QUESTIONS:
a. Determine the WACC for the company. Compute the NPV of the new project based on the free cash flows you calculated using the WACC method.
[40 marks]
b. Determine the NPV using the APV and FTE methods. In both cases, assume the company maintains the target leverage ratio you computed in WACC.
[40 marks]
c. Compare the results under the three methods and explain how the resulting NPVs are achieved under each of the three different methods.
[20 marks]
FINANCIAL ANALYSIS BY USING THREE METHODS OF CAPITAL BUDGETING
Table of Contents
FINANCIAL ANALYSIS BY USING THREE METHODS OF CAPITAL BUDGETING.. 1
INTRODUCTION: 3
ANSWER 1: 3
ANSWER 2: 7
ANSWER 3: 12
References. 15
Appendix I. 18
Appendix II. 18
Appendix III. 18
INTRODUCTION:
The annual income reports of a renowned company of UK have been chosen for the financial assignment (Nakagawa, 2011). The name of the company is TESCO PCL. It is a public limited company, dealing in retailing industry. It is a British multinational grocery and general merchandise retailer, founded in the year 1919 at Hackney, in London. Jack Cohen is the founder of the company, and it is headquartered at “New Tesco House” which is in Cheshunt, Hertfordshire. It is present throughout the world and has as many as 6,784 stores. Sir Richard Broadbent is the chairman of the company, and Dave Lewis is the Group CEO. The main three products of the company TESCO PCL are – supermarket, hypermarket and superstore. According to the record of the year 2015, the number of employees working in TESCO PCL is 500,000 and revenue is £ 63.557 billion, according to the record of the year 2014. The main subsidiaries of TESCO PCL are – Tesco Stores Ltd., Tesco Bank, Tesco Mobile, Tesco Ireland, Dobbies Garden Centers, Tesco Family Dining Ltd., Giraffe Restaurants and Dunnhumby.
ANSWER 1:
Net Present Value, in short popular as NPV is defined as the differences of the present value of cash inflow and the present value of cash outflow (Brealey, Myers & Allen, 2011). It is calculated to determine the efficiency of a project, rather than a new project of a company. That is, for any new project, company has to invest initially a large amount, and in return the company will earn a certain amount of money every year. The earning per year after the initial year, that is year (Y) = 0, may vary. But as this process of NPV is done on the basis of estimated data, similar or same amount is calculated as cash inflow (Agarwal, 2013). The period of the project life is same as the cash inflow.
It is estimated for the calculation of NPV, that, TESCO PCL is currently going to launch a project. The initial investment of the project at year zero (Y = 0) is £ 100 million, and every year the company is earning £ 50 million from the new project (estimated). The project life is 5 years (let). And cost of capital of a new project is 10% (estimated). Then the NPV of the new project can be calculated as follows, by using the standardized following formula:
NPV = Present Value of Cash Inflow – Present Value of Cash Outflow
Discounting factor is calculated by the formula = 1/ (1+r)^{n}
YEAR  CASH OUTFLOW (million, £)  DISCOUNTING FACTOR  CASH INFLOW (million, £)  PRESENT VALUE OF CASH INFLOW (million, £) 
0/2010  100  0  0  
1/2011  0  0.9091  50  45.455 
2/2012  0  0.8264  50  41.320 
3/2013  0  0.7513  50  37.565 
4/2014  0  0.683  50  34.150 
5/2015  0  0.6209  50  31.045 
TOTAL  100  3.7907  250  189.353 
NPV (million, £)  89.535 
Refer to Appendix I
It can be concluded from the above calculation, that the new project may be accepted by the company, as the amount of NPV is positive. If the calculated result of NPV becomes negative, then the project may not be accepted, that is, the project should be rejected, as the negative result of NPV may bring loss for the company (Estrada, 2011).
Advantages of Net Present Value:
 NPV highlights more on time value of money (Berk, DeMarzo& Harford, 2012).
 Both after cash flow and before cash flow over the life span of the project are considered.
 It helps in maximizing the value of the firm.
Limitations of Net Present Value:
 Using of NPV method is complex.
 If the investment amount of two mutually exclusive projects is not equal, then, NPV cannot provide accurate result.
 Calculation of appropriate discount rate is difficult.
 When the projects are of unequal life span, NPV may not provide correct decision(Adair, 2011).
CALCULATION OF WACC:
Weighted average cost of capital, in short known as WACC. It is the rate at which any organization is expected to pay to all its security holders to finance its assets (Lucas, 2013). WACC is generally the cost of capital of a company.Generally, the debt and equity financed the assets of the company (Essayyad, 2012). In the given situation,WACCis the average costs of these above origin of financing. Each and every one of these financing is weighted by its corresponding use. By calculating the weighted average, it can be understand the amount of interest the organization has to pay for its every currency it finances.
Mathematically, WACC is calculated by the following formula:
WACC = E/ (E + D) * Cost of Equity + d / (E + D) * Cost of Debt * (1 – Tax Rate)
Here all the amounts are in Million, and 1 $ = 0.64 £
Where,
E = Market value of the firm’s equity = $ 28491.445 million
D = Market value of the firm’s debt = $ 18990.1068541million
V = Total value i.e. (E + D) = $ (28491.445 + 18990.1068541) million
Re = Equity cost = 9.675 %
Rd = Debtcost = 4.0302 %
T = Tax Rate = 12.83%
Tesco PLC’s market capitalization (E) is $ 28491.445 million. Book value of debt has been used to calculate the market value of debt. As of February, 2015, Tesco PLC’s two year averagedebt that is, short term and long term debt are $ 3121.00312843 million and $ 15869.1037257 million.
Therefore, the book value of debt (D) = $ 18990.1068541 million.
a) Weight of equity = E / (E + D) = 28491.445 / (28491.445 + 18990.1068541) = 0.6001
b) Weight of Debt = D / (E + D) = 18990.1068541 / (28491.445 + 18990.1068541) = 0.3999
c) Cost of Equity:
ü Risk free rate = 2.4%(data.okfn.org, 2015)
ü Tesco PLC’s beta = 0.97(reuters.com, 2015)
ü Market premium = 7.5 %
Cost of Equity = 2.4 % + 0.97 * 7.5 % = 9.675 %
d) Cost of Debt:
As per February 2015, Tesco PLC’s interest expense was $ 765.337423313 million. Its Book value of Debt (D) is $ 18990.1068541million.
Cost of Debt = 765.337423313 / 18990.1068541 = 4.0302 %
e) Latest two year average tax rate = 12.83 %(Gov.uk, 2015)
Therefore, Tesco PLC’s Weighted Average Cost of Capital, that is, WACC as per today is calculated as follows:
WACC = E/ (E + D) * Cost of Equity + d / (E + D) * Cost of Debt * (1 – Tax Rate)
= 0.6001 * 9.675 % + 0.3999 * 4.0302 % * (1 – 12.83%)
= 7.21 %
CALCULATION OF NPV USING WACC:
By using WACC, NPV is calculated below. Let us assume that, the new project of Tesco PLC is having a life span of 4 years, and the initial investment is 150000 and the inflow per year is 55000. It is estimated that the inflow per year remains constant and the WACC is 7.21 %. Then the NPV will be as follows:
YEAR 
CASH OUTFLOW (million, $)  DISCOUNTING FACTOR  CASH INFLOW (million, $)  PRESENT VALUE OF CASH INFLOW (million, $) 
0/2010  150000  0  0  
1/2011  0  0.9327  55000  51298.5 
2/2012  0  0.87  55000  47850 
3/2013  0  0.8115  55000  44632.5 
4/2014  0  0.7569  55000  41629.5 
5/2015  150000  3.3711  220000  185410.5 
NPV (million, $)  35410.5 
Thus, by calculating NPV, it can be suggested that the company TESCO PLC can accept the new project, as the calculated NPV is positive.
ANSWER 2:
APV is the acronym of Adjusted Present Value, which generally refers to NPV, that is, Net Present Value as APV is an investment appraisal technique similar to NPV (Damodaran, 2011).Without using weighted average cost of capital as the discount rate, ungeared equity cost can be used in APV, for discounting the cash flows of a project (Scheld, 2013). Thereisan tax shield adjustment also, which is given by related debt capital (Foerster& Sapp, 2011). A company may invest in a project by using shareholder’s equity alone, that is, without leveraged.
Mathematically, APV is calculated by the following formula:
APV = Present Value of Cash flows using Ungeared cost of Equity + Present value of Tax Shield
Where,
Ungeared cost of equity = Risk free rate + Asset Beta * (Market return – Risk free Return)
Tax savings =Tax Rate * Interest Expense related to the Project
OR, simply it can be calculated as follows:
APV = NPV + Present Value of Debt Financing Advantages
Decision Rule of APV:
Positive value of APV of a project is accepted and negative value of APV of a project is rejected. It is same as the decision rule of NPV (Myers & Read, 2012).
Thus, Advantages of using APV method are:
Profitability:
APV measures the profitability of investment, in which tax deductions apply on the basis of debt financing through an unleveraged equity cash flow (Robin, 2011).
Flexibility:
APV is ideal for those organizations whose ratio of debt to equity is in constant flux. Companies that go through many different projects which are capitalintensive would count, as would opportunities to carry out a leveraged buyout (Damodaran, 2011).
Transparency:
Net present value (NPV) only looks at the more visible items contained in assets and liabilities of a company, but, APV also looks at other realworld costs that will most certainly affect operations. These include the implications of filing for bankruptcy, issuing bonds and writing off certain expenditures as tax deductions (Damodaran, 2011). Thus, APV is more useful than NPV.
The only theoretical disadvantage of APV is that, in the method of APV, debt is considered as risk free and irredeemable.
CALCULATION OF APV:
Let us assume that, TESCO PLC is initially investing $ 150000 million in a new project. The part of equity is $ 28491.445million and the part of debt is $ 18990.1068million(refer to annual report of Tesco Plc, 2015). The annual cash inflow per year is projected to be $ 55000 million. The tax rate is 12.83 % and the interest rate and the cost of debt isestimated to be same as 4.0302 %, and the return on equity is 7.21 %.
APV = NPV + Present Value of Debt Financing Advantages
The NPV is earlier calculated. So directly the value of NPV is inserted here in the above formula. Present Value of Debt Financing Advantages is calculated as follows:
Present Value of Debt Financing Advantages
= [Tax rate * (Debt * Debt interest)] / [1 – (1 / 1 + Debt cost)]
= [0.1283 * ($ 18990.1068 * 0.040302)] / [1 – (1 / 1 + 0.04)]
= 0.1283 * 765.339 / [1 – (1 / 1 + 0.04)]
= 98.1929 / (1 – 0.96)
= 98.1929 / 0.04
= $ 2454.8225million
Therefore, APV = NPV + Present Value of Debt Financing Advantages
= $35410.5 + $2454.8225
= $ 37865.3225 million
As the APV value is positive, it can be stated that the new project of the company Tesco PLC can be easily accepted by the management of the company Tesco PLC as positive value indicates that the new project may bring profit to the company. The decision rule of APV is similar to that of NPV. So, if the value of APV is negative then, it may not be accepted, or in other words, it can be said that that the company might reject the project, having negative APV, as negative value of APV indicates that the new project might bring loss to the company (Ross, 2011).
FTE:
FTE is the acronym of Free Cash Flow to Equity. It is also known as FCFTE. This is the toolof measuring the amountof cash can be paid to the equity shareholders of the company (Vernimmen&Vernimmen, 2011). FTE is generally used by financial analysts in order to determine the business value or the firm value (Poniachek, 2013). Thisis the other method of gaining popularity of valuation (Harris, 2013).
Mathematically, FTE is calculated by the following formula:
FCFE = Net Income – Net Capital Expenditure – Change in Net Working Capital + New Debt – Debt Repayment
From the income statement of the firm and the earnings after expenses of the firm, the net income is calculated, involving the taxes and interest expenses. The other place of collecting data about the net income isthe cash flow statement that generally, saves time by considering other factors of the free cash flow to equity formula (Moles, 2011). An organization’smain capital expenditure may be found on its cash flow statement, which represents the capital used for long term or fixed assets (Stanley, 2011). Working capital of an organization is equal to current assets minus current liabilities. Current assets and liabilities are found on a firm’s balance sheet. The term ‘current’ represents the liquid assets and liabilities that is, short term operations, which means less than one year.
CALCULATION OF FREE CASH FLOW TO EQUITY (FTE):
Calculating NPV by using the method Free Cash Flow to Equity (FTE) is very simple. All the values of initial investment of the project, life span of the project, the cost of capital of the project and the cash inflows per year has already been estimated earlier. According to that assumption, the initial investment of the company Tesco PLC for the new project is $ 150000 million, the life span of the project is 4 years, and the cash inflow per year is constant, and the amount is $ 55000 million(Tesco plc, 2015). The cost of capital is 7.21 %, according to the calculation of WACC.
It can be estimated for calculating FCFE that, for the Year 2011, Net income = $ 75000 million, Net capital expenditure = $ 20000 million, New debt is = $ 5000 million, Debt repayment = $ 4000 million, and the change in net working capital is equal to zero constantly for 4 years. Therefore,
C_{1} = $ (75000 – 20000 – 0 + 5000 – 4000) = $ 56000 million
For year 2012, Net income = $ 70000 million, Net capital expenditure = $ 15000 million, New debt is = $ 4500 million, Debt repayment = $ 3500 million. Therefore,
C_{2} = $ (70000 – 15000 – 0 + 4500 – 3500) = $ 56000 million
For year 2013, Net income = $ 80000 million, Net capital expenditure = $ 15000 million, New debt is = $ 5500 million, Debt repayment = $ 3500 million. Therefore,
C_{3 }= $ (80000 – 15000 – 0 + 5500 – 3500) = $ 67000 million
For year 2014, Net income = $ 80000 million, Net capital expenditure = $ 25000 million, New debt is = $ 5000 million, Debt repayment = $ 3500 million. Therefore,
C_{4} = $ (80000 – 25000 – 0 + 5000 – 3500) = $ 56500 million
Where, C_{1}, C_{2}, C_{3} and C_{4 }are the Free Cash Flows of Equity for the Year 2011, 2012, 2013 and 2014 respectively.
Therefore, NPV = [C_{1} / (1 + r)^{ 1} + C_{2} / (1 + r)^{2} + C_{3} / (1 + r)^{3} + C_{4 }/ (1 + r)^{4}] – Initial Outflow
= $ [56000 / (1.09675)^{1}+ 56000 / (1.09675) ^{2} + 67000 / (1.09675) ^{3} +56500 / (1.09675) ^{4} – $ 150000
= $ [51059.949 + 46555.687 + 50786.919 + 39049.715] – $ 150000
= $ 187452.27 – $ 150000
= $ 37452.27 million
The calculation is shown in the following chart form:
YEAR  CASH OUTFLOW (million, $)  DISCOUNTING FACTOR  CASH INFLOW (million, $)  PRESENT VALUE OF CASH INFLOW (million, $) 
0/2010  150000  0  0  
1/2011  0  0.911784818  56000  51059.949 
2/2012  0  0.831351555  56000  46555.687 
3/2013  0  0.758013727  67000  50786.919 
4/2014  0  0.691145409  56500  39049.715 
5/2015  150000  3.192295509  235500  187452.27 
NPV (million, $)  37452.27 
Refer to Appendix II
By calculating NPV under free cash flow to equity, it is found that, the NPV is positive. That is, the new project should be accepted by the company. Tesco PLC should not reject the new project as it may bring profit to the company as the value of NPV is positive.
ANSWER 3:
For valuing the leveraged project, there are mainly three methods. These are –
ü Weighted Average Cost Of Capital Method (WACC)
ü Adjusted Present Value Method (APV)
ü Flow to Equity Method (FTE)
Under the WACC method, the value of calculated NPV is $ 35410.5million.
Under the APV method, the value of calculated NPV is $37865.3225 million.
Under the FTE method, the value of calculated NPV is $ 37452.27 million.
With the same estimated value, the result of calculated NPV is different in different methods. In all the three methods, that is, WACC method, APV method, and the FTE method, the result of NPV is positive, that is, the company Tesco PLC may accept the new project, as from the positive report of the NPV, the managers of the company Tesco PLC might assume that the new project may turn them into profit (Cornuel&Kletz, 2011). So, the managers of the company should suggest for investing money in the new project (Berk&DeMarzo, 2011).
By comparing the value of NPV in three different methods, it can be concluded that, under the WACC method, the value of NPV is the least, that is, $35410.5million. And the calculated NPV under APV method and FTE method are almost similar. The value of NPV under APV method is $ 37865.3225 million and the value of NPV under FTE method is $ 37452.27 million. Though both the values are nearly similar, it can be said that, NPV under APV method is greater than the NPV value under FTE method. Thus, APV method gives the highest NPV, WACC method gives the lowest result of NPV, and in between these two lies the APV method.
Resulting NPVs are achieved in the following ways:
STEP NUMBER 
WACC 
APV 
FTE 
1  The weight of the equity is calculated.  Present Value of Debt Financing Advantages is calculated.

Net income, net expenditure, new debt, debt repayment are estimated for 4 years. 
2  The weight of the debt is calculated.  NPV is calculated.  FCFE is calculated individually for 4 different years. 
3  The cost of equity is calculated.  APV is calculated by adding up NPV and Present Value of Debt Financing Advantages.  By putting different FCFEs of 4 different years, NPV is calculated. 
4  The cost of debt is calculated.  
5  WACC is calculated.  
6  NPV is calculated. 
Thus, from the above table, it can be said that, NPV can be easily calculated by all the three methods i.e. WACC, APV and FTE methods.
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Appendix I
YEAR  CASH OUTFLOW (£)  DISCOUNTING FACTOR  CASH INFLOW (£)  PRESENT VALUE OF CASH INFLOW (£) 
0  100  0  0  
1  0  0.9091  50  45.455 
2  0  0.8264  50  41.32 
3  0  0.7513  50  37.565 
4  0  0.683  50  34.15 
5  0  0.6209  50  31.045 
TOTAL  100  3.7907  250  189.535 
NPV  89.535 
Appendix II
YEAR  CASH OUTFLOW ($)  DISCOUNTING FACTOR  CASH INFLOW ($)  PRESENT VALUE OF CASH INFLOW ($) 
0  150000  0  0  
1  0  0.911784818  56000  51059.94981 
2  0  0.831351555  56000  46555.68708 
3  0  0.758013727  67000  50786.91971 
4  0  0.691145409  56500  39049.71561 
TOTAL  150000  3.192295509  235500  187452.2722 
NPV  37452.27221 
Appendix III
Profit  Rate  2015  2014  2013  2012 
Less than £300000  Small profit  20%  20%  20%  20% 
More than £300000  Main rate  20%  21%  23%  24% 