Chapter 20 interactions between investment and financing decisions
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Chapter 20 -- Interactions Between Investment and Financing Decisions. Separation Principle Investment decisions and financing decisions are independent of each other Exceptions to the separation principle Wealth transfers from debt to equity holders

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Chapter 20 interactions between investment and financing decisions
Chapter 20 -- Interactions Between Investment and Financing Decisions

  • Separation Principle

    • Investment decisions and financing decisions are independent of each other

  • Exceptions to the separation principle

    • Wealth transfers from debt to equity holders

    • Wealth transfers from equity to debt holders

    • Investments that change risk characteristics

    • Investments with special financing attached


Wealth transfer examples
Wealth transfer examples Decisions

  • Funding a new project entirely with debt decreases the value of existing debt

  • If the value of the total company does not change, and the value of the debt decreases, the value of the equity increases.

  • Funding a new project entirely with equity could similarly increase the wealth of the creditors


Wealth transfers
Wealth Transfers Decisions

  • Wealth transfer may happen without a capital investment:

    • Company could issue debt to buy back equity, or vise. versa.

  • Restrictive covenants work to minimize this type of wealth transfer


Information asymmetry
Information Asymmetry Decisions

  • If investors are not aware of the expected return on new investments, the stock price may be below its intrinsic value

  • Selling stock below its intrinsic value would dilute the interests of current shareholders

  • Financing with debt would allow the company to delay equity financing until investors had observed the success


Investments that change the risk and optimal debt level of the firm
Investments that change the risk and optimal debt level of the firm

  • A new investment may reduce the variance of the firm’s cash flows because it is negatively correlated. The new investment will increase the optimal level of debt and lower the marginal cost of capital for a project


Investments with special financing attached
Investments with special financing attached the firm

  • Communities or manufacturers may offer special financing to encourage capital investment

  • NPV with special financing equals regular NPV + Net advantage of financing (NAF)

    nNAF = SF -  [Pt + Intt(1-Tc)]/(1+kd)t=1

    where SF is the amount of special financing, Pt and Intt are principal and interest payments, Tc is the corporate tax rate, and kd is the cost of debt


Alternative npv methods for dealing with financing mix
Alternative NPV methods for dealing with financing mix the firm

  • Arditti-Levy net present value

  • Adjusted present value

  • Equity residual net present value


Arditti levy npv
Arditti-Levy NPV the firm

  • Often used by public utilities

nΣ [(EBITt- Intt)(1 - Tc) + Dept + Intt]/(1 + kAL)t - I0t=1

Where EBITt is earnings before interest and tax for year t, Intt is interest payment for year t, Tc is the corporate tax rate, Deptt is depreciation in year t, I0 is the initial investment, and KAL is the Arditti-Levy required return


Adjusted present value
Adjusted Present Value the firm

nAPV = Σ [(EBITt(1 - Tc) + Dept]/(1 + ku)t - I0t=1n + Σ TcIntt/(1+Rd)t t=1

Where Ku is required return for an unlevered investment and Rd is the interest rate on the corporation’s debt


Equity residual method
Equity Residual Method the firm

  • Used in banking and often used for international investments where the U.S. firm is putting in only the equity

  • Essentially looks at cash flows to and from shareholders


Equity residual npv
Equity Residual NPV the firm

n Σ [EBITt – Intt)(1-Tc)+Dept + (Bt – Bt-1)]/(1+ke)tt=1 – (I0 – B0)

Where Bt = amount of debt at time t and other variable are as previously defined


Comparing methods
Comparing Methods the firm

  • Under assumptions including a constant debt ratio over time, we get the same answers from regular NPV, Arditti-Levy NPV, and equity residual NPV.

  • The choice is then one of convenience for a particular company