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Corporate Finance

Corporate Finance. Lecture 10. Topics covered. Capital budgeting with debt APV FTE WACC Beta and leverage. Capital budgeting with debt. Adjusted Present Value Approach Flows to Equity Approach Weighted Average Cost of Capital Method. Adjusted Present Value . APV = NPV + NPVF

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Corporate Finance

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  1. Corporate Finance Lecture 10

  2. Topics covered • Capital budgeting with debt • APV • FTE • WACC • Beta and leverage

  3. Capital budgeting with debt • Adjusted Present Value Approach • Flows to Equity Approach • Weighted Average Cost of Capital Method

  4. Adjusted Present Value APV = NPV + NPVF • The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF): • There are four side effects of financing: • The Tax Subsidy to Debt • The Costs of Issuing New Securities • The Costs of Financial Distress • Subsidies to Debt Financing

  5. APV Example Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: –$1,000 $125 $250 $375 $500 0 1 2 3 4 The unlevered cost of equity is r0 = 10%: The project would be rejected by an all-equity firm: NPV < 0.

  6. APV Example (continued) • Now, imagine that the firm finances the project with $600 of debt at rB = 8%. • Pearson’s tax rate is 40%, so they have an interest tax shield worth TCBrB = .40×$600×.08 = $19.20 each year. The net present value of the project under leverage is: APV = NPV + NPV debt tax shield So, Pearson should accept the project with debt.

  7. APV Example (continued) • Another way to calculate the NPV of the loan. • Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan: APV = NPV + NPVF Which is the same answer as before.

  8. Flows to Equity • Discount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital, rS. • There are three steps in the FTE Approach: • Step One: Calculate the levered cash flows • Step Two: Calculate rS. • Step Three: Valuation of the levered cash flows at rS.

  9. CF4 = $500 –28.80 –600 CF3 = $375 –28.80 CF2 = $250 –28.80 CF1 = $125 –28.80 $96.20 $221.20 $346.20 –$128.80 Step One: Levered Cash Flows • Since the firm is using $600 of debt, the equity holders only have to come up with $400 of the initial $1,000. • Thus, CF0 = –$400 • Each period, the equity holders must pay interest expense. The after-tax cost of the interest is B×rB×(1 – TC) = $600×.08×(1 – .40) = $28.80 –$400 0 1 2 3 4

  10. B B To calculate the debt to equity ratio, , start with S V Step Two: Calculate rS PV = $943.50 + $63.59 = $1,007.09 B = $600 when V = $1,007.09 so S = $407.09.

  11. –$400 $96.20 $221.20 $346.20 –$128.80 0 1 2 3 4 Step Three: Valuation • Discount the cash flows to equity holders at rS = 11.77%

  12. WACC Method for Pearson • To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital. • Suppose Pearson’s target debt to equity ratio is 1.50

  13. Valuation for Pearson using WACC • To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital NPV7.58% = $6.68

  14. A Comparison of the APV, FTE and WACC • All three approaches attempt the same task:valuation in the presence of debt financing. • Guidelines: • Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over the life of the project. • Use the APV if the project’s level of debt is known over the life of the project. • In the real world, the WACC is the most widely used by far.

  15. Summary: APV, FTE, and WACC APV WACC FTE Initial Investment All All Equity Portion Cash Flows UCF UCF LCF Discount Rates r0 rWACC rS PV of financing effects Yes No No Which approach is best? • Use APV when the level of debt is constant • Use WACC and FTE when the debt ratio is constant • WACC is by far the most common • FTE is a reasonable choice for a highly levered firm

  16. Estimating the discount rate • Firm A wants to finance a new project with a B/S ratio of 1/3. Its borrowing rate is 10%. • Firm B in the same industry has a B/S ratio of 2/3. The beta of its equity is 1.5. Firm B’s borrowing rate is 12%. • Corporate tax rate = 40%. • Market risk premium = 8.5% • Rf = 8% • What is the discount rate for Firm A’s new project?

  17. Estimating the discount rate • Firm B’s cost of equity • Firm B’s cost of capital if unlevered

  18. Estimating the discount rate

  19. Beta and Leverage

  20. Beta and Leverage

  21. Beta and Leverage

  22. Beta and Leverage

  23. Beta and Leverage: with Corp. Taxes • In a world with corporate taxes, and riskless debt >1 for a levered firm

  24. Beta and Leverage

  25. Beta and leverage: Example • A firm considers to invest $1 million in a new project. • The projct is expected to bring a perpetual unlevered after-tax cash flow of $300,000 a year. • The target debt to equity ratio for this project is 1. • The three competitors in the same industry have unlevered betas of 1.2, 1.3, 1.4. • The risk free rate is 5%. The market premium is 9%. • The corporate tax rate is 34%. • What is the NPV of the project?

  26. Beta and leverage: Example 1. Average unlevered beta: (1.2+1.3+1.4)/3=1.3 2. Levered beta: (1+1/1*(1-0.34))*1.3=2.16 3. Cost of levered equity Rs 0.05+2.16*0.09=0.244

  27. Beta and leverage: Example 4. Rwacc ½*0.05*0.66+1/2*0.244=0.139 5. NPV -1,000,000+300,000/0.139=1,158,273

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