COMPLETE - NOTES

Chapter 2- : Capital Structure and Capital

Investment

1. Operating and Financial Leverage

Leverage is the employment of an asset/source of finance for which firm pays fixed
cost/fixed return.

There are two types of leverage – operating and financial. The leverage associated with
investment activities is referred as operating leverage and leverage associated with
financing activities is called financial leverage.

1.1 Operating Leverage

Operating leverage is caused due to fixed operating expense in the firm. It denotes the
sensitivity of PBIT to a change in contribution/sales volume. When proportionate change
in PBIT as a result of a given change in sales is more than the proportionate change in
sales, operating leverage exists.

This can be calculated using the formula:

Operating Leverage = Contribution/PBIT

Operating leverage indicates by how much fixed costs could increase without the company
making an operating loss. The larger the operating fixed costs, the higher the firm’s degree
of operating leverage and business operating risk. Business operating risk is the risk
of the firm not being able to cover it fixed operating costs.

Operating Breakeven point is at which Fixed operating costs equal Contribution.

1.2 Financial Leverage

Financial leverage is caused due to fixed financial cost (interest) in the firm. It denotes
the sensitivity of PBT to a change in PBIT. As a rule, when a percentage change in PBT as
a result of a given change in PBIT is more than the proportionate change in PBIT,
financial leverage exists.

This can be calculated using the formula:

Financial Leverage = PBIT/ (PBT-(Pref. div/ (1-t))

Financial leverage indicates by how much interest payments could increase without the
company making a pre-tax loss. The larger the financial fixed costs, the higher the firm’s
degree of financial leverage and financial risk. Financial risk is the risk of the firm not
being able to cover it fixed financial costs.
COMPLETE - NOTES

Financial Breakeven point is at which Fixed financial costs (Interest + preference

dividend) equal PBIT.

1.3 Total Leverage

Total leverage is the product of operating leverage and financial leverage. It denotes the
sensitivity of PBT to a change in contribution/sales volume.

This can be calculated using the formula:

Total Leverage = Contribution/ (PBT-(Pref. div/ (1-t)) OR FL x OL

Class practice

ICAP Summer 2011 Q 1.

2 Financing Decisions and Capital Structure

a. Theories about selecting the financing method

Capital investments have to be financed, and management must choose which method of
financing they will use. There are different theories about how the method of financing is
decided. These include:

 Static trade-off theory;

 Pecking order theory;
 Market timing theory.

Static Trade-off Theory

Static trade-off theory argues that for each company there is an optimal capital structure,
with an optimal level of gearing. There is a trade-off between the benefits of taking on
more debt and the costs of higher indebtedness.

The optimal gearing level for a company is reached at a point where:

 the marginal benefits of taking on additional debt capital
 equals the marginal costs of taking on the extra debt.

Pecking Order Theory

Pecking order theory takes a different view of gearing and methods of financing new
investments. It was put forward as a challenge to static trade-off theory.

This theory states that companies do not have optimal capital structure and companies
show preferences for the source of finance that they use. There is an order of preference
or ‘pecking order’.
COMPLETE - NOTES

 1st. The source of finance that is preferred most is retained earnings.

 2nd. Debt capital is the source of finance second in the order of preference.
 3rd. New equity capital (an issue of new shares) is the least preferred source of
finance for investment.

Market timing Theory

Market timing theory states that the choice of financing method for companies can be
driven by opportunities in the capital markets. These opportunities occur because of
‘asymmetries of information’. These occur when the managers of a company have
more information and better information about the company than shareholders and other
investors.

b. Designing Capital Structure

Capital structure is the proportion of debt, preference shares and equity shares on a
firm’s balance sheet.

Optimum Capital structure is the capital structure at which the weighted average cost
of capital (WACC) is minimum and thereby value of the firm is maximum.

i- Net Operating Income (NOI) Approach

The essence of this approach is that capital structure decision of an entity does not affect
its cost of capital and valuation, and, hence, irrelevant. As per this approach overall cost
of capital (WACC) is constant, the value of firm, given the level of EBIT, is determined by
using following formula:

Value of firm= EBIT/WACC

The main argument of NOI is that an increase in the proportion of debt in the capital
structure would lead to an increase in financial risk of the equity holders. To compensate
for the increased risk, they would require a higher rate of return on equity (Ke). As a
result, the advantage of the lower cost of debt would exactly be neutralized by the increase
in cost of equity.

The cost of debt has two components (i) explicit, represented by rate of interest, and (ii)
implicit, represented by increase in the cost of equity. Therefore the real cost of debt and
equity would be the same and there is nothing like an optimum capital structure.

As the increase in debt is increasing the cost of equity (Ke), revised Ke can be calculated
using following formula:

Ke= WACC+ (WACC-Kd) (debt/equity)

COMPLETE - NOTES

Example:

An entity has net operating income of Rs 50,000, outstanding debt is Rs 200,000 with
cost of debt of 10%. WACC (overall capitalization rate) is 12.5%. What would be the total
value of firm and Cost of equity (equity capitalization rate) using NOI approach?

In order to examine the effect of changing capital structure, let’s assume that the firm has
increased the amount of debt to Rs 300,000 and used the proceeds of the debt to
repurchase equity shares. Other factors are same as above. What would be the revised
total value of firm and revised Cost of equity (equity capitalization rate) using NOI
approach?

Now changing capital structure by retiring debt of Rs 100,000 by issuing fresh equity
shares of the same amount. Other factors are same as above. What would be the revised
total value of firm and revised Cost of equity (equity capitalization rate) using NOI
approach?

ii- Traditional Approach

As per this approach there is an optimal capital structure and firm can increase the total
value by using optimal mix of debt and equity. This approach argues that the firm can
initially lower its cost of capital and increase its value. Although use of debt will increase
the required return of equity investors (Ke) but increase in Ke would not exactly offset the
benefit of cheaper debt till a certain level. After a certain level it would exceed the benefit
of taking cheaper debt. That level would be Optimal Capital Structure, at which WACC
would be lowest and value of the firm will be maximum.

Class Practice question ICAP Summer 2009 Q5

iii- Modigliani and Miller Approach (MM Theory)

(a) Without Tax
The theory illustrates that if tax effects are ignored, WACC of geared and ungeared
companies would be equal. It is same as net operating income approach. It proposes that
the value and returns of a company are based on its assets and not on the way these assets
are financed.

Assumptions

 Perfect Capital Markets;

 No transactions costs;
 No taxations;
 Operating income would remain same;
 Risk free debt.
COMPLETE - NOTES

Modigliani and Miller’s arguments, ignoring taxation, can be summarized as two

propositions.
 Proposition 1. The WACC is constant at all levels of gearing. For companies
with identical annual profits and identical business risk characteristics, their
total market value (equity plus debt) will be the same regardless of differences in
gearing between the companies i.e. Market value of the company is the product
of business risk and has nothing to do with the financial risk.
 Proposition 2. The cost of equity rises as the gearing increases. The cost of
equity will rise to a level such that, given no change in the cost of debt, the WACC
remains unchanged.

The above can be summarized using following three formulae for the Modigliani and
Miller theory, ignoring corporate taxation.

Value of geared= Value of ungeared

WACC geared= WACC ungeared
Ke geared= Ke ungeared+ (D/E) (Ke ungeared- Kd geared)

Here D= Market value of debt E= Market value of equity.

Example:

ABC Co. is entirely equity financed. Its cost of equity is 15% and market value of equity is
Rs 100,000. It proposes to change its capital structure by obtaining debt amounting to Rs
30,000 and repaying existing equity. The cost of debt is 10%. Calculate the new WACC,
Ke and the value of the company.

Homemade Leverage

The support for this position rests on the idea that investors are able to substitute personal
for corporate leverage, thereby replicating any capital structure the firm might undertake.
Because the company is unable to do something for its stockholders (leverage) that they
cannot do for themselves, capital structure changes are not a thing of value in the perfect
capital market world that MM assume. Therefore, two firms alike in every respect except
capital structure must have the same total value. If not, arbitrage will be possible,
and its occurrence will cause the two firms to sell in the market at the same
total value.

(b) With Tax

M and M model without tax leads to the conclusion that gearing is irrelevant. But this is
not true in real world. In real world there are corporate taxes affecting the cost of capital.
M&M revised their model to include corporate taxes.

Modigliani and Miller’s arguments, allowing taxation, can be summarized as two

propositions.
COMPLETE - NOTES

 Proposition 1. The WACC falls continually as the level of gearing increases. In

theory, the lowest cost of capital is where gearing is 100% and the company is
financed entirely by debt. (Modigliani and Miller recognised, however, that
‘financial distress’ factors have an effect at high levels of gearing, increasing the
cost of debt and the WACC.) For companies with identical annual profits and
identical business risk characteristics, their total market value (equity plus debt)
will be higher for a company with higher gearing.
 Proposition 2. The cost of equity rises as the gearing increases. There is a positive
correlation between the cost of equity and gearing (as measured by the debt/equity
ratio).

In this case, debt is assumed to be perpetual and tax shield is calculated as follows: (Debt
x interest rate x tax rate) x (1/interest rate) = Debt x tax rate = Dt

The above can be summarized using following three formulae for the Modigliani and
Miller theory, ignoring corporate taxation.

Value of geared= Value of ungeared + Dt

WACC geared= WACC ungeared (1- (Dt/(D+E)))
Ke geared= Ke ungeared+ (1-t) (D/E) (Ke ungeared- Kd geared)
Here D= Market value of debt E= Market value of equity.
Kd= Pre-tax cost of debt.

Exam techniques for questions requiring calculation of change in WACC as a result of

change in gearing.
 Calculate Keu=WACCu
 Calculate Vu
 Calculate Vg
 Calculate new debt and equity values after gearing ratio change from Vg above.
 Calculate WACCg
 If existing condition is geared, first ungear the V , Ke and WACC using above
formulae.

Example:

ABC Co. is entirely equity financed. Its cost of equity is 15% and market value of equity is
Rs 100,000. It proposes to change its capital structure by obtaining debt amounting to Rs
30,000 and repaying existing equity. The cost of debt is 10%. Tax rate is 30%. Calculate
the new WACC, Ke and the value of the company.

Class Practice Question (ICAP Summer 2008 Q 3)

COMPLETE - NOTES

Uncertainty of Tax Shield

If uncertainty about tax shield exists then value of levered firm will be calculated as
follows:

Vg = Vu + D.t – present value lost through uncertainty

Corporate plus Personal Taxes

Apart from tax shield uncertainty, the presence of taxes on personal income may reduce
or possibly eliminate the corporate tax advantage associated with debt. If returns on debt
and on stock are taxed at the same personal tax rate, however, the corporate tax advantage
remains. If personal tax exists then tax shield will be calculated as follows:

Tax shield = 1 –(( 1 – Tc)(1-Tps))/1-Tpd

Where Tc is corporate tax rate, Tps is personal tax rate on stock income, Tpd is personal
tax rate on debt income.

Effect of Costs associated with debt/leverage

If induction of debt/leverage results in other costs i.e. bankruptcy costs,

agency costs etc. then value of firm will be calculated as follows:

Vg = Vu + D.t – present value of costs

Break-Even, or indifference, Analysis

The indifference point between two methods of financing can be determined

mathematically by:

EBIT- C1 = EBIT- C2
N1 N2

Where EBIT is the breakeven or indifference point, C1 is the interest expense under
capital structure option 1, N1 is the number of shares under capital structure option 1, C2
is the interest expense under capital structure option 2 and N2 is the number of shares
under capital structure option 2.

Example

ABC Ltd is considering to alter its capital structure by increasing its existing debt capital
of Rs 80 million to 125 million, interest rate on existing debt is 9% and it is expected to be
12 % for any additional debt. ABC Ltd has 6 million ordinary shares and market price per
share is Rs 75. Calculate breakeven EBIT.
COMPLETE - NOTES

c. Gearing and de-gearing of Beta Factors

What is Beta Factor?

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in

comparison to the market as a whole.
Asset beta (βa)
The beta factor for a company’s business operations is called its asset beta. An asset beta
is the beta factor that would be applied to a company’s assets if financing risk is removed
from the calculation. It is therefore a beta factor that applies to entire companies or
individual projects. It provides a measure of the underlying business risk faced by the
entire firm regardless of its financing structure. An asset beta is sometimes called
unlevered beta or ungeared beta.

Equity beta (βe)

The equity beta of a company is the beta factor of its equity capital that allows for both
business risk and financial risk.

Debt capital also has a beta factor (a ‘debt beta’), although this is much lower than the
equity beta.

Conversion of Beta

βa= βe x E + βd x D(1-t)
E+ D(1-t) E+ D(1-t)

Exam steps:

 Take beta equity of industry. Ungear this beta using industry gearing % and tax %
to convert beta asset of the industry.
 Use this beta asset and re-gear using gearing % and tax % for the project/company
to get beta equity of the project/company.
 This beta equity is then used in CAPM model to determine cost of equity (Ke).
 Calculate WACC using this Ke, this WACC is known as Risk Adjusted WACC.

Example:

A ltd is engaged in food business and financed by 60% equity and 40% debt. βe is 1.1. Pre-
tax cost of debt is 10% and tax rate is 30%. Market rate of return is 15% and risk free rate
is 10%. A is now planning to invest in power sector (with 50% equity and 50% debt). βe
COMPLETE - NOTES

of power sector listed company is 1.5 with 70% equity and 30% debt. Calculate the power
sector risk adjusted WACC.

Class practice ICMA August 2014 Q .3

Class practice ICMA March 2015 Q 2(b)
Class practice ICMA February 2013 Q.4
Class Practice Question (ICAP Summer 2012 Q 1)

Suggested Study Material (ICAP CFAP BFD study text Chapter 16 (part 1, 2
& 3), Financial Management and Policy by James C Van Horne 12 th edition
Chapter 9 &10.

Investment Decisions and Project Control

Time value of money

The relationship between Rs 100 in the future and Rs 100 today. For most of
us, Rs 100 in the future is less valuable. Moreover, Rs 100 two years from
now is less valuable than Rs 100 one year from now. We will pay more for
an investment that promises returns over years 1 to 5 than we will
pay for an investment that promises identical returns for years 6
through 10. This relationship is known as the time value of money.

Compound Interest and Terminal Values

Compound interest means that interest paid on a loan or an investment is

added to the principal. As a result, interest is earned on interest. To begin
with, consider a person who has Rs 100 in an account. If the interest rate is
8 percent compounded annually, how much will the Rs 100 be worth at the
end of a year? Setting up the problem, we solve for the terminal value (or
future value as it is also known) of the account at the end of the year:

Terminal Value = Rs 100 (1+0.08)= Rs 108

Similary if we want to know the worth of Rs 100 of 2 years it would be:

Terminal value after two years = Rs 100 (1+.08)^2 = Rs 116.64

Similarly, at the end of n years, the terminal value is

TV= Amount invested (1+I )^n

COMPLETE - NOTES

Compounding More Than Once a Year

If interest is paid semiannually or quarterly then the formula for calculating

the future value or terminal value would be as follows:

Terminal Value = amount invested ( 1+ i/m)^mn

m means number times interest paid.

Present Values

Present value is a future amount discounted to the present by some required

rate. Present value is calculated using the following formula:

PV = FA/ (1+i)^n

Present Value of an Annuity

A series of even cash flows is known as an annuity. In case of annuity we may

use annuity formula to determine the present value instead of discounting
each year separately using the following formula=

PV= Annuity factor* Period installment

Annuity factor – Normal

1-(1+i) ^-n
i
Annuity factor – Advance payments

1-(1+i) ^-n x (1+i)

i

Present Value When Interest Is Compounded More Than Once a

Year

PV = FA /( 1+ i/m)^mn
COMPLETE - NOTES

Investment/ Project Appraisal Techniques

ROCE

This is also known as accounting rate of return and is calculated using

following formula:

ROCE= (Average profits before interest and tax/ initial investment or

average investment)* 100

Decision Rule: If the expected ROCE of the investment is greater than target
or hurdle rate the project should be accepted.
Cash flows and relevant costs

Only relevant cash flows should be considered. These are:

I. Future
II. Incremental
III. Cash based

Ignore:

I. Sunk costs
II. Committed costs
III. Non-cash items
IV. Allocated costs

Payback method

The payback period is the time a project will take to pay back the money spent
on it. It is calculated using the following formulae:

a) Constant annual cash flows:

Payback period = Initial investment / annual cash flows

b) Uneven annual cash flows:

In practice, cash flows from a project are unlikely to be constant. Where cash
flows are uneven, payback is calculated working out the cumulative cash flow
over the life of the project.
COMPLETE - NOTES

Decision rule:

 Only select projects which pay back within the specified time period
 Choose between options on the basis of the fastest pay back.

Discounted Payback

It is same as payback (above) with just the difference that the cash flows
taken are discounted at WACC.

Net Present Value Method

If we treat outflows of a project as negative and inflows as positive, NPV is

the sum of PVs of all flows that arise as a result of the project. It assumes
reinvestment at cost of capital. NPV gives impact of the project on
shareholder’s wealth.

Cash flows:

Only relevant cash flows and opportunity cost of scarce resource as discussed
above are considered.

Inflation:

Cash flows ignoring inflation are called “real” or “current”.

Cash flows after incorporating inflation are called “money” or “nominal”.

Money Cash Flows (MCF) = Real Cash Flows (RCF) (1+i) ^n

Discount rate ignoring inflation are called “real”

Discount rate after incorporating inflation are called “money” or “nominal”.

(1+m)= (1+r) x (1+inflation rate)

 Inflation must be accounted for on a cumulative basis for each year if

real cash flows are to be translated into nominal cash flows.
 When single rate of inflation is given then either discount RCFs at real
rate or discount MF at money rate, the answer will be same ( except for
rounding difference).
COMPLETE - NOTES

 When separate inflation rates are given for different items (like sales,
costs etc.) then inflate RCFs of each item using relevant inflation rate
to make it MCFs and discount those MCFs at money rate. In this case
if real rate is given it will be converted to money rate using general
inflation rate.

Working Capital

 Take initial WC at year 0 as outflow.

 Subsequently take investment as at i.e. take differential WC each year
as outflow/ (inflow).
 Recover WC as positive cash flow at the end of the project life.

Tax:
 Tax details are normally given in question, in absence of any details
following assumptions to be used:
 Tax is payable in the same year
 Tax depreciation is charged on full year basis
 Asset is purchased at the start of the year.
 Tax outflows are shown when tax is actually paid.
 Tax saving on tax allowable non-cash expenses e.g. tax depreciation are
reduced from tax out flow.
 Tax on disposal profits are shown as outflow.

Discount Rate

 Should reflect the gearing and financial risk of the project/Company.

 Should reflect the business risk of the project.
 Should reflect the project specific cost of debt and equity.

Decision Rule

 If NPV is positive – The project is financially viable.

 If NVP is zero- The project breaks even.
 If NPV is negative- The project is not financially viable.
COMPLETE - NOTES

Internal Rate of Return (IRR)

The IRR represents the discount rate at which the NPV of an investment is
zero. It assumes reinvestment at IRR.

IRR of perpetuity

IRR of a perpetuity = (Annual inflow / Initial investment) x 100

IRR of irregular cash inflows

This is determined by interpolation/extrapolation formula

IRR= A + (a/a-b) (B-A)

(Where A is lower %; B is higher %; a is NPV at A; b is NPV at B)

Decision Rule

Accept the project if IRR is greater than or equal to company’s required rate
of return. If projects are mutually exclusive then project with highest IRR
should be accepted.

If there is conflict between IRR and NPV, NPV shall be preferred for project/
investment appraisal because reinvestment assumption in NPV is more
realistic.

Since IRR is an estimation, your answer may differ from others by around
+/- 1%.

Two IRRs

One weak point of the IRR is that there may be two IRRs if negative cash
flows occur at different times in a project.

Modified Internal Rate of Return (MIRR)

MIRR method assumes that cash flows are reinvested at the cost of capital.
Since the reinvestment at IRR is generally not correct, the MIRR is generally
COMPLETE - NOTES

a better indicator of a project’s true profitability. MIRR can be calculated

using the following formula.

(1+MIRR)^n = Terminal value of inflows (compounded at cost of capital)/

PV of costs

Decision Rule

Accept the project if MIRR is greater than or equal to company’s WACC.

Economic Internal Rate of Return (EIRR)

It is calculated in the same way as IRR but cash flows also include effect of
cash flows of other parties affected by the project. For example, a government
planning a road construction might use EIRR by including fuel savings by
general public as a result of road construction in addition to toll receipt.

Economic Value Addition

EVA indicates whether the opportunity cost of shareholder’s investment in

the company is positive or negative.

EVA = EBIT (1-T) – WACC (Capital employed)

Where EBIT = PBT + + interest + accounting depreciation – economic

depreciation + R&D written off + Goodwill written off

Capital employed = Capital employed as per SFP + R&D written off +

Goodwill written off

Targeted NPV

All cash flows other than target cash flows are discounted and then divided
by the annuity factor to compute the equal targeted cash flows or put into
equation to compute unequal target cash flows.
COMPLETE - NOTES

Profitability Index

It is a measure of profitability of a project based on cash flows.

PI = NPV / Initial outlay or PV of inflows / Initial outlay

Class practice

ICMA Feb 2013 Q. 5 (a)

RISK AND UNCERTAINITY IN INVESTMENT APPRAISAL

 Sensitivity Analysis

Sensitivity analysis investigates what happens to NPV and IRR of the

project/investment when one or more variable change. The idea is that we
freeze all the variables except for one being analyzed and check how sensitive
the NPV or IRR are to changes in that variable. It is done by calculating
Margin of safety (MOS) for each variable factor such as sales, variable cost,
fixed costs and residual value. Lower the margin more sensitive is the NPV
to that factor.

Safety Margin:

For cash flows based factors

= NPV/after tax PV of all cash flows relevant to the factor

(Note: for sensitivity of number of units, MOS is calculated for

contribution).

For discount rate:

IRR- WACC x 100

WACC

For project life:

Project life – discounted payback period
Project life
COMPLETE - NOTES

 Expected value
If any factor is uncertain, then its expected value is used in investment
appraisal. Various values along with their respective probabilities are given
in question.

Expected value = px

Here

x=value p= probability

Standard Deviation

The standard deviation σ (sigma) is the square root of the variance of X; i.e.,
it is the square root of the average value of (X − μ) ^2. The standard deviation
of a probability distribution is the same as that of a random variable having
that distribution. In this case σ will be calculated by taking the square root of
the value of (X − μ) ^2 multiply by respective probability.

Coefficient of variation

To find the coefficient of variation, divide the standard deviation by the mean
and multiply by 100.

Exam tips on probability question requiring expected NPV

 Identify certain and uncertain cash flows. All those cash flows with a
certain probabilities are uncertain.
 Make a cumulative probability for all uncertain cash flows.
 Present value each possibility of the uncertain cash flows and multiply
respective probability wit this PV.
 Add up the PVs and then add PV of certain cash flows to them.
 The sum total of all PVs is the Expected NPV.

ICMA Feb 2014 Q5

COMPLETE - NOTES

 Scenario Analysis
Begin with the base-case scenario, which uses the most likely set of input
values. We then specify a worst case scenario (low units sale, low unit price,
highest costs) and then a best case scenario and then compare the results.

 Decision Tree
Sometimes decision is to be made in two or more stages and second stage is
dependent upon decision taken in first stage. For this purpose, decision tree
is a useful technique of calculating expected values. Probability is allotted to
each branches of tree.

Exam techniques

 Work backwards, first calculate NPV at each end event point.

 Then calculate expected NPV at each event point.
 For decision points simple take higher NPV from the off shoots.
 Finally calculate the NPV for the project as whole.

 Capital Rationing

It is a situation where entity has multiple +ve NPV projects under

consideration but sufficient funds are not available to undertake all.

Types of Capital Rationing

 Single period rationing: Funds are limited in single period (generally

at T0)
 Multi period rationing: Funds are limited in more than one periods.

Decision mechanism:

1. Single period rationing

a. Divisible projects
 Rank each project on the basis of profitability index (PI)
 Keep selecting +ve NPV projects until funds are used up.
 In case of mutually exclusive projects, follow trial & error method
to ensure total NPV is maximized.
COMPLETE - NOTES

b. Indivisible projects

Follow trial & error method to ensure total NPV is maximized. Any
unused funds are assumed to be invested at WACC thus giving 0
NPV.

Hard capital rationing Soft capital rationing

Due to external factors Due to internal factors (Company
impose its own rationing).

ICMA - August 2013 Q 5.

Adjusted Present Value Method

The APV technique separate the financing decision from the investment
decision i.e. it calculates the effect of various financing and investment
options separately. It should be used in exam when:
 The company is venturing into new business plus there is some issue
cost/subsidized loan: or
 The question requires to use APV.

Exam format for APV

Investment decision:

Base case NPV xxx

Financing decisions

PV of issue costs xxx

PV of tax shield on debt xxx
PV of subsidized loan benefit xxx
Adjusted Present Value xxx

Base case NPV

 The discount rate for base case NPV is computed by putting beta asset
into the CAPM formula.
 This beta asset is computed by using beta equity and gearing of new
industry.
COMPLETE - NOTES

 Simply discount all operating and investment cash flows at above

mentioned discount rate.

Issue Costs
 Issue costs are calculated at gross. (i.e. finance raised x cost / 100-cost)
 These are normally occur at T0 therefore no need of discounting.
 Deduct Tax saving from issue costs only IF issue costs are mentioned
to be tax deductible.
 If tax deduction of issue cost is not mentioned in question, then issue
cost of debt can be assumed to tax deductible. (Do not forget to give
a “note”).
 Discount tax savings @ Rf if tax is payable in arrears.

Tax shield on debt

 Tax shield is based on debt capacity created by the project.
 Calculate the tax shield amount based on repayment schedules.
 Discount the tax shield of respective years @ Rf or Pre-tax cost of debt.
(Rf is more logical to use however pre-tax Kd can also be used).

Subsidized Loan
 Saving in form of low cost loan or Govt Subsidy on interest.
 Benefit of subsidized loan = Loan amount (Kd- Subsidized loan cost%)
(1-tax rate %) x relevant annuity factor at Rf/ Kd(pre-tax).
 If the loan is irredeemable, benefit only for the term of project is
considered.
 If tax is payable in arrears discount tax effects by one year delay.
 If subsidized loan is to be repaid in instalments, the benefit of
subsidized loan is given to be computed in ACCA books as

Annual repayment = Loan amount (including issue costs)/ Annual

factor at actual loan %.

PV of loan subsidy = (loan amount – (annual repayment x annuity

factor at Kd %) x (1-tax rate)
 The above method is slightly faulty and better approach is to make two
tables and compare.

Class practice
ICAP summer 2010 Q.3
COMPLETE - NOTES

International investment decisions

International investment decisions are similar to normal investment

decisions with differences only in the conversion of foreign exchange rates
and application of risk commensurate discount rates and techniques. The
relevant cash inflows for a foreign investment are those that can be
repatriated to the investor.

The problem arises because operating cash flows occur in foreign currency
whereas NPV is to be calculated in domestic currency. Another important
issue to be considered here is payment of additional tax in local currency in
respect of foreign operations.

Exam steps for foreign investment question

 Estimate future exchange rate by using any of following:

 Current exchange rate x (1+inflation Pakistan)/ (1+inflation
abroad)
 Current exchange rate x (1+interest rate Pakistan)/ (1+interest
rate abroad)
 Calculate pre-tax net cash flows in foreign currency.
 Provide tax in foreign currency at foreign tax rate and compute after
tax net cash flows.
 Apply estimated exchange rate and convert to local currency.
 Add local cash flows associated to foreign investment, take tax on these
amounts at local tax rate and calculate total cash flows.
 Discount the total cash flows at appropriate rate.

INTERNATIONAL COST OF CAPITAL

Country risk premium

Using CAPM to estimate the cost of equity in developing countries is

problematic because the beta does not adequately capture the country risk.
To reflect the increased risk associated with investing in a developing
country, a country risk premium is added to the market risk premium
when using the CAPM.

Capital asset pricing model adjusted for country risk premium

RE = RRF + β (RM – RRF + CRP)

COMPLETE - NOTES

Where CRP is country risk premium

Country risk premium can be calculated using following formula:

Sovereign yield spread x Annualized standard deviation of equity index of developing country
Annualized standard deviation of sovereign bond market in terms of the developed
market currency

Where the sovereign yield spread is the difference between the yields of
government bonds in the developing country and treasury bonds of similar
maturities.

Class practice

ICAP Winter 2011 Q.5

Real options in investment decisions

In practice, investment projects are not necessarily to set in concrete once

they are accepted. Managers can, and often do, make changes that affect
subsequent cash flows and/or the life of the project. These real, or
managerial options are embedded in the investment projects.

The presence of real options enhances the worth of an investment project.

It’s worth can be viewed as the net present value of the project, calculated in
the usual way together with the value of the option(s).

Project worth = NPV + Option value

Option Value

The difference between the expected NPVs with and without the relevant
option. It is the value that is not accounted for in a traditional NPV analysis.
A positive option value expands the firm’s opportunities.

Types of Real Options

The types of real options available include:

1. Timing/Postpone, where a project can be delayed until more

information about demand and/or costs can be obtained;
COMPLETE - NOTES

2. Abandonment, where the project can be shut down if its cash flows
are low;
3. Expansion, where the project can be expanded if demand turns out
to be stronger than expected;
4. Output flexibility, where the output can be changed if market
conditions change; and
5. Input flexibility, where the inputs used in the production process
(say, coal versus oil for generating electricity) can be changed if input
prices and/or availability change.

Example Timing/ Post pone

Assume that Williams Inc. is considering a project that requires an initial

investment of Rs 5 million at the beginning of 2016 (or t0). The project
will generate positive net cash flows at the end of each of the next four
years (t 1, 2, 3, and 4). However, the size of each annual cash flow will
depend on what happens to future market conditions. There is a 50
percent probability that market conditions will be strong, in which case
the project will generate cash flows of Rs 2.5 million at the end of each of
the next four years. There is also a 50 percent probability that demand
for the product will be weak, in which case the annual cash flows will be
only Rs 1.2 million. Williams considers the project to have average risk,
hence it will be evaluated using a 10 percent WACC.

Now suppose Williams can delay the project until next year when more
information will be available about market conditions, before making the
decision. If conditions are good, the firm will make investment at the
beginning of 2017. The project will generate positive net cash flows at the
end of each of the next four years, but if they are bad, it will not make the
investment. The probability of each outcome is 50 percent.

Calculate NPVs under existing and delay options and recommend the
most suitable course of action.

Example - Abandonment

ICAP Summer 2015 Q.1

COMPLETE - NOTES

Example - Expansion

We can illustrate expansion options with a distribution center in

mainland China being considered by the Crum Corporation. An
investment of Rs 3 million would be required at time 0. Under good
conditions the project would generate cash flows of Rs 1.5 million during
each of the next 3 years (i.e. 1, 2, and 3), but under bad conditions its cash
flows would be only Rs 0.75 million. There is a 50 percent probability of
each outcome. Crum uses a WACC of 12 percent for international
investments.

Crum believes that if it invests in the distribution center and conditions

are good, it will gain experience that will give it the opportunity to make
another investment in China. The new venture would cost Rs 10 million
at time 2, and it could be sold for cash one year after it is completed, at
time 3, for Rs 20 million.

Evaluate the project with and without expansion options.

Control of investment projects

 Gather information
– collect historical costs
– gather external information
– assess opportunity costs
– consider strategic direction
Make predictions
– determine costs of project e.g. purchase and installation
– evaluate the expected hard and soft benefits of the new system
 Accept project
– compare predicted costs with benefits over a period of years, that is,
investment appraisal
– consider all other aspects of decision
 Implementation decision
– prepare plan for implementation
– carry out implementation
 Evaluate performance
– monitor events by collecting regular statistics
– carry out a post-completion appraisal
 Use knowledge gained
COMPLETE - NOTES

– assess findings of post-completion appraisal

– implement improvements to system

Post-completion auditing

A post-completion audit (PCA) can be defined as ‘an objective and

independent appraisal of all phases of the capital expenditure process as it
relates to a specific project’. The main purposes may be summarized as:

● project control;
● improving the investment system;
● assisting the assessment of performance of future projects.

A project’s PCA provides the mechanism whereby experience of past projects

can be fed into the entity’s decision-making processes as an aid to the
improvement of future projects.

Past Evidence also suggests that the growing interest in PCA has arisen from
a realisation that past investments have frequently failed to live up to
expectations, and firms are keen to avoid repetition of the same mistakes.

Benefits of post-completion auditing

Six potential benefits from the operation of a post-auditing system have been
identified, and these are listed below:

Post Completion Auditing (CIMA, 1993):

1. It improves the quality of decision-making, by providing a mechanism
whereby past experience can be made readily available to decision-makers.
2. It encourages greater realism in project appraisal, by providing a
mechanism whereby past inaccuracies in forecasts are made public.
3. It provides a means of improving control mechanisms, by formally
highlighting areas where weaknesses have caused problems.
4. It enables speedy modification of under-performing/over-performing
projects, by identifying the reasons for the under- or over-performance.
COMPLETE - NOTES

5. It increases the frequency of project termination for ‘bad projects’.

6. It highlights reasons for successful projects, which may be important in
achieving greater benefits from future projects.

● Type (a) – those which relate to the performance of the current project, i.e.
the project under review.
● Type ( b) – those which relate to the investment system itself.
● Type (c) – those which relate to the choice and performance of future
projects.

Feasibility Study

A feasibility study evaluates the project’s potential for success; therefore,

perceived objectivity is an important factor in the credibility of the study for
potential investors and lending institutions. There are five types of feasibility
study—separate areas that a feasibility study examines, described below:

1. Technical Feasibility - this assessment focuses on the technical

resources available to the organization. It helps organizations
determine whether the technical resources meet capacity and whether
the technical team is capable of converting the ideas into working
systems. Technical feasibility also involves evaluation of the hardware,
software, and other technology requirements of the proposed system.
As an exaggerated example, an organization wouldn’t want to try to put
Star Trek’s transporters in their building—currently, this project is not
technically feasible.
2. Economic Feasibility - this assessment typically involves a cost/
benefits analysis of the project, helping organizations determine the
viability, cost, and benefits associated with a project before financial
resources are allocated. It also serves as an independent project
assessment and enhances project credibility—helping decision makers
determine the positive economic benefits to the organization that the
proposed project will provide.
3. Legal Feasibility - this assessment investigates whether any aspect
of the proposed project conflicts with legal requirements like zoning
laws, data protection acts, or social media laws. Let’s say an
organization wants to construct a new office building in a specific
location. A feasibility study might reveal the organization’s ideal
location isn’t zoned for that type of business. That organization has just
COMPLETE - NOTES

saved considerable time and effort by learning that their project was
not feasible right from the beginning.
4. Operational Feasibility - this assessment involves undertaking a
study to analyze and determine whether—and how well—the
organization’s needs can be met by completing the project. Operational
feasibility studies also analyze how a project plan satisfies the
requirements identified in the requirements analysis phase of system
development.
5. Scheduling Feasibility - this assessment is the most important for
project success; after all, a project will fail if not completed on time. In
scheduling feasibility, an organization estimates how much time the
project will take to complete.

Benefits of Conducting a Feasibility Study

Below are some key benefits of conducting a feasibility study:

 Improves project teams’ focus

 Identifies new opportunities
 Provides valuable information for a “go/no-go” decision
 Narrows the business alternatives
 Identifies a valid reason to undertake the project
 Enhances the success rate by evaluating multiple parameters
 Aids decision-making on the project
 Identifies reasons not to proceed

Suggested Study Material (ICAP CFAP BFD study text Chapter 2, 5,6,7,8, 11
and 20. Financial Management and Policy by James C Van Horne 12 th edition
Chapter 6 &7.

Practice (Mandatory)
ICMAP

Sr. Q No. in Attempt Topic

No. paper
1. 4 (a&b) February 2013 Capital structure and
leverage
2. 4 August 2013 Capital structure
COMPLETE - NOTES

3. 5(a),(b) August 2013 Capital rationing,

expansion option
4. 4(a) November 2013 Capital structure
5. 5(b) November 2013 Sensitivity analysis
6. 5 (a&b) February 2013 NPV, payback, expected
value
7. 6 November 2013 APV
8. 4 February 2014 Project appraisal and
feasibility theory
9. 5 February 2014 Expected value NPV
10. 3 August 2014 Capital structure, M&M
11. 2(b) March 2015 Capital structure
12. 5 March 2015 Capital structure
13. 1 August 2015 NPV
14. 2 February 2016 Capital structure
15. 4 August 2016 Capital structure
16. 4 February 2017 Leverage
17. 4 September 2017 Capital structure

ICAP

Sr. Q No. in Attempt Topic

No. paper
1. 3 Summer 2008 Share issue & MM
2. 5 Summer 2009 M&M and WACC
3. 5 Winter 2010 M&M and WACC
4. 1 Summer 2011 Leverage
5. 1 Summer 2012 Pureplay and WACC
6. 2 Winter 2015 Capital structure
7. 5 Winter 2015 Capital structure
8. 3 Summer 2010 APV
9. 4 Winter 2014 APV
10. 4 Winter 2010 International investment
11. 5 Winter 2011 International investment
12. 3 Winter 2017 International investment
13. 4 Winter 2008 NPV & IRR
14. 5 Winter 2008 NPV, WACC and
sensitivity analysis
15. 6 Summer 2009 Expected value
COMPLETE - NOTES

16. 2 Winter 2009 NPV and WACC

17. 4 Summer 2011 NPV
18. 2 Winter 2011 NPV and decision tree
19. 3 Summer 2012 NPV, IRR MIRR, payback
20. 4 Summer 2013 NPV and sensitivity
21. 2 Winter 2013
22. 4 Summer 2014 Appraisal and sensitivity
23. 1 Summer 2015 Abandonment option
24. 6 Winter 2015 NPV
25. 1 Summer 2017 Discounted Cash Flows
26. 4 Summer 2018 MIRR
27. 2 Summer 2012 Capital rationing
28. 1 Winter 2014 Capital rationing
29. 3 Winter 2016 Capital rationing