Amberle Co is a listed company with divisions which manufacture cars, motorbikes and cycles. Over the last few years, Amberle Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new investment of $150 million in facilities to produce electric cars, which it proposes to finance solely by debt finance.
Project information
Amberle Co’s finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:
Year 1 2 3 4
$m $m $m $m
Post-tax operating cash flows 28·50 36·70 44·40 50·90
Realisable value 45·00
Working capital of $6 million, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.
Predicted rates of inflation are as follows:
Year 1 2 3 4
8% 6% 5% 4%
The finance director has proposed the following finance package for the new investment:
Calculate the adjusted present value (APV) for the project and conclude whether the project should be accepted or not.
Base case net present value is approximately ($5·09 million) and on this basis, the investment should be rejected.
Workings
1 Working capital
Year 0 1 2 3 4
$m $m $m $m $m
Working capital 6·00 6·48 6·87 7·21
Required/(released) 6·00 0·48 0·39 0·34 (7·21)
2 Discount rate
Using asset beta
All-equity financed discount rate = 4% + (11% – 4%) 1·14 = 12%
3 Issue costs
$80 million/0·97 = $82,474,227
Issue costs = 3% x $82,474,227 = $2,474,227
There will be no issue costs for the bank loan.
4 Tax shield on subsidised loan
Use PV of an annuity (PVA) years 1 to 4 at 8% (normal borrowing rate)
$80m x 0·031 x 30% x 3·312 = $2,464,128
Note to markers
Full credit should be given if tax shield is discounted at the government interest rate of 3·1% rather than the normal borrowing rate of 8%.
5 Tax shield on bank loan
Annual repayment = ($70m/PVA 8% Yr 1 – 4) = ($70m/3·312) = $21,135,266
6 Subsidy benefit
Benefit = $80m x (0·08 – 0·031) x 70% x 3·312 = $9,088,128
7 Financing side effects
Discuss the factors which may determine the long-term finance policy which Amberle Co’s board may adopt and the factors which may cause the policy to change.
Amberle Co’s board can use various principles to determine its long-term finance mix. The directors may aim to follow consistent long-term policies, or they may have preferences which change as circumstances change.
Long-term policy factors
At present Amberle Co is using a mix of finance, raising the question of whether the directors are aiming for an optimal level of gearing, or there is a level which they do not wish gearing to exceed. If the board wishes to maintain gearing at an optimal level, this is likely to be determined by a balance of risks and advantages. The main risks are not being able to maintain the required level of payment to finance providers, interest to debt providers or required level of dividend to shareholders. Advantages may include lower costs of debt, tax relief on finance costs as shown in the APV calculation or, on the other hand, not being legally required to pay dividends in a particular year.
Another issue is whether Amberle Co’s board has preferences about what source of finance should be used and in what order. One example of this is following the pecking order of retained earnings, then debt, then equity. The board may prefer this pecking order on the grounds that avoiding a new equity issue means that the composition of shareholdings is unchanged, or because retained earnings and longer term debt are judged low risk, or because the market will assume that an equity issue is being made because directors want to take advantage of Amberle Co’s shares being over-priced. Other specific sources of finance may have benefits which attract the directors or drawbacks which deter them.
This investment highlights the aspect of whether the board prefers to match sources of finance with specific investments. Matching arguably gives greater flexibility and avoids committing Amberle Co to a long-term interest burden. However, to adopt this approach, the board will need assurance either that the investment will be able to meet finance costs and ultimately repayment burdens, or these can be met from surpluses from other operations.
Changing long-term financing policy
As well as deciding what financing mix or sources of finance they desire to use, the directors will also need to consider what factors would cause this decision to change.
A major change in the scope of the operations, with investment requirements being paramount, may cause a change in financing policy. Here the $150 million investment has been financed entirely by medium-term debt. Amberle Co may have chosen solely to use debt if it has made a recent equity issue and does not feel it can make another one so soon afterwards. In addition, if Amberle Co expands its manufacture of electric cars, it may decide to sell off its motorbike or cycles divisions if they are performing less well. If part of the business is sold, the sale proceeds could help finance new investment in the cars division.
The board may also be flexible at times and take advantage of whatever source of finance seems to be offering the best terms for Amberle Co. Here the board is taking advantage of loan finance being available at a low cost, thanks to the government loan scheme.
A change in the business or economic environment may also lead to the board rethinking how the company is financed. An economic recession, leading to falling share prices, may mean that the results of a share issue are uncertain. On the other hand, an increase in economic or business risk may mean that lenders are less likely to lend at acceptable rates or will impose greater restrictions. If the directors are risk-averse, they may not seek new finance during a recession but instead rely on retained earnings to finance any expansion.