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Topics Covered

Topics Covered. After Tax WACC Tricks of the Trade Capital Structure and WACC Adjusted Present Value. Alternative Specifications. Tax-adjusted required rate where t = marginal corporate tax rate D/V = virtual debt ratio r = r F +  (r M – r F ). After Tax WACC.

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Topics Covered

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  1. Topics Covered • After Tax WACC • Tricks of the Trade • Capital Structure and WACC • Adjusted Present Value

  2. Alternative Specifications • Tax-adjusted required rate where t = marginal corporate tax rate D/V = virtual debt ratio r = r F +  (rM – rF)

  3. After Tax WACC • The tax benefit from interest expense deductibility must be included in the cost of funds. • This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate. OldFormula

  4. After Tax WACC Tax Adjusted Formula

  5. After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

  6. After Tax WACC Example - Sangria Corporation - continued

  7. After Tax WACC Example - Sangria Corporation - continued

  8. After Tax WACC Example - Sangria Corporation - continued Debt ratio = (D/V) = 50/125 = .4 or 40% Equity ratio = (E/V) = 75/125 = .6 or 60%

  9. After Tax WACC Example - Sangria Corporation - continued

  10. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  11. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  12. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  13. After Tax WACC • Preferred stock and other forms of financing must be included in the formula.

  14. After Tax WACC Example - Sangria Corporation - continued Calculate WACC given preferred stock is $25 mil of total equity and yields 10%.

  15. Adjusted Present Value APV = Base Case NPV + PV Impact • Base Case = All equity finance firm NPV. • PV Impact = all costs/benefits directly resulting from project.

  16. Adjusted Present Value example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.

  17. Adjusted Present Value example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Project NPV = 150,000 Stock issue cost = -200,000 Adjusted NPV - 50,000 don’t do the project

  18. Adjusted Present Value example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.

  19. Adjusted Present Value example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option. Project NPV = - 20,000 Stock issue cost = 60,000 Adjusted NPV 40,000 do the project

  20. Topics Covered • Leveraged Buyouts • Spin-offs and Restructuring • Conglomerates • Private Equity Partnership • Control and Governance

  21. Definitions • Corporate control -- the power to make investment and financing decisions. • Corporate governance -- the role of the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions. • Financial architecture -- the financial organization of the business.

  22. Leveraged Buyouts • The difference between leveraged buyouts and ordinary acquisitions: 1. A large fraction of the purchase price is debt financed. 2. The LBO goes private, and its share is no longer trade on the open market.

  23. Leveraged Buyouts • The three main characteristics of LBOs: 1. High debt 2. Incentives 3. Private ownership

  24. Leveraged Buyouts 10 Largest LBOs in 1980s and 1997/98 examples

  25. Private Equity Partnership Investment Phase Payout Phase General Partner put up 1% of capital General Partner get carried interest in 20% of profits Mgmt fees Limited partners get investment back, then 80% of profits Limited partners put in 99% of capital Partnership Partnership Company 1 Company 2 Investment in diversified portfolio of companies Sale or IPO of companies Company N

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