Module 5: Special Financing and Investment Decisions

Reading 5.1: Introduction to Project Financing

Some projects are so large that it may be best to finance them as they are standalone operations. Projects are typically large, complex, and capital intensive; but generate steady cash flows. Contractual arrangements: Completion & quality assurance Raw material supply Output/service purchase Completion, quality assurance, & purchase Cash flow guarantee One or more sponsoring companies will provide the equity investment, with the rest coming from outside debt financing.

Advantages of project financing Can share the benefits of the project while being able to spread the risk around (sponsors, suppliers, customers, & creditors). Expand debt capacity (special purpose vehicles, off balance sheet) Disadvantages of project financing Significant legal and advisory fees. If financial institution requires guarantees another fee. Can t always pass on the risk lenders may demand premium.

Reading 5.1-2 : Investment Analysis Using Adjusted Present Value

Adjusted present value Separate a project s cash flows into two groups: 1. NPV of unlevered project (assume 100% equity financed) 2. NPV of cash flows associated with financing

Base-case NPV Calculated the same way as in Module 2 (equations 2-16 &2-16a) Discount rate is unlevered cost of equity (CAPM). Typically, a company s cost of equity will incorporate the company s leverage. To adjust for leverage: Use equation 2-22 to calculate the unlevered beta:

Base-case NPV Use equation 2-20 using unlevered beta to determine the unlevered firm s cost of equity. Unlevered Beta

Discount rates used in financing related cash flows: Interest tax shield after-tax interest payment discounted using after-tax cost of debt After-tax PV of Flotation costs - Total flotation costs PV of tax shield (discounted using after-tax cost of debt) similar to Bond/Pfd share refi in Module 3 Financing-related investment credits and subsidies If firm receives credits/subsidies due to using debt pv of credits/subsidies treated as financing related item and added to base case NPV. If firm receives credits/subsidies regardless of financing amounts included in base case NPV reduction of initial investment outlay. If a company receives investment tax credit related to purchase of specific asset reduces net investment outlay Operating subsidy is after tax benefit discounted by after tax cost of debt

**Both the value of low interest loan & value of subsidies are added to NPV**

Minicase 5-2

Questions 1-6 deal with calculating base case NPV, questions 7-9 deal with the financing related benefits.

Reading 5.2: Investment Analysis Using Weighted Average Cost of Capital (WACC) Applying firm s WACC to a project assumes project s risks & characteristics are the same as the company s.

Adjusting discount rate for project s financial leverage Or, when beta is not given:

WACC WACC is used to discount cash flows to determine NPV: 1. Estimate after-tax cash flows assuming all equity financing (same as APV) 2. Calculate WACC 3. Discount cash flows at WACC 4. For calculating tax shields lost to salvage, discount salvage value at cost of equity. 5. Estimate cash flows that are low risk side effects/related to financing and discount at after tax cost of debt. 6. NPV = PV a/tax cash flows from operations + PV salvage price WACC + PV investment tax credits/subsidies - PV a/tax flotation costs initial outlays Equation 5-7

Other cash flows All cash flows are discounted at WACC except: Salvage price & salvage value term in calculating tax shields lost to salvage discounted at levered cost of equity Tax shield on flotation costs discounted at a/tax cost of debt A/tax tax credits/subsidies discounted at a/tax cost of debt

Differences between APV & WACC APV discounts operating cash flows for base case NPV at unlevered cost of equity. APV adjusts for debt by adding present value of interest tax shield to base case NPV; WACC method adjusts discount rate (lower) which leads to higher present value of operating cash flows

NPV using APV method = $ 2,080,138 NPV using WACC = $744,220 WACC method assumes constant capital structure, while APV can allow for the capital structure to change. Using the APV method, the bulk of the value came from discounting the interest tax shield by a a/tax cost of debt (7.48%). Remember, when computing a present value calculation the lower the discount rate (all other things being equal), the higher the present value number.

Reading 5.3: Investment Analysis Using Equity Residual (Flow to Equity)

Equity residual method (ERM) Determine cash flows that accrue to shareholders (i.e after paying operating & financing costs and debt repayments.

Cash flows get discounted at levered cost of equity. Do you use company s cost of equity or projects? Use company s if: 1. Project has same risk as firm s assets 2. Firm is expected to use debt level for project that is similar to firm s capital structure. 3. Capital structure is expected to stay stable during project s life span. If you need to adjust for financial leverage use same procedure as in APV.

If project s capital structure is going to change over time

Reading 5.5: Leases

Reading 5.6: Analysis of the Lease/Purchase Financing Decision

Equivalent loan Lease financing is a substitute for debt financing. To compare leasing with borrowing to purchase, we need to determine the equivalent loan that would commit the firm to exactly the same cash outflows under the lease. Discount cash flows by a/tax cost of debt (except salvage value and tax shield related to salvage WACC)

PV CCA tax shields 5-14 C = initial undepreciated capital cost of the asset d = CCA rate of the class to which the asset belongs T = corporate tax rate S = salvage value of the asset at the end of year n r = after-tax interest rate on debt WACCn = weighted average cost of capital

PV operating cost savings 5-15 Operating costs under a lease can be cheaper than from ownership.

Net present value to leasing (NVL) NVL = initial investment outlay equivalent loan Equation 5-16 NVL measures net cost savings realized by firm if it leases rather than borrows to purchase. Same decision rules apply.

Solution Step 1: Calculate the initial investment outlay. = purchase price federal government investment tax credit = $50,000 (0.10 $50,000) = $45,000 Step 2: Calculate the leasing costs. Present value of lease payments: If RBC purchases the cement mixer through a bank loan, the interest rate will be 9%. The after-tax cost of debt = 9% (1 0.40) = 5.40% The lease payment per year is $12,855, to be paid at the beginning of each year. PV of the annuity due = $12,855 PVIFA(5.4%, 5) (1 + 0.054) = $58,018

Solution The lease payments are deductible for tax purposes, and the tax shield due to the lease payment is received at the end of each year. PV of the tax shield due to lease payments = $12,855 0.40 PVIFA(5.4%, 5) = $22,018 PV of the lease payments on an after-tax basis = $58,018 $22,018 = $36,000

Present value of operating costs RBC will incur no operating costs if it leases the cement mixer. Under the borrowing alternative, it would incur these costs. PV of the after-tax operating costs = $2,000 (1 0.40) PVIFA(5.4%, 5) = $5,138 Present value of tax shields lost by leasing over buying (Equation 5-14): The initial capital cost of the asset is $45,000 CCA rate is 30% after-tax interest rate is 5.40% WACC is 15% tax rate is 40%, salvage value of the cement mixer at the end of five years is $6,000.

CCA tax shield available on purchase of the asset, if the asset is held indefinitely. CCA tax shield lost to the purchaser of the asset due to sale of the asset for its salvage value. PV of CCA lost tax shields if RBC leases = 14,863 1,011 = 13,852 PV of the salvage value lost by leasing (discounted at the WACC) = $6,000 (1.15) 5 = 2,983 PV of the provincial government subsidies lost under the lease option = $1,000 (1 0.40) PVIFA(5.4%, 5) = 2,569

Step 3: Calculate the equivalent loan. Equation 5-13 Borrowing to purchase is preferable the amount that RBC could borrow under the equivalent loan is more than initial investment outlay.

Step 4: Calculate the net value to leasing. Equation 5-16 The net value to leasing (NVL) = initial investment outlay equivalent loan = $45,000 $50,266 = $5,266 RBC should not lease the asset.