Traditional NPV WACC Modigliani and Miller meet CAPM

Traditional NPV& WACC Modigliani and Miller meet CAPM PWC Course Notes P 62 ACCA Paper P 4 Also suitable for ICAEW, ICAS, CFA etc mefielding. com 1

Traditional NPV We are going to calculate the discount factor to be used in an NPV calculation Before you listen to this please make sure you are comfortable with CAPM and M&M Wyke plc is a company that makes ice cream in Scotland Wyke wants to expand into Europe has no surplus demand for ice cream but their market research shows that South Europe needs freezers. Wyke decides to investigate freezer distribution in S Europe. Aranalde is a Spanish firm that distributes freezers throughout South Europe Wyke has prepared a cashflow for the proposed freezer distribution business but does not know at what rate to discount it mefielding. com 2

Traditional NPV Wyke Aranalde Equity Beta Geared 1. 1 1. 2 Gearing Ratio (Book Value, D: E) 1: 1 3: 7 Gearing Ratio (Market Value, D: E) 1: 4 1: 1 Cost of Debt % 6 6 Assumptions Corporate debt is risk free, corporate tax is charged at 30% The project will be financed in the same ratio as existing capital in Wyke Return on treasury bills is 6%, return on the market portfolio 9% mefielding. com 3

Traditional NPV mefielding. com 4

Traditional NPV mefielding. com 5

Traditional NPV We use the formula + So we need an asset beta which reflects the business risk of freezer distribution in Europe. If we take Aranalde’s beta it will reflect the business risk but also Aranalde’s gearing, so we degear Aranalde’s equity beta We must always use market values, the value of the equity to debt is 1: 1. Aranalde’s beta reflects the business risk, the tax rate is 30%. The asset beta tells us the ungeared beta of the mefielding. com 6 Freezer distribution industry. Debt is risk free so debt beta is zero

Asset Beta mefielding. com 7

Traditional NPV So the asset beta reflects the business risk but Wyke will use debt finance in part to fund the project we need therefore to factor that it Debt is risk free so 2 nd half of the equation is omitted The asset beta therefore, as said , gives us the risk for an ungeared business distributing freezers in S Europe. But our business will not be ungeared, therefore we have to put in our project gearing mefielding. com 8

Re-gearing the Asset Beta Putting into the equation Wyke’s own gearing we get Debt is risk free so 2 nd half of the equation is omitted mefielding. com 9