© Prentice Hall, 200717-1

1717

Corporate Financial Management 3e

Emery Finnerty Stowe

Managing Capital Structure (APV)Pages 488-491

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17.4 Adjusting PV and Required Returns for Capital Structure Effects

In chapter 8, we treated investing and financing as independent of each other

When they are not independent, we can adjust the WACC to reflect capital structure in addition to the project’s risk.

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The Project’s Cost of Capital

The WACC (an opportunity cost) can be expressed as:

WACC = (1 - L)re + L(1 - T)rd

However, L, T, re, and rd are more easily measured for the firm than for a specific project. Financing cannot be accounted for on a project-by-project basis.Loans also can be tied to specific assets or projects, and the firm’s capital structure will change over time.Many corporations, therefore, use the Adjusted Present Value method for capital budgeting projects.

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17.5 Adjusted Present Value

Recall that the value of a leveraged firm can be expressed as:

VL = VU + T*D

where T* is the net effect of capital market imperfections.

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Adjusted Present Value

Consider the case where a firm’s debt is tied to one or more specific asset: Mortgage Lease

The interest and principal payments occur within the asset’s life. The asset’s value declines over time with use. The “capital structure” (i.e. remaining debt)

changes over time as debt is repaid.

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Adjusted Present Value

In such cases, the Adjusted Present Value (APV) accounts for the changing capital structure over the asset’s life.

The APV is the present value of the project as if it were financed solely with equity plus the net benefits from debt financing.

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Adjusted Present Value

where CFATt is the “basic” cash flow in period t, r is the return required by investors in the unleveraged firm, INT is the interest payment in period t, and rd is the return required by the debtholders.

n

tt

d

tn

ttt

r

INTT

r 1

*

10 )1()1(

CFATAPV

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Adjusted Present Value

CSI is evaluating a new seed processing machine which costs $100,000, has a life of 3 years, and can be sold off for $20,000 net of taxes after 3 years. The annual CFAT are expected to be $40,000. CSI will borrow $60,000 at 10% to finance the purchase of this machine, with the rest coming from CSI’s equity. The net benefit to leverage factor (T*) is 0.25 and CSI’s unleveraged required return for this project is 18%.What is the project’s APV?

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APV: Loan Repayment

The annual payment on the 3-year, $60,000, 10% loan is:

CALCULATOR SOLUTION

Data Input Function Key

N

I

PV

PMT

FV

3

10

60,000

0

–24,127

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APV: Loan Amortization Table

Year 1 Year 2 Year 3

LB at BOYInterest (@ 10%)PaymentLB at EOY

$60,000$6,000

$24,127$41,873

$41,873$4,187

$24,127$21,934

$21,934$2,193

$24,127$0

Note:

LB = Loan Balance, BOY = Beginning of Year, EOY = End of Year

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Adjusted Present Value

n

tt

d

tn

ttt

r

INTT

r 1

*

00 )1()1(

CFATAPV

707,9$

)10.1(

193,2$

)10.1(

187,4$

)10.1(

000,6$25.0

)18.1(

000,20$

)18.1(

000,40$000,100$APV

321

3

3

10

t

t