Chapter 20 -- Interactions Between

Investment and Financing Decisions

Separation

Principle

Investment

decisions and financing decisions

are independent of each other

Exceptions
Wealth

to the separation principle

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

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

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

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
A new

investment may reduce the

variance of the firms 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

Communities or manufacturers may offer special

financing to encourage capital investment
NPV with special financing equals regular NPV +
Net advantage of financing (NAF)
n

NAF=SF[Pt+Intt(1Tc)]/(1+kd)
t=1
whereSFistheamountofspecialfinancing,Ptand
Inttareprincipalandinterestpayments,Tcisthe
corporatetaxrate,andkdisthecostofdebt

Alternative NPV methods for

dealing with financing mix
Arditti-Levy

net present value

Adjusted present value
Equity residual net present value

Arditti-Levy NPV

Often used by public utilities

n
[(EBITt- Intt)(1Tc)+Dept+ Intt]/(1+kAL)t - I0
t=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

n
APV = [(EBITt (1Tc)+Dept]/(1+ku)t - I0
t=1
n

+ TcIntt/(1+Rd)t
t=1

Where Ku is required return for an unlevered

investment and Rd is the interest rate on the
corporations debt

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

Equity Residual NPV

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

Where Bt = amount of debt at time t and other

variable are as previously defined

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