The first part of an ANPV analysis determines the discounted expected value of the project's future free cash flows (FCF). The value of the ability to deduct interest payments for tax purposes is called an interest tax shield. Companies limit their influence because the costs of financial distress offset the benefits of interest tax shields.
A bankruptcy proceeding may result, with the firm's assets officially transferred from shareholders to bondholders. Academic studies of the direct costs of financial distress find that they are typically about 3% of the firm's market value. Therefore, the present value of the subsidized debt cash flows using the market interest rate for corporate debt is.
R EAL O PTIONS
The appropriate discount rate for an interest subsidy is simply the market interest rate on corporate debt. Because the corporation is just as likely to default on a government-subsidized loan as it is on a normal loan at market interest rates. Suppose that a corporation can borrow a principal of D for one period at a subsidized interest rate of r S < r D , which, as before, is the market interest rate for corporate debt.
The company pays back 11 + rS2D and receives the interest tax shield of t r SD in the second period. 11 + rD2 (15.6) Equation (15.6) shows that the value of a subsidized loan is the present value of the interest subsidy, which is the difference between the interest paid on a market loan and the interest on the subsidized loan, plus the current value of the actual interest tax shield. After the first year, however, the company's managers will know for certain which of the two levels of sales will continue into the indefinite future.
Also assume that the managers have an option to abandon the project if first-year sales are only :750,000. In the good condition, the project will be worth that year's free cash flow plus the value of the perpetual continuation in the good condition, or. On the other hand, in the bad condition, the project will be abandoned and will be worth that year's free cash flow plus the scrap value of the machinery, or.
8 An additional source of value for the project arose from the fact that part of the investment was made with a debt-equity swap. P&G purchased Brazilian government dollar debt in the secondary market, which traded at a significant discount, presented the debt to the Brazilian government and received more cruzeiros in value than could have been obtained by purchasing cruzeiros with those dollars at the market exchange rate.
Problems with the Discounted Cash Flow Approach
Valuing a Project Using Discounted Cash Flows Versus a Ratio Analysis
P ARENT V ERSUS S UBSIDIARY C ASH F LOWS
The cash flows of a foreign subsidiary may differ significantly from the cash flows that ultimately accrue to the parent company. The fundamental point of free cash flow analysis is to determine the net present value of the cash available for distribution to the ultimate shareholders of the corporation. If taxes, regulations, and foreign exchange controls severely limit the amount of funds that can be transferred from the foreign subsidiary to the parent company, the project is worth less than if it were done by an independent company that owns the project within the country.
Of course, the parent's free cash flow from the foreign subsidiary may also significantly exceed the subsidiary's free cash flow due to royalty payments, license agreements, and management overhead. Therefore, the subsidiary's income is reduced by these costs, while the parent's income is increased. In addition, if the parent company sells intermediate parts to a subsidiary, the subsidiary's cost of goods sold includes the amount of profit included in the transfer prices of the intermediate parts.
Clearly, this profit increases the value of the subsidiary from the parent company shareholder's perspective. Although the parent's perspective is ultimately what we want to value, it is often easiest to do international capital budgeting with a three-step approach. We start with the subsidiary's view of free cash flow and then see how the cash flow changes when the parent's view is taken into account.
A Three-Step Approach to Determining the Value of a Foreign Subsidiary
IWPI-Spain’s Free Cash Flows Initial Investments
Until the initial plant and equipment is fully depreciated, which is Figure 15.4 Forecasts of additions to net working capital and capital expenditure for IWPI-Spain. Total variable costs in row 2 represent the estimated number of units sold in a given year (row 2 in Exhibit 15.3) multiplied by the sum of variable labor costs per unit and both material costs. The following section of Exhibit 15.5 forecasts the costs associated with the royalty and overhead allocation agreements between the IWPI-U.S.
The royalty fee paid by IWPI-Spain to its parent company in line 3 is 5% of total turnover. Fixed costs and direct overhead costs of IWPI-Spain are shown in line 5 of Annex 15.5. The total costs in Line 7 of Figure 15.5 are the sum of the total variable costs in Line 2, the royalty fee in Line 3, the overhead allocation fee in Line 4, the overhead costs in Line 5, and the depreciation in Line 6.
Note: All numbers except the unit values in line 1 are in millions of euros. For NOPLAT, we add accounting depreciation in line 6 of Figure 15.5 because accounting depreciation is deducted as an expense but is not a cash flow. Multiplying these discount factors by the free cash flow forecasts in line 5 yields the current values of the free cash flows in line 7.
The terminal value in line 8 of Figure 15.7 represents the discounted present value of all expected future free cash flows in year 11 and beyond into the indefinite future. In the last line of Figure 15.7, the present values of the free cash flows in line 7 and the terminal value in line 8 are added together to give an initial net present value of the project of: 0.05 million.
The Parent Company’s Perspective
The most important part of Figure 15.9 is the assumed-paid credit calculation in Line 4. In Line 2 of Figure 15.9 we see that IWPI-Spain's second year free cash flow forecast is :3.02 million, and this amount will be paid out as dividend to the parent company. The sum of the fictitious tax credit (line 4) and the dividend tax (line 5) gives the foreign tax credit in line 6 of Exhibit 15.9.
The royalty fee in line 1 in appendix 15.12 is expected to be 5% of the total turnover, which was calculated in appendix 15.3. The Spanish government deducts a 10% withholding tax on royalty payments in line 2, recognizing that the royalty payment is income to the parent company, just like a dividend. The overhead allocation fee in line 3 of Appendix 15.12 is also a cost to the subsidiary and a profit to the parent company.
This is predicted to be 2% of total revenues, and the Spanish government levies a 14% withholding tax on such payments, as calculated in line 4. These profits are also discounted at 11.1% per annum, and the discount factors are presented again. in line 10. Multiplying the expected values in line 9 by the discount factors in line 10 gives the current values of the allowances in line 11.
The net present value of the fees, which is the sum of the discounted values on line 11 and the final value on line 12, is :102.26 million. The profit margin on these export sales is known to be 16%, and this is calculated in line 4.
Valuing the Financial Side Effects
If IWPI-Spain were certain to make these interest payments, the tax shields should be discounted at the risk-free interest rate in euros. However, in a more likely scenario, the interest payments would not be without risk because there would be a probability that IWPI-Spain would default and be forced into bankruptcy. If there is a probability of bankruptcy, the firm's debt will not be risk-free and the firm will not expect to make the full value of the interest payments.
An increase in the required interest rate above the risk-free rate reflects the market's assessment of the potential default of IWPI. If the default risk of the Spanish sovereign loan is the same as the default risk of the market loan, then 6.0% is the appropriate rate to discount interest tax shields. The present value of these interest tax shields is the sum of the numbers in line 3 or: 2.32 million.
This calculation undoubtedly overestimates the value of debt owed to the corporation because it ignores the cost of financial distress. If IWPI had to borrow :30 million at its market interest rate of 6.0% per annum, its annual interest payment would be Because the Spanish government only charges 3% per year, IWPI's actual interest payment is: 0.9 million.
The Full ANPV of IWPI-Spain
Cannibalization of Export Sales
S UMMARY In this chapter, we develop the adjusted net present
The first part of an NPV calculates the net present value (NPV) of the project's free cash flow assuming that the project is financed entirely with equity. The third part of an ANPV analysis adds the present value of any real options arising from the execution of the project. The terminal value of a project represents the present value of all expected future free cash flows in the years extending into the indefinite future beyond the explicit forecast horizon of the project and can be calculated using perpetuity formulas.
Fundraising costs should be deducted from the project value. The third step involves adjusting the project value for the net present value of the project's financial side effects and growth potential. Cannibalizing exports to the market to be served by the foreign subsidiary can significantly reduce the value of establishing the subsidiary.
How license agreements, royalties and overheads affect the value of a foreign project. Why does adjusted net present value analysis treat the present value of financial side effects as a separate item? What is the net present value of the financial side effects of the project.
What percentage of the adjusted net present value of the IWPI Spain project results from the dividends that will occur more than 10 years into the future. How sensitive is the value of IWPI-Spain to the assumed discount rate of 11.1%.
Valuing Metallwerke’s Contract with Safe Air, Inc
