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Principles of Corporate Finance Brealey and Myers Sixth Edition. Interactions of Investment and Financing Decisions. Slides by Matthew Will. Chapter 19. Irwin/McGraw Hill. The McGraw-Hill Companies, Inc., 2000. Topics Covered. After Tax WACC Tricks of the Trade

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slides by matthew will

Principles of Corporate Finance

Brealey and Myers Sixth Edition

  • Interactions of Investment and Financing Decisions

Slides by

Matthew Will

Chapter 19

Irwin/McGraw Hill

  • The McGraw-Hill Companies, Inc., 2000
topics covered
Topics Covered
  • After Tax WACC
  • Tricks of the Trade
  • Capital Structure and WACC
  • Adjusted Present Value
after tax wacc
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

after tax wacc1
After Tax WACC

Tax Adjusted Formula

after tax wacc2
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?

after tax wacc3
After Tax WACC

Example - Sangria Corporation - continued

after tax wacc4
After Tax WACC

Example - Sangria Corporation - continued

after tax wacc5
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%

after tax wacc6
After Tax WACC

Example - Sangria Corporation - continued

after tax wacc7
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?

after tax wacc8
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?

after tax wacc9
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?

after tax wacc10
After Tax WACC
  • Preferred stock and other forms of financing must be included in the formula.
after tax wacc11
After Tax WACC

Example - Sangria Corporation - continued

Calculate WACC given preferred stock is $25 mil of total equity and yields 10%.

tricks of the trade
Tricks of the Trade
  • What should be included with debt?
    • Long-term debt?
    • Short-term debt?
    • Cash (netted off?)
    • Receivables?
    • Deferred tax?
tricks of the trade1
Tricks of the Trade
  • How are costs of financing determined?
    • Return on equity can be derived from market data.
    • Cost of debt is set by the market given the specific rating of a firm’s debt.
    • Preferred stock often has a preset dividend rate.
wacc vs flow to equity
WACC vs. Flow to Equity
  • If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were 41-equity financed. The value of interest tax shields is picked up in the WACC formula.
wacc vs flow to equity1
WACC vs. Flow to Equity
  • The company's cash flows will probably not be forecasted to infinity. Financial managers usually forecast to a medium-term horizon -- ten years, say -- and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of post-horizon flows. Estimating the terminal value requires careful attention, because it often accounts for the majority of the value of the company.
wacc vs flow to equity2
WACC vs. Flow to Equity
  • Discounting at WACC values the assets and operations of the company. If the object is to value the company's equity, that is, its common stock, don't forget to subtract the value of the company's outstanding debt.
adjusted present value
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.
adjusted present value1
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.

adjusted present value2
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

adjusted present value3
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.

adjusted present value4
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