Ron Muller MODULE 6: SPECIAL FINANCING AND INVESTMENT DECISIONS QUESTION 1

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1 MODULE 6: SPECIAL FINANCING AND INVESTMENT DECISIONS QUESTION 1 Barney s Ltd. is trying to decide whether or not to lease or borrow to buy a new computer facility from the manufacturer. Annual maintenance costs are $200 which are payable by lessor if computer is leased. The first payment is due on the delivery and installation of the computer. Other relevant details appear below: 1. Lease term: 3 year, noncancellable with an annual premium of $25,000 payable in advance. 2. Purchase price: $70, Expected salvage value: $5,000 and let us assume it is uncertain. 4. CCA rate: 30% 5. Corporate tax rate: 49% 6. Cost of debt financing: 12% 7. Required rate of return on assets of this risk: 20% 8. Investment tax credit to purchase is $5,000. Required: a) Should the computer facility be leased or purchased to own? b) What is the equivalent loan amount? 1

2 QUESTION 1 SOLUTION Cost of asset avoided + 70, ,000 Less: ITC ( 5,000) - PV of CCA tax shield 65,000 x.3 x.49 (2.0612) ( 25,691) 2 ( ) (1.0612) - PV of salvage = 5,000 ( 2,893) (1.20) 3 + PV lost tax shield on salvage 5,000 (.3 x.49) + 1,178 (1.20) 3 ( ) - PV after tax lease payments ( 36,087) 25,000 (1 -.49) a % Pmt = 12,750; n = 3; i = 6.12%; FV = 0; CPT DUE PV =? + PV after tax maintenance costs saved by leasing (1 -.49)a % Pmt = 102; n = 3; i = 6.12%; FV = 0; CPT DUE PV =? NPV leasing + 1,796 b) Equivalent loan = PV after tax lease payments 36,087 - PV after tax maintenance costs ( 289) + PV of CCA tax shield 25,691 - PV of CCA tax shield lost on salvage ( 1,178) + PV of salvage 2,893 63,204 OR, an easier way to calculate the equivalent loan providing you calculate the NPV leasing first is as follows: Equivalent loan = 65,000-1,796 (net present value of leasing) = 63,204 2

3 QUESTION 2 ABC Ltd. is considering acquiring XYZ Company. XYZ has 1,000,000 million shares outstanding and the closing price five business days ago was $19.50 per share. The accounting manager and his staff found 4 mergers in the same industry that took place over the past 10 years. Data on the 4 mergers is shown below. The share price represents the closing price five business days prior to the merger. Per Share Figures Merger 1 Merger 2 Merger 3 Merger 4 Purchase Price Share Price EPS Cash flow Book Value Replacement Cost Answer the following questions: a) Prepare a table of important ratios based on the above data. b) Information for XYZ s Balance Sheet and Income Statement are reported below: Net income after tax = 925,000 Common shares + retained earnings = 18,750,000 Amortization expense (CCA) = 1,825,000 Replacement cost of assets - liabilities = 19,750,000 Based on the above information: 1) Calculate five ranges for a reasonable share price offer to the shareholders of XYZ. 2) Determine a range for the offer price based on past mergers. 3

4 QUESTION 2 SOLUTION a) Ratio Merger 1 Merger 2 Merger 3 Merger 4 Premium 28.57% 25% 16.67% 33.33% Times Earnings Times cash flow Times book value Times Replacement Cost b) EPS = NIAT/ # shares outstanding = 925,000/1,000,000 =.925 Book value per share = common shares + ret earnings = 18,750,000/1,000,000 = # shares outstanding Cash flow per share = NIAT + CCA = (925, ,825,000) = 2.75 # shares outstanding 1,000,000 Replacement cost per share = replacement cost of assets - liab = 19,750,000 = # shares outstanding 1,000,000 Range of Possible Offer Prices Item considered Level of Minimum Maximum XYZ Item Prior rate Offer Price Prior rate Offer Price Time earnings paid Times cash flow paid Times book value paid Premium paid Times replacement cost An overall range could be: to (calculated as from the maximum of the minimum amounts to the minimum of the maximum amounts). 4

5 QUESTION 3 SYC Inc. manufactures small household appliances and employs many disabled workers in its assembly operation. A proposal to expand plant capacity will cost $600,000 for new equipment, including specialized facilities to accommodate special needs of the workforce. If the expansion is undertaken, operating income will increase by $120,000 per year for the 7-year life of the new equipment. The provincial government will provide a low-interest loan for the expansion costs. The loan will be at a reduced rate of 5%, which is below the regular 7.5% borrowing rate for firms with the characteristics of SYC. The loan will be for a 7-year term, with annual interest payments at end of year and the principal amount due on maturity. SYC has a corporate tax rate of 35%. SYC is now entirely equity financed. If the expansion proposal is undertaken, SYC will then be financed 25% with debt and 75% with equity. The new equipment has a 20% CCA rate and no expected salvage value. Required a. Calculate the cost of equity financing for SYC, with and without the expansion of the plant. Assume that the unlevered beta of SYC is 1.1, the expected return on the market is 10%, and the risk free rate of interest is 6%. b. Calculate the weighted average cost of capital for SYC, both with and without the effects of the expansion proposal. Identify which of the weighted average costs of capital is lower, and explain why. c. State three reasons to explain why the adjusted present value (APV) method would be more appropriate for evaluation of this project than the net present value (NPV) method would be. d. Calculate the base-case NPV for the expansion proposal. e. Should SYC undertake the expansion proposal? Support your answer using the adjusted present value method assuming a debt amount of $600,000. (consider interest aspects only). 5

6 QUESTION 3 SOLUTION a. The cost of equity for SYC without the plant expansion is calculated using the unlevered beta and the capital asset pricing model: = 6% (10% 6%) = 10.4% The plant expansion proposal involves a change in capital structure, including debt financing. The levered beta will be: L = U + (1 T) (D/E) U = (1 0.35) (25 / 75) (1.1) = = 1.34 So the cost of equity, if the plant expansion proposal is accepted, will be: = 6% (10% 6%) = 11.4% b. Without the plant expansion, SYC is 100% equity financed, so the weighted average cost of capital equals the unlevered cost of equity for SYC, or 10.4%. With the plant expansion, SYC is financed 25% with debt and 75% with equity. The weighted average cost of capital is: = 0.25 (7.5%) (1 0.35) (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. Note that the market rate of interest and the levered cost of equity are used in this calculation. c. 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 SYC with interest tax shields. d. Base-case NPV is calculated using the unlevered cost of equity as the discount rate: Investment outlay ( 600,000) PV of after tax incremental operating revenues 120,000 (1 0.35) a % 374,787 PV of CCA tax shields 600,000 x.20 x.35( ) 131,650 2 ( ) ( ) Base Case NPV ( 93,563) 6

7 e. For APV, add the PV of the two side effects, using the after-tax cost of debt at the market rate for SYC as the discount rate [7.5% (1 0.35)] = 4.875%. PV of subsidized loan after tax = 600,000( )(1 -.35)a % = 56,673 PV interest tax shield = 5% (600,000) (0.35) a % = 61,033 Adjusted Present Value = base-case NPV + PV side effects = (93,563) + 56, ,033 = 24,143 The APV is positive so the project is acceptable. 7

8 QUESTION 4 INV Corp. is evaluating an investment proposal with the characteristics outlined below. The project will be financed initially with 75% debt, but as cash flows are received, debt will be reduced and ultimately eliminated. The average levered cost of equity over the entire 4-year project life is estimated at 16%. The weighted average cost of capital for INV projects financed in the regular pattern is 11%, and debt can be obtained at a per annum rate of 6%. The debt principal will be repaid in 4 equal annual payments, with interest charged each year on the outstanding balance. The equity investment will be made from retained earnings, so no new shares need to be issued. Investment Proposal Initial investment $15,000,000 Annual revenues from project 7,000,000 Annual variable costs 1,220,000 Salvage value 2,500,000 CCA rate of plant and equipment 30% Tax rate 50% Required Evaluate this investment proposal using the equity residual method, and advise INV Corp. on whether to undertake the project. 8

9 QUESTION 4 SOLUTION Initial investment (15,000,000) Debt =.75 x 15,000,000 11,250,000 + PV of revenues expenses after tax (7,000,,000-1,220,000) (1 -.5) a 4 16% = 2,890,000a 4 16% + 8,086,742 + PV CCA tax shield - PV lost tax shield on salvage 15,000,000 x.3 x.5(2.16) - 1 x 2,500,000 x.3 x.5 2 ( ) (1.16) (1.16) 4 x ( ) + 4,103,736 + PV salvage 2,500,000/(1.16) 4 + 1,380,728 - PV debt principal repayments: 2,812,500 a 4 16% ( 7,869,883) - PV of after tax interest payments (calculation below) ( 633,772) Net Present Value 1,317,551 Calculation: Principal payments = 11,250,000/4 = 2,812,500 Interest calculations Year Interest (6%) 1 675, , , ,750 PV of after tax interest payments Year Interest (after tax) PV factor PV 1 337, , , , , , , ,600 Total 633,772 Project should be undertaken as the NPV is positive. 9

10 QUESTION 5 XYZ Corp. wants to acquire a $200,000 machine. XYZ has a 40% marginal tax rate. If purchased, the machine would be a Class 10 asset with a CCA rate of 30%. The salvage value is expected to be $20,000 at the end of 10 years. To finance the purchase, XYZ could borrow at an annual pre-tax interest rate of 10% over a period of 10 years. XYZ would also incur annual maintenance expenses of $1,000. These expenses will not be incurred if the machine is leased. The lease rate would be $28,000 per year for 10 years, payable at the beginning of each year. XYZ s weighted-average cost of capital is 12%. Required a. What alternative, leasing or buying, should be chosen, according to the equivalent loan amount approach? Explain. b. Determine the pre-tax lease payment that will make XYZ indifferent between leasing and buying. 10

11 QUESTION 5 SOLUTION 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) 1.06 = $218,447 The tax shield due to the lease payment each year: $28, = $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) = $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) (4,416) The present value of CCA tax shield available on purchase of the asset: 200,000 (30%) (40%) [ (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 / (1 + 12%) 10 6,439 Equivalent loan $ 200,671 NVL = $200,000 $200,671 = $ 671 < 0 Since the net value to leasing is negative, XYZ should not lease the asset. 11

12 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 Let X = pre-tax annual lease payment: [X PVIFA (6%, 10) (1.06)] [X (0.4) PVIFA (6%, 10)] = $135,343 X = $27,862 12

13 QUESTION 6 Q1. What is the discount rate used to estimate base case net present value when conducting an adjusted present value analysis of an investment proposal? 1) The weighted-average cost of capital. 2) The after-tax cost of debt. 3) The unlevered cost of equity. 4) The cost of equity adjusted to reflect the project s business risk and financial leverage. Q2. When is the weighted-average cost of capital method of capital budgeting most effective? 1) When you are evaluating projects for which the capital structure is significantly different from the average capital structure for the firm. 2) When you are evaluating projects with special financing arrangements. 3) When the debt-to-equity ratio will change during the life of the project. 4) When project risk is equal to the firm s overall risk. Q3. Which of the following is involved in the equity residual method for analyzing investment projects? i) Calculating the present value of cash flows that can be distributed to shareholders after paying operating costs, financing costs, and debt repayments. ii) Using the after-tax cost of equity capital as the discount rate. iii) Using the after-tax unlevered cost of capital as the discount rate. 1) i) only 2) ii) only 3) i) and ii) 4) i) and iii) Q4. When are the adjusted present value and equity residual methods of capital budgeting both useful? i) When capital structure changes over time. ii) When debt used to finance a project is significantly different from the firm s other financing arrangements. iii) When the required rate of return on equity is expected to change over time. 1) i) only 2) i) and ii) 3) i) and iii) 4) ii) and iii) Q5. Which of the following is the main disadvantage of the adjusted present value method of capital budgeting? 1) It discounts the cash flows that will be used to pay debtholders at the rate required on the unlevered firm s equity. 2) It is not effective in evaluating projects for which the capital structure is significantly different from the average for the firm. 3) It assumes that the debt to equity ratio will be constant over time. 4) It is cumbersome because the cash flows of the project per period must be estimated. 13

14 Q6. In what way does the equity residual method of capital budgeting differ from the weighted-average cost of capital method? 1) Only the equity residual method adjusts for interest tax shields that are generated by debt securities used for project financing. 2) Only the weighted-average cost of capital method adjusts for differences in capital structure between the various projects undertaken by the firm. 3) Only the equity residual method calculates the present value of cash flows that can be distributed to shareholders. 4) Salaries and commissions not exceeding $2,000 per employee that were earned within 3 months preceding the bankruptcy petition. Q7. In evaluating capital projects, when is the equity residual method advantageous? 1) When the project has the same risk as the existing projects of the firm 2) When the capital structure of the project is the same over the project s useful life 3) When the project has a life in excess of 10 years 4) When the required rate of return on equity is constant for the project Q8. Which of the following statements is correct when one firm leases machinery to another? 1) The lessor enjoys the CCA tax shields. 2) The lessor is obtaining debt financing from the lessee. 3) The lessee owns the machinery. 4) The lessor can deduct its lease payments as rental expenses. Q9. Which of the following statements best describes a direct lease? 1) A lease that entails acquiring the right to use an asset 2) A lease arrangement in which a company sells an asset that it owns to another party for cash, and then contracts to lease the asset back for a specified term 3) A lease arrangement in which the lessor finances the cost of an asset with debt secured by the same asset 4) A lease that can be cancelled if the equipment becomes obsolete or is no longer needed Q10. Under which of the following circumstances would a vertical merger be advantageous? 1) If outside suppliers are few and are likely to behave in an opportunistic manner. 2) If scale economies in the intermediate activity are large. 3) If the volume of intermediate input required by the company is small. 4) If overhead costs are high. 14

15 QUESTION 6 SOLUTIONS 1 (3) 2 (4) 3 (3) 4 (2) 5 (1) 6 (3) 7 (3) 8 (1) 9 (1) 10 (1) 15

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