Chapter 20 -- Interactions Between Investment and Financing Decisions

1. 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

2. Wealth transfer examples • 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

3. Wealth Transfers • 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

4. Information Asymmetry • 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

5. 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

6. Investments with special financing attached • 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

7. Alternative NPV methods for dealing with financing mix • Arditti-Levy net present value • Adjusted present value • Equity residual net present value

8. Arditti-Levy NPV • 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

9. Adjusted Present Value 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

10. Equity Residual Method • 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

11. Equity Residual NPV 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

12. Comparing Methods • 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