(^286) Financial Management
Recall that kU is the cost of capital of an all-equity (unlevered) firm, it X(1-T) is
perpetual after-tax cash flows (net operating income) of an all-equity firm and Tkd D
is a perpetual stream of interest tax shield, Equation (14) implies the following required
rate of return for a levered firm:
kt = Vu (1-TL)
where k, is the cost of capital of the levered firm and L is debt ratio (D/V).
We can use kl, as the discount rate for those investment projects that generate perpetual
cash flows (perpetual after-tax all-equity cash flows and perpetual interest tax shields).
In practice, it not common to find projects with perpetual cash flows. Projects have
finite life, and firms are able to raise funds from financial institutions or public which
are tied to specific projects. This is more so under project financing ∑ Thus, the amounts
of interest and principal repayments are predetermined, and they are accounted for
within the life of the project. Such projects have their unique capital structure.
How can we evaluate the net present value of projects that are not prepetual investments
and that do not have constant capital structure? It is not possible to estimate the
weighted cost of capital for such projects We can use the adjusted present value
(APV) method for evaluating such investments.
We can rewrite Equation (14) for valuing an investment project with finite cash flows
as follows:
APV =
= = ++
+
&'(...(39)
In practice, a project may get many other benefits (or involve penalties) in addition to
the interest tax shield. Equation (39) can be extended to incorporate the value of such
benefits (or costs). There is no method available to adjust such items in estimating the
weighted average cost of capital.
Illustration 4: Gujarat Engineering Company is considering a new project to
manufacture steel tubes. The estimated project outlay is Rs 64 crore which will be
raised by issuing equity of Rs 40 crore and borrowing a 15 per cent loan of Rs 24 crore
from a financial institution for eight years. The loan will be repaid in three equal
instalments at the end of years 6, 7 and 8. The project is expected to generate an annual
after-tax cash flow of Rs 12 crores over the eight-year life of the project. The all-
equity required rate of return is 18 per cent. The corporate tax rate is 35 percent. The
terminal value of the project is assumed to be zero. Should the company make investment
to manufacture steel tube? We can use APV method for evaluating the project.
The project is expected to generate an after-tax annuity of Rs 12 crore for 8 years.
The interest tax shield is calculated as follows: