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Base case NPV and Adjusted Present Value (APV):
This concept is based on design of the capital structure. In case of Base Case NPV, cash flows will not include financial cash flows & flotation cost. Relevant cash flows will be cash required for project and operating cash flows generated by the project. Discount rate will be the Ke for an all-equity financed firm. Base case NPV is the minimum possible NPV without affected by design of capital structure.
When base case NPV is further adjusted for impact of financing & flotation cost it is called as Adjusted Present value. Stewart Myers proposed APV approach. In APV approach, project cash flows are broken down into two components: Unlevered operating cash flows and those associated with financing the project. The rationale behind this is to use two discount rates. As operating cash flows are more risky, they are discounted at a higher rate i.e. Ke for all equity-financed firm. Cash flows associated with financing the project include P.V. of tax shield on interest, P.V. of flotation cost and other costs associated with financing of project. Present values of tax shield on interest and flotation cost or any other specific costs associated with finance are calculated on the basis of borrowing rate in the absence of any specific information as borrowing rate is the least required rate of return from a project. Flotation cost or any other specific cost associated with finance will be taken after tax, if deductible for tax purpose. APV is calculated as follows:
APV = Base case NPV + P.V. of tax shield on interest - P.V. of flotation cost or any other specific cost associated with financing of project
XYZ Ltd. is planning to introduce a new product. The initial investment required is Rs. 48 lacs. Total requirement of Rs. 48 lacs will be met by Rs. 8 lacs from internally generated funds. Rs. 15 lacs' from a right issue and remaining from a long-term loan at 12% p.a. The ratio of loan reflects debt capacity of the company. Right issue will involve floatation cost at 3% and term loan processing cost will be 1 %. Corporate taxes are payable at 40% p.a. on net operating cash flows of the particular year. Risk free rate of interest is 9%. Market return is 14% and relevant company assets beta for the investment is estimated to be 1.5. Net operating after tax cash flows from the project is
Year 1 = Rs. 15 lacs
Year 2 = Rs. 34 lacs
Year 3 = Rs. 12 lacs
Besides these inflows residual value of Rs. 5 lacs (after all taxes) is also expected at the end of third year. You are required to estimate APV of the investment and decide whether the investment is worth undertaking.
Santana Ltd. is evaluating a project costing Rs. 20 lacs. The project generates savings (cash inflows) of Rs. 2.95 Lacs p.a., perpetuity. The business risk of the project warrants a rate of return of 15%.
a. Calculate Base case NPV of the project assuming no tax.
b. Assuming tax rate of 30% with 12% cost of debt constituting 30% of the cost of the project, after tax cash flows 2.95 lacs p.a., determine APV.
c. Find out minimum acceptable Base Case NPV and annual after tax cash inflows.