Page 19 - SCS May 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

Gearing level

The above assumes that the new venture will be financed by a mix of both equity and debt funds
in such a way as to keep our gearing level the same as it is now. If this is not going to be the case
then the change in gearing level should be taken into account, as well as the different business
risk. This can be done by using a technique called Adjusted Present Value (APV). This APV is
calculated in two steps; firstly the ‘base case NPV’ and then the ‘present value of the financing
side effects’. The results of these two steps are then added together to give the APV. This APV
then again reflects the increase (or decrease) in shareholder wealth that should result from the
proposal.

Base Case NPV

In this step it is assumed that the new project will in fact be financed entirely by equity, and the
cash flows are therefore discounted at a ‘pure’ equity rate. (This is the rate of return that
shareholders would want from the project taking into account only the projects business risk.) As
with the risk adjusted WACC, the start point is identifying a company in the same line of business
as the new proposal and un-gearing its β coefficient. Now however this ungeared β coefficient is
not re-geared for our own gearing, but is used directly in the CAPM to give the required pure
equity rate at which to discount the cash flows.

Financing side effects

This step then takes into account that some of the finance will in fact come from debt rather than
equity. The benefits of using debt finance (basically the resultant tax savings) are discounted at
the pre-tax cost of debt (to correctly reflect the risk associated with these cash flows) to give the
PV of the financing side effects.

As the cost of debt is unlikely to be influenced by the different level of business risk, the cost can
be determined by looking at our existing debt finance.

Reservations

The two techniques suggested above to take account of changing levels of business and financial
risk both depend on the use of β coefficients to measure the level of risk present. However, β
coefficients measure just the systematic risk and ignore the specific (or unsystematic) risk that is
also present. Ignoring this specific risk is only valid if the shareholders of the company hold well
diversified portfolios of shares where the specific risk has been diversified away.

As far as our external investors are concerned this will probably be the case but, dependent on
what other investments you have, may not be true for you and your fellow founder members; in
which case the two techniques are not strictly applicable for you. Unfortunately there are no
techniques available to deal with such a situation so the above are the best available. Despite not
being strictly applicable they will nonetheless give a reasonable guide to the desirability of the
investment.

Additionally both techniques require us to find a company similar to ourselves operating in Russia,
and what is really needed is a company operating solely in Russia. Whilst there may well be
Russian based companies we could look at they will not face the same level of political risk as
foreign companies. Ideally we need to find a non-Russian company operating solely in Russia and
that would seem unlikely. A compromise situation is probably the best we can hope for.

KAPLAN PUBLISHING 75