Valuation and Capital Budgeting RWJ Chp 17. Adjusted Present Value Approach. 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:
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Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are:
-RM1,000 RM125 RM250 RM375 RM500
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.
TCBrB = 0.40 × RM600 × 0.08
= RM19.20 each year.
PV of loan
CF3 = RM375 -28.80
CF2 = RM250 -28.80
CF1 = RM125-28.80
0 1 2 3 4
so S = RM407.09.
-RM400 RM96.20 RM221.20 RM346.20 -RM128.80
0 1 2 3 4
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?
Worldwide Trousers, Inc. is considering a RM5 million expansion of their existing business.
Let’s work our way through the four terms in this equation:
The PV unlevered project is the present value of the unlevered cash flows discounted at the unlevered cost of capital, 18%.
The PV depreciation tax shield is the present value of the tax savings due to depreciation discounted at the risk free rate , at rf = 4%
Project: RM5 mil
Lifespan: 5 years
Salvage Value: 0
The PV interest tax shield is the present value of the tax savings due to interest expense discounted at the firms debt rate, at rD = 12.5%
Let’s add the four terms in this equation:
Since the project has a positive APV, it looks like a go.