# Situation 5.4. Cross-subsidization of investment projects...

## Situation 5.4. Cross-subsidization of investment projects

Project H of corporation A has a life expectancy of 6 years and the cash flow is:

 Year 0th period From 1st to 6th Annually CP, thousand dollars -382.63 105.11

For the implementation of this project, the lender agrees to grant a loan with double coverage and full repayment in no more than three years at 15% per annum. At the same time, at least 30% of all investments should be financed from own sources of corporation A.

The rate of risk-free investment is 6% per annum, the market premium for the United States is 24% per annum, the free-flow coefficient is & szlig; for the industry in which the company operates, - 0.5 (but to finmanager.ru , section "Consultations"). Profit tax is 30%.

However, Corporation A has other projects and thanks to them there is an opportunity to receive an additional loan of \$ 80 thousand and send this money to the financing of the project N. Is Project H eligible for corporation A?

The answer to this question is not so unambiguous, as is usually assumed in the basic theory.

Consider first the classical way of solving this problem.

Cost of equity in the absence of financial leverage

= N/+ pDY = 6% + 0.5 x 24% = 18% per annum.

The maximum amount of debt that provides double coverage of cash flow obligations from the project for three years is equal to

The maximum amount of debt, which provides 70% of financing (as 30% must be financed from own capital),

02 = 382.63 thousand dollars x 0.7 = 267.8 thousand dollars

The maximum possible debt size

Ахх = т'п (120 thousand dollars, 267,8 thousand dollars) = 120 thousand dollars.

NPV Project H without the impact of funding

М5У = -382.63 thousand dollars + 105.11 thousand dollars х Lv0) 8 = -15 thousand dollars

We will evaluate the project taking into account the impact of financing on the technique. If we take the theoretical amount of debt that this project can claim, AGC will be is equal to

AGC = NPV + RU (T \$) = -15 thousand dollars + 120 thousand dollars x 0.15 x 0.3 x L3; 015 =

= -2.67 thousand dollars,

and the project will be unprofitable.

If we take in the calculations the debt, actually received by the project taking into account all the possibilities of corporation A, equal to

AGC = NPV + RU (T5) = -15 thousand dollars + (120 thousand dollars + 80 thousand dollars) x

х 0,15 х 0,3 хЛ3: 015 = 5,55 thousand dollars,

then the project will give a positive effect and it is profitable to take it. Which of the conclusions is correct?

For the vast majority of cases, the classical rule is fulfilled: since the possibility of obtaining a loan existed with the corporation and without a project, the effect from its receipt is not a merit of Project H and should not be taken into account when analyzing this project and calculating its effect. This means that the project is unprofitable and should be rejected, and when analyzing the project, one should be guided by the theoretical, and not by the actual size of the obligations.

However, this rule has an exception , associated with a specific feature of emerging markets - the possibility of corporation's projects with abnormally high returns.

We will clarify the conditions of this situation with respect to the "other project", which subsidizes the implementation of Project II. So, suppose Corporation A has another project - K, whose cash flows:

Project K is anomalous in terms of profitability (its IRR = 84.74% per annum in foreign currency). This project can be given a debt on the same terms (maximum loan - 70% of investment needs and double coverage of liabilities with cash flows for three years, rate - 15% per annum).

If you focus only on the cash flows of project K, then he could get a loan of

But the lender will not give him such a sum, as 271.7 thousand dollars more than 70% of the investments required by this project, i.e. 273.8 thousand dollars x 0.7 = 191.7 thousand dollars

Therefore, the project K will receive only 191.7 thousand dollars. The opportunity to receive additional debt of \$ 271.7 thousand - \$ 191.7 thousand = 80 thousand dollars and have from this additional income (tax winnings) will remain unrealized.

This money can master and realize an opportunity, if you start the project N. Then the total investment requirement for the two projects is

273.8 thousand dollars + 382.63 thousand dollars = 656.43 thousand dollars

Thanks to this, you can claim a loan capital

Anax = m'n (120 thousand dollars + 271.7 thousand dollars, 0.7 x 656.43 thousand dollars) = = 391.7 thousand dollars for two projects.

Project K will receive a loan of \$ 191,700 (this is its "limit"), and the remaining \$ 200,000 will be received precisely in connection with the unprofitable and inefficient project of N. If there was no project II , corporation A would not have the opportunity to receive this money and increase its value due to this. Therefore, the tax shield with interest from the entire loan (ie, with 200 thousand dollars) should be considered as the effect of the project H, and its this is not minus 2.67, and plus \$ 5.55 thousand, which indicates its profitability.

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

[...]

## Other services that we offer

If you don’t see the necessary subject, paper type, or topic in our list of available services and examples, don’t worry! We have a number of other academic disciplines to suit the needs of anyone who visits this website looking for help.

## How to ...

We made your life easier with putting together a big number of articles and guidelines on how to plan and write different types of assignments (Essay, Research Paper, Dissertation etc)