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IBUS 302: International Finance Topic 20-International Capital Budgeting II Lawrence Schrenk, Instructor 1 (of 30) Learning Objectives 1. 2. 3. Explain the conditions for using adjusted present value (APV).▪ Calculate a basic APV problem. Calculate an international APV problem.▪ 2 (of 30) Why APV? 3 (of 30) Firm/Project Value Firms create two sources of value: Operating Value: What they ‘produce’ Left-Hand Side of Balance Sheet Financing Value: How they finance what they ‘produce’. Right-Hand Side of Balance Sheet 4 (of 28) NPV versus APV Strategy NPV Strategy Include the financing values, e.g., the tax advantages of debt, financial distress costs, by adjusting the discount rate. That is, use the WACC as the discount rate. APV Strategy Separate the financing values, e.g., the tax advantages of debt, financial distress costs, into different calculations. Value Additivity Model 5 (of 28) NPV Flaws Aggregates Operating and Financing Values WACC Estimation Problems Book Values Changes in WACC over Time Sensitivity Analysis Cannot always use the firm’s WACC for a project Single Discount Rate No Real Options 6 (of 28) APV Solutions Financing, etc. Valued Separately No WACC Multiple Discount Rates Real Options 7 (of 28) Why APV? APV is better at: Accurate Valuation of Financing Values Providing Information on the Sources of Value APV can include features NPV cannot: Real Options Changes in Capital Structure, e.g., LBO’s Debt Repayment Schedule 8 (of 28) APV Basics 9 (of 30) Key Idea Separate Valuation of… A) Operating Cash Flows for Unlevered Firm B) Other Value Components Tax Advantages of Debt Financial Distress Subsidies Hedges Costs of Issuing Securities Etc. 10 (of 28) A) Operating Cash Flows for Unlevered Firm Construct Annual OCF Same procedure as in NPV Discount with Cost of Equity Estimation of the Cost of Equity CAPM Empirical Comparisons Why is this easier and more accurate than WACC? Find NPVOCF for OCF of Unlevered Firm 11 (of 28) B) Other Value Components These are ‘adjustments’ to the NPVOCF to account for other value changes. Financing Tax Advantages of Debt and Depreciation (+) Financial Distress (-) Hedges (+ hopefully ) Other Subsidies (+) Real Options (+) 12 (of 28) The APV Calculation APV = NPVOCF + PV(Tax Advantage) – PV(Financial Distress) + PV(Real Options) +… A B 13 (of 28) Multiple Discount Rates NPV/WACC has a single discount rate. Everything is discounted at the ‘average’ rate APV allows multiple rates: Discount rates should reflect risk of individual cash flows Do all cash flows have the same risk? Are sales predictions as reliable as cost predictions? 14 (of 28) A Simple Example A firm is considering a new project which will cost $500,000 and generate $175,000 for four years. The cost of equity for the firm is 12%. The project will be funded by issuing $300,000 in debt at 8% and the rest from internal funds. The issuance costs are 1.5% of the principal, and the corporate tax rate is 20%. 15 (of 28) A Simple Example Investment Annual Cash Flow Debt Issued Cost of Equity Cost of Debt Corporate Tax Rate Issuance Costs $500,000 $175,000 $300,000 12% 8% 20% 1.5% 16 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 1 2 3 4 ($500,000) 17 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 $175,000 2 $175,000 3 $175,000 4 $175,000 18 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 $175,000 2 $175,000 3 $175,000 4 $175,000 $31,536 19 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 $175,000 2 $175,000 3 $175,000 4 $175,000 $31,536 $300,000 20 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 $175,000 2 $175,000 3 $175,000 4 $175,000 $31,536 $300,000 ($4,500) 21 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 2 3 4 $175,000 $175,000 $175,000 $175,000 $4,800 $4,800 $4,800 $4,800 $31,536 $300,000 ($4,500) 22 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 2 3 4 $175,000 $175,000 $175,000 $175,000 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $31,536 $300,000 ($4,500) ($4,500) 23 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 2 3 4 $175,000 $175,000 $175,000 $175,000 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $31,536 $300,000 ($4,500) ($4,500) $11,398 24 (of 28) A Simple Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 2 3 4 $175,000 $175,000 $175,000 $175,000 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $4,800 $31,536 $300,000 ($4,500) ($4,500) $11,398 $42,934 25 (of 28) A Simple Example Such a simple example illustrates APV, but doesn’t really show its true value. APV analysis does allow us to distinguish The value of the project: The value of the financing: $31,536 $11,398 NPV calculation would obscure this. ▪ Could APV be positive if the value of the project were negative? ▪ 26 (of 28) Second Example What is the value if the debt must be repaid in equal installments over the first three years of the project? NOTE: You could not value this with NPV. The project leverage changes, But WACC must be constant. 27 (of 28) Second Example PV NPVOCF Investment Annual Cash Flows NPVOCF Debt Value Debt Issued Issuance Cost Installment Interest Portion Annual Tax Advantage Annual Net Advantage PV(Tax Advantage) APV 0 ($500,000) ($500,000) 1 2 3 $175,000 $175,000 $175,000 ($116,410) ($24,000) $4,800 $4,800 ($116,410) ($18,674) $3,321 $3,321 ($116,410) ($12,922) $1,725 $1,725 4 $175,000 $31,536 $300,000 ($4,500) ($4,500) $4,161 $35,697 28 (of 28) International APV 29 (of 30) Lessard Model APV model for a multinational corporation analyzing a foreign capital expenditure. This model incorporates many features that are distinctive to foreign direct investment. Parent firm perspective 30 (of 28) Lessard Model The Full Equation T StOCFt (1 τ ) T St τ Dt St τ It APV t t t (1 K ud ) t 1 t 1 (1 id ) t 1 (1 id ) T T ST TVT St LPt S0C0 S0 RF0 S0CL0 T t (1 K ud ) t 1 (1 id ) Lessard Model: OCF Discounting Operating Cash Flows 1. Find after-tax OCF StOCFt (1 τ ) t (1 K ) t 1 ud T 2. Convert OCF to dollars 3. Discount at unlevered rate 32 (of 28) Lessard Model: Depreciation Discounting Depreciation Tax Shields 1. Find annual tax advantage StτDt t (1 i ) t 1 d T 2. Convert CF to dollars 3. Discount at cost of debt 33 (of 28) Lessard Model: Interest/Debt Interest Tax Shields 1. Find annual tax advantage StτIt t (1 i ) t 1 d T 2. Convert CF to dollars 3. Discount at cost of debt 34 (of 28) Lessard Model: Terminal Value Discounting Terminal Value 1. 2. Convert OCF to Dollars Discount at unlevered rate STTVT (1 Kud )T 35 (of 28) Lessard Model: Investment and Restricted Funds Investment: Convert to Dollars S0C0 Restricted Funds: Convert to Dollars S0RF0 36 (of 28) Lessard Model: Concessionary Loans Concessionary Loan Principal: Convert to Dollars S0CL0 Concessionary Loan Principal: Convert to Dollars and Discount T St LPt t t 1 (1 i d ) 37 (of 28) Estimating the Future Expected Exchange Rates We can apply PPP: (1 π d )t St S 0 (1 π f )t Note: This is what we did in the NPV example. Example A project in Germany will generate €150,000 for three year and requires an investment of €400,000. €300,000 of the investment is depreciable using straight line depreciation. The project funding will include issuing €200,000 in debt. 39 (of 28) Example Cost of Equity Cost of Debt Corporate Tax Rate Dollar Inflation Euro Inflation Issuance Costs S($/€) 15% 11% 35% 6% 3% 2% 1.5544 40 (of 28) Example: Spot Rates Calculate expected spot rates using PPP (1.06)t St 1 St (1.03)t 1.5544 1.5997 1.6463 1.6942 41 (of 28) Example: NPVOCF PV NPVOCF Investment Annual Cash Flows (€) S($/€) Annual Cash Flows ($) NPVOCF 0 € € 1 (400,000.00) (400,000.00) € 130,000.00 1.5544 1.5997 ($621,760.00) $207,957.59 2 € 130,000.00 1.6463 $214,014.61 3 € 130,000.00 1.6942 $220,248.04 ($134,284.85) (NOTE: Discounted at cost of equity) 42 (of 28) Example: Depreciation PV Depreciation Value Depreciation Annual CF (€) S($/€) Annual CF ($) PV 0 1 € € 1.5544 100,000.00 35,000.00 1.5997 $55,988.58 2 € € 100,000.00 35,000.00 1.6463 $57,619.32 3 € € 100,000.00 35,000.00 1.6942 $59,297.55 $140,563 (NOTE: Discounted at cost of debt) 43 (of 28) Example: Debt Debt Value Debt Issued Issuance Cost Annual CF (€) S($/€) Annual CF ($) PV € € 200,000.00 (4,000.00) € 1.5544 ($4,000.00) 7,700.00 1.5997 $12,317.49 € 7,700.00 1.6463 $12,676.25 € 7,700.00 1.6942 $13,045.46 $24,256 (NOTE: Discounted at cost of debt) 44 (of 28) Example: APV PV NPVOCF Investment Annual Cash Flows (€) S($/€) Annual Cash Flows ($) NPVOCF Depreciation Value Depreciation Annual CF (€) S($/€) Annual CF ($) PV Debt Value Debt Issued Issuance Cost Annual CF (€) S($/€) Annual CF ($) PV APV 0 € € 1 (400,000.00) (400,000.00) € 130,000.00 1.5544 1.5997 ($621,760.00) $207,957.59 2 3 € 130,000.00 1.6463 $214,014.61 € 130,000.00 1.6942 $220,248.04 € € 100,000.00 35,000.00 1.6463 $57,619.32 € € 100,000.00 35,000.00 1.6942 $59,297.55 € 7,700.00 1.6463 $12,676.25 € 7,700.00 1.6942 $13,045.46 ($134,284.85) (NOTE: Discounted at cost of equity) € € 1.5544 100,000.00 35,000.00 1.5997 $55,988.58 $140,563 (NOTE: Discounted at cost of debt) € € 200,000.00 (4,000.00) € 1.5544 ($4,000.00) 7,700.00 1.5997 $12,317.49 $24,256 (NOTE: Discounted at cost of debt) $30,534 45 (of 28)