Adjusted Present Value Modigliani and Miller meet CAPM PWC Course Notes P62 ACCA Paper P4 Also suitable for ICAEW, ICAS, CFA etc mefielding.com1

APV  We are going to undertake a project appraisal calculation  Before you listen to this please make sure you are comfortable with CAPM and M&M  The APV is an alternative to NPV  It can give a different decision from NPV  It is not used in real life but is frequently examined  IT IS BASED ON MODIGLIANI & MILLER mefielding.com2

APV  Wyke plc is a company that makes ice cream in Scotland  Wyke wants to expand into Europe. Europe has no surplus demand for ice cream but their market research shows that South Europe needs freezers. Wyke decides to investigate freezer distribution in S Europe.  Aranalde is a Spanish firm that distributes freezers throughout South Europe  Wyke has prepared a cash flow for the proposed freezer distribution business but does not know at what rate to discount it mefielding.com3

APV WykeAranalde Equity Beta Geared Gearing Ratio (Book Value, D:E) 1:13:7 Gearing Ratio (Market Value,D:E) 1:41:1 Cost of Debt %66 mefielding.com4 Other Information Corporate debt is risk free, corporate tax is charged at 30% The project will be financed in the same ratio as existing capital in Wyke Return on treasury bills is 6% pa, return on the market portfolio 9% pa The project shows an initial investment will be required of $7.5m Net cash flows will be $1.1m for 5 years Issue costs will be 2% for debt and 5% for equity, both of gross sum raised Debt will be a 5 year loan payable at the end of the project

APV mefielding.com5

APV Step 1 mefielding.com6

APV Step 1 mefielding.com7 We use the formula + So we need an asset beta which reflects the business risk of freezer distribution in Europe. If we take Aranalde’s beta it will reflect the business risk but also Aranalde’s gearing, so we degear Aranalde’s equity beta We must always use market values, the value of the equity to debt is 1:1. Aranalde’s beta reflects the business risk, the tax rate is 30%. The asset beta tells us the ungeared beta of the Freezer distribution industry. Debt is risk free so debt beta is zero

Asset Beta mefielding.com8

APV Step 1 mefielding.com9

APV Step 2- The Tax Shield Step 3 Things That Shouldn’t Exist!  Step 2 Tax Shield  But M&M said that debt raised was tax deductible, so we take into account the tax relief on debt interest  7.5m x 20% x 30% x = 2537  Step 3- Market Inefficiencies  Issue costs  Equity [(6m/0.950)-6m]= 316  Debt [(1.5m/0.98)-1.5m]= 31  Total issue costs (347) mefielding.com10

APV Summary  Cash flow (1300)  Tax Shield 2537  Other Items (347)  Result +890 mefielding.com11

Comparison of NPV and APV NPV APV mefielding.com12