Chapter 20 -- Interactions Between
Investment and Financing
Decisions
 Separation
Principle
Investment
decisions and financing decisions
are independent of each other
 Exceptions
Wealth
to the separation principle
transfers from debt to equity holders
Wealth transfers from equity to debt holders
Investments that change risk characteristics
Investments with special financing attached
Wealth transfer examples
 Funding
a new project entirely with debt
decreases the value of existing debt
 If the value of the total company does not
change, and the value of the debt decreases, the
value of the equity increases.
 Funding a new project entirely with equity
could similarly increase the wealth of the
creditors
Wealth Transfers
Wealth
transfer may happen
without a capital investment:
Company
could issue debt to buy
back equity, or vise. versa.
Restrictive
covenants work to
minimize this type of wealth
transfer
Information Asymmetry
 If
investors are not aware of the expected
return on new investments, the stock price may
be below its intrinsic value
 Selling stock below its intrinsic value would
dilute the interests of current shareholders
 Financing with debt would allow the company
to delay equity financing until investors had
observed the success
Investments that change the risk
and optimal debt level of the firm
 A new
investment may reduce the
variance of the firm’s cash flows
because it is negatively correlated. The
new investment will increase the
optimal level of debt and lower the
marginal cost of capital for a project
Investments with special
financing attached
Communities or manufacturers may offer special
financing to encourage capital investment
 NPV with special financing equals regular NPV +
Net advantage of financing (NAF)

n
NAF = SF -  [Pt + Intt(1-Tc)]/(1+kd)
t=1
where SF is the amount of special financing, Pt and
Intt are principal and interest payments, Tc is the
corporate tax rate, and kd is the cost of debt
Alternative NPV methods for
dealing with financing mix
 Arditti-Levy
net present value
 Adjusted present value
 Equity residual net present value
Arditti-Levy NPV
 Often
used by public utilities
n
Σ [(EBITt- Intt)(1 - Tc) + Dept + Intt]/(1 + kAL)t - I0
t=1
Where EBITt is earnings before interest and tax
for year t, Intt is interest payment for year t, Tc is
the corporate tax rate, Deptt is depreciation in
year t, I0 is the initial investment, and KAL is the
Arditti-Levy required return
Adjusted Present Value
n
APV = Σ [(EBITt (1 - Tc) + Dept]/(1 + ku)t - I0
t=1
n
+ Σ TcIntt/(1+Rd)t
t=1
Where Ku is required return for an unlevered
investment and Rd is the interest rate on the
corporation’s debt
Equity Residual Method
 Used
in banking and often used for international
investments where the U.S. firm is putting in
only the equity
 Essentially looks at cash flows to and from
shareholders
Equity Residual NPV
n
Σ [EBITt – Intt)(1-Tc)+Dept + (Bt – Bt-1)]/(1+ke)t
t=1
– (I0 – B0)
Where Bt = amount of debt at time t and other
variable are as previously defined
Comparing Methods
 Under
assumptions including a constant debt
ratio over time, we get the same answers from
regular NPV, Arditti-Levy NPV, and equity
residual NPV.
 The choice is then one of convenience for a
particular company