1 / 32

npv - PowerPoint PPT Presentation

  • Updated On :

NPV. NPV. There are three ways to apply the NPV principle Weighted Average Cost of Capital (WACC) Adjusted Present Value (APV) Flow to Equity (FTE). NPV WACC. Work out the WACC using the after tax cost of debt R wacc = E re + D rd (1-Tc) E + D E + D

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
Download Presentation

PowerPoint Slideshow about 'npv' - Audrey

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

Slide2 l.jpg

  • There are three ways to apply the NPV principle

  • Weighted Average Cost of Capital (WACC)

  • Adjusted Present Value (APV)

  • Flow to Equity (FTE)

Npv wacc l.jpg

  • Work out the WACC using the after tax cost of debt

  • Rwacc = E re + D rd (1-Tc)

    E + D E + D

    E = market value of equity

    D = market value of debt

    Tc = marginal corporate tax rate

    re = equity cost of capital

    rd = debt cost of capital

Npv wacc4 l.jpg

  • Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, by discounting its future free cash flow using the WACC.

Npv wacc5 l.jpg

  • Assume Avco is considering introducing a new line of packaging, the RFX Series.

    • Avco expects the technology used in these products to become obsolete after four years. However, the marketing group expects annual sales of $60 million per year over the next four years for this product line.

    • Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively, per year.

Npv wacc6 l.jpg

  • Developing the product will require upfront R&D and marketing expenses of $6.67 million, together with a $24 million investment in equipment.

    • The equipment will be obsolete in four years and will be depreciated via the straight-line method over that period.

  • Avco expects no net working capital requirements for the project.

  • Avco pays a corporate tax rate of 40%.

Npv wacc7 l.jpg

Npv wacc8 l.jpg

NB Net debt used i.e. less cash

Npv wacc9 l.jpg

  • Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the RFX project. Thus, Avco’s WACC is

Npv wacc10 l.jpg

  • The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows.

    • The NPV of the project is $33.25 million

      $61.25 million – $28 million = $33.25 million

Slide11 l.jpg


Implementing a Constant Debt-Equity Ratio

  • By undertaking the RFX project, Avco adds new assets to the firm with initial market value $61.25 million.

    • Therefore, to maintain its debt-to-value ratio, Avco must add $30.625 million in new debt.

      • 50% × 61.25 = $30.625

Npv wacc12 l.jpg

  • Avco can add this debt either by reducing cash and/or by borrowing and increasing debt.

    • Assume Avco decides to spend its $20 million in cash and borrow an additional $10.625 million.

      • Because only $28 million is required to fund the project, Avco will pay the remaining $2.625 million to shareholders through a dividend (or share repurchase).

        • $30.625 million − $28 million = $2.625 million

Npv wacc13 l.jpg

Slide14 l.jpg

Npv wacc15 l.jpg
NPV million.WACC

  • Debt Capacity

    • The amount of debt at a particular date that is required to maintain the firm’s target debt-to-value ratio

    • The debt capacity at date t is calculated as:

      • Where d is the firm’s target debt-to-value ratio and VLt is the levered continuation value on date t.

Npv wacc16 l.jpg
NPV million.WACC

  • Implementing a Constant Debt-Equity Ratio (cont'd)

  • Debt Capacity

    • VLt calculated as:

Npv wacc17 l.jpg
NPV million.WACC

  • Table 18.4

e.g. 47.41 = 18/1.068 + 18/1.1406 +18/1.218

Npv the adjusted present value method l.jpg
NPV million.The Adjusted Present Value Method

Adjusted Present Value (APV)

  • A valuation method to determine the levered value of an investment by first calculating its unlevered value and then adding the value of the interest tax shield and deducting any costs that arise from other market imperfections

Npv apv l.jpg
NPV million.APV

  • We first need to calculate the unlevered value

  • Then add the value of the tax shield plus any other costs

  • To calculate unlevered value need the unlevered cost of equity

  • The unlevered cost of equity will equal the pre tax WACC

Npv apv20 l.jpg
NPV million.APV

Npv apv21 l.jpg
NPV million.APV

  • The value of $59.62 million is the value of the unlevered project and does not include the value of the tax shield provided by the interest payments on debt.

    • The interest tax shield is equal to the interest paid multiplied by the corporate tax rate.

Npv apv22 l.jpg
NPV million.APV

  • Now value the tax shield

We know from slide 17 what the debt capacity is

1.84 = 30.62 x .06 and 1.84 x .4 = .73

Slide23 l.jpg

Npv apv24 l.jpg
NPV tax shield.APV

  • The total value of the project with leverage is the sum of the value of the interest tax shield and the value of the unlevered project.

    • The NPV of the project is $33.25 million

      • $61.25 million – $28 million = $33.25 million

        • This is exactly the same value found using the WACC approach.

Npv apv25 l.jpg
NPV tax shield.APV

  • Determine the investment’s value without leverage.

  • Determine the present value of the interest tax shield.

    • Determine the expected interest tax shield.

    • Discount the interest tax shield.

  • Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage.

Npv apv26 l.jpg
NPV tax shield.APV

  • More complex to use as have to:

    - compute unlevered cost of equity

    - compute value of tax shield

  • So when would you use it?

    - easier to apply when a constant debt

    equity ratio not going to be used

    - explicitly includes earnings and costs due

    to debt

Npv fte l.jpg
NPV tax shield.FTE

  • Flow-to-Equity

    • A valuation method that calculates the free cash flow available to equity holders taking into account all payments to and from debt holders

    • The cash flows to equity holders are then discounted using the equity cost of capital.

Npv fte28 l.jpg
NPV tax shield.FTE

  • Free Cash Flow to Equity (FCFE)

    • The free cash flow that remains after adjusting for interest payments, debt issuance and debt repayments

  • The first step in the FTE method is to determine the project’s free cash flow to equity.

  • Then discount them using the cost of equity

Npv fte29 l.jpg
NPV tax shield.FTE

Npv fte30 l.jpg
NPV tax shield.FTE

  • Because the FCFE represent payments to equity holders, they should be discounted at the project’s equity cost of capital.

    • Given that the risk and leverage of the RFX project are the same as for Avco overall, we can use Avco’s equity cost of capital of 10.0% to discount the project’s FCFE.

Npv fte31 l.jpg
NPV tax shield.FTE

  • Determine the free cash flow to equity of the investment.

  • Determine the equity cost of capital.

  • Compute the equity value by discounting the free cash flow to equity using the equity cost of capital.

Npv fte32 l.jpg
NPV tax shield.FTE

  • The FTE method offers some advantages.

    • It may be simpler to use when calculating the value of equity for the entire firm, if the firm’s capital structure is complex and the market values of other securities in the firm’s capital structure are not known.

    • It may be viewed as a more transparent method for discussing a project’s benefit to shareholders by emphasizing a project’s implication for equity.

  • The FTE method has a disadvantage.

    • One must compute the project’s debt capacity to determine the interest and net borrowing before capital budgeting decisions can be made.