount rate for new projects but feels that this
rate may not be appropriate for this new type of investment. It intends to
raise the full amount of funds through debt finance and take advantage of
the government’s offer of a subsidised loan. Issue costs are 4% of the gross
finance required. It can be assumed that the debt capacity available to the
company is equivalent to the actual amount of debt finance raised for the
project.

Although no other companies produce mobility vehicles in Megaera, Haizum


Co, a listed company, produces electrical-powered vehicles using similar
technology to that required for the mobility vehicles. Haizum Co’s cost of
equity is estimated to be 14% and it pays tax at 28%. Haizum Co has 15
million shares in issue trading at $2·53 each and $40 million bonds trading at
$94·88 per $100. The five-year government debt yield is currently estimated
at 4·5% and the market risk premium at 4%.

Required:
(a) Evaluate, on financial grounds, whether Fubuki Co should proceed with
the project.
(b) Discuss the appropriateness of the evaluation method used and
explain any assumptions made in part (a)above.

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