IBUS 302:
International Finance
Topic 20-International
Capital Budgeting II
Lawrence Schrenk, Instructor
1 (of 30)
Learning Objectives
1.
2.
3.
Explain the conditions for using adjusted
present value (APV).▪
Calculate a basic APV problem.
Calculate an international APV problem.▪
2 (of 30)
Why APV?
3 (of 30)
Firm/Project Value

Firms create two sources of value:

Operating Value: What they ‘produce’


Left-Hand Side of Balance Sheet
Financing Value: How they finance what they
‘produce’.

Right-Hand Side of Balance Sheet
4 (of 28)
NPV versus APV Strategy

NPV Strategy



Include the financing values, e.g., the tax
advantages of debt, financial distress costs, by
adjusting the discount rate.
That is, use the WACC as the discount rate.
APV Strategy


Separate the financing values, e.g., the tax
advantages of debt, financial distress costs, into
different calculations.
Value Additivity Model
5 (of 28)
NPV Flaws


Aggregates Operating and Financing Values
WACC







Estimation Problems
Book Values
Changes in WACC over Time
Sensitivity Analysis
Cannot always use the firm’s WACC for a project
Single Discount Rate
No Real Options
6 (of 28)
APV Solutions




Financing, etc. Valued Separately
No WACC
Multiple Discount Rates
Real Options
7 (of 28)
Why APV?

APV is better at:



Accurate Valuation of Financing Values
Providing Information on the Sources of Value
APV can include features NPV cannot:



Real Options
Changes in Capital Structure, e.g., LBO’s
Debt Repayment Schedule
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APV Basics
9 (of 30)
Key Idea

Separate Valuation of…


A) Operating Cash Flows for Unlevered Firm
B) Other Value Components






Tax Advantages of Debt
Financial Distress
Subsidies
Hedges
Costs of Issuing Securities
Etc.
10 (of 28)
A) Operating Cash Flows for
Unlevered Firm

Construct Annual OCF


Same procedure as in NPV
Discount with Cost of Equity

Estimation of the Cost of Equity




CAPM
Empirical Comparisons
Why is this easier and more accurate than
WACC?
Find NPVOCF for OCF of Unlevered Firm
11 (of 28)
B) Other Value Components


These are ‘adjustments’ to the NPVOCF to
account for other value changes.
Financing




Tax Advantages of Debt and Depreciation (+)
Financial Distress (-)
Hedges (+ hopefully )
Other


Subsidies (+)
Real Options (+)
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The APV Calculation
APV =
NPVOCF
+ PV(Tax Advantage)
– PV(Financial Distress)
+ PV(Real Options)
+…
A
B
13 (of 28)
Multiple Discount Rates

NPV/WACC has a single discount rate.


Everything is discounted at the ‘average’ rate
APV allows multiple rates:


Discount rates should reflect risk of individual
cash flows
Do all cash flows have the same risk?

Are sales predictions as reliable as cost predictions?
14 (of 28)
A Simple Example




A firm is considering a new project which will
cost $500,000 and generate $175,000 for four
years.
The cost of equity for the firm is 12%.
The project will be funded by issuing $300,000
in debt at 8% and the rest from internal funds.
The issuance costs are 1.5% of the principal,
and the corporate tax rate is 20%.
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A Simple Example







Investment
Annual Cash Flow
Debt Issued
Cost of Equity
Cost of Debt
Corporate Tax Rate
Issuance Costs
$500,000
$175,000
$300,000
12%
8%
20%
1.5%
16 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
1
2
3
4
($500,000)
17 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
$175,000
2
$175,000
3
$175,000
4
$175,000
18 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
$175,000
2
$175,000
3
$175,000
4
$175,000
$31,536
19 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
$175,000
2
$175,000
3
$175,000
4
$175,000
$31,536
$300,000
20 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
$175,000
2
$175,000
3
$175,000
4
$175,000
$31,536
$300,000
($4,500)
21 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
2
3
4
$175,000
$175,000
$175,000
$175,000
$4,800
$4,800
$4,800
$4,800
$31,536
$300,000
($4,500)
22 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
2
3
4
$175,000
$175,000
$175,000
$175,000
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$31,536
$300,000
($4,500)
($4,500)
23 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
2
3
4
$175,000
$175,000
$175,000
$175,000
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$31,536
$300,000
($4,500)
($4,500)
$11,398
24 (of 28)
A Simple Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
2
3
4
$175,000
$175,000
$175,000
$175,000
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$31,536
$300,000
($4,500)
($4,500)
$11,398
$42,934
25 (of 28)
A Simple Example


Such a simple example illustrates APV, but
doesn’t really show its true value.
APV analysis does allow us to distinguish




The value of the project:
The value of the financing:
$31,536
$11,398
NPV calculation would obscure this. ▪
Could APV be positive if the value of the
project were negative? ▪
26 (of 28)
Second Example


What is the value if the debt must be repaid
in equal installments over the first three years
of the project?
NOTE: You could not value this with NPV.


The project leverage changes,
But WACC must be constant.
27 (of 28)
Second Example
PV
NPVOCF
Investment
Annual Cash Flows
NPVOCF
Debt Value
Debt Issued
Issuance Cost
Installment
Interest Portion
Annual Tax Advantage
Annual Net Advantage
PV(Tax Advantage)
APV
0
($500,000)
($500,000)
1
2
3
$175,000
$175,000
$175,000
($116,410)
($24,000)
$4,800
$4,800
($116,410)
($18,674)
$3,321
$3,321
($116,410)
($12,922)
$1,725
$1,725
4
$175,000
$31,536
$300,000
($4,500)
($4,500)
$4,161
$35,697
28 (of 28)
International APV
29 (of 30)
Lessard Model



APV model for a multinational corporation
analyzing a foreign capital expenditure.
This model incorporates many features that
are distinctive to foreign direct investment.
Parent firm perspective
30 (of 28)
Lessard Model

The Full Equation
T
StOCFt (1  τ ) T St τ Dt
St τ It
APV  


t
t
t
(1  K ud )
t 1
t 1 (1  id )
t 1 (1  id )
T
T
ST TVT
St LPt

 S0C0  S0 RF0  S0CL0  
T
t
(1  K ud )
t 1 (1  id )
Lessard Model: OCF

Discounting Operating Cash Flows
1.
Find after-tax OCF
StOCFt (1  τ )

t
(1

K
)
t 1
ud
T
2.
Convert OCF to dollars
3.
Discount at unlevered rate
32 (of 28)
Lessard Model: Depreciation

Discounting Depreciation Tax Shields
1.
Find annual tax advantage
StτDt

t
(1

i
)
t 1
d
T
2.
Convert CF to dollars
3.
Discount at cost of debt
33 (of 28)
Lessard Model: Interest/Debt

Interest Tax Shields
1.
Find annual tax advantage
StτIt

t
(1

i
)
t 1
d
T
2.
Convert CF to dollars
3.
Discount at cost of debt
34 (of 28)
Lessard Model: Terminal Value

Discounting Terminal Value
1.
2.
Convert OCF to Dollars
Discount at unlevered rate
STTVT
(1  Kud )T
35 (of 28)
Lessard Model: Investment
and Restricted Funds

Investment: Convert to Dollars
S0C0

Restricted Funds: Convert to Dollars
S0RF0
36 (of 28)
Lessard Model: Concessionary
Loans

Concessionary Loan Principal: Convert to
Dollars
S0CL0

Concessionary Loan Principal: Convert to
Dollars and Discount
T
St LPt

t
t 1 (1  i d )
37 (of 28)
Estimating the Future
Expected Exchange Rates
We can apply PPP:
(1  π d )t
St  S 0
(1  π f )t
Note: This is what we did in the NPV example.
Example



A project in Germany will generate €150,000
for three year and requires an investment of
€400,000.
€300,000 of the investment is depreciable
using straight line depreciation.
The project funding will include issuing
€200,000 in debt.
39 (of 28)
Example







Cost of Equity
Cost of Debt
Corporate Tax Rate
Dollar Inflation
Euro Inflation
Issuance Costs
S($/€)
15%
11%
35%
6%
3%
2%
1.5544
40 (of 28)
Example: Spot Rates

Calculate expected spot rates using PPP
(1.06)t
St 1  St
(1.03)t
1.5544
1.5997
1.6463
1.6942
41 (of 28)
Example: NPVOCF
PV
NPVOCF
Investment
Annual Cash Flows (€)
S($/€)
Annual Cash Flows ($)
NPVOCF
0
€
€
1
(400,000.00)
(400,000.00) € 130,000.00
1.5544
1.5997
($621,760.00)
$207,957.59
2
€
130,000.00
1.6463
$214,014.61
3
€
130,000.00
1.6942
$220,248.04
($134,284.85) (NOTE: Discounted at cost of equity)
42 (of 28)
Example: Depreciation
PV
Depreciation Value
Depreciation
Annual CF (€)
S($/€)
Annual CF ($)
PV
0
1
€
€
1.5544
100,000.00
35,000.00
1.5997
$55,988.58
2
€
€
100,000.00
35,000.00
1.6463
$57,619.32
3
€
€
100,000.00
35,000.00
1.6942
$59,297.55
$140,563 (NOTE: Discounted at cost of debt)
43 (of 28)
Example: Debt
Debt Value
Debt Issued
Issuance Cost
Annual CF (€)
S($/€)
Annual CF ($)
PV
€
€
200,000.00
(4,000.00)
€
1.5544
($4,000.00)
7,700.00
1.5997
$12,317.49
€
7,700.00
1.6463
$12,676.25
€
7,700.00
1.6942
$13,045.46
$24,256 (NOTE: Discounted at cost of debt)
44 (of 28)
Example: APV
PV
NPVOCF
Investment
Annual Cash Flows (€)
S($/€)
Annual Cash Flows ($)
NPVOCF
Depreciation Value
Depreciation
Annual CF (€)
S($/€)
Annual CF ($)
PV
Debt Value
Debt Issued
Issuance Cost
Annual CF (€)
S($/€)
Annual CF ($)
PV
APV
0
€
€
1
(400,000.00)
(400,000.00) € 130,000.00
1.5544
1.5997
($621,760.00)
$207,957.59
2
3
€
130,000.00
1.6463
$214,014.61
€
130,000.00
1.6942
$220,248.04
€
€
100,000.00
35,000.00
1.6463
$57,619.32
€
€
100,000.00
35,000.00
1.6942
$59,297.55
€
7,700.00
1.6463
$12,676.25
€
7,700.00
1.6942
$13,045.46
($134,284.85) (NOTE: Discounted at cost of equity)
€
€
1.5544
100,000.00
35,000.00
1.5997
$55,988.58
$140,563 (NOTE: Discounted at cost of debt)
€
€
200,000.00
(4,000.00)
€
1.5544
($4,000.00)
7,700.00
1.5997
$12,317.49
$24,256 (NOTE: Discounted at cost of debt)
$30,534
45 (of 28)