Slides by Matthew Will

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# Slides by Matthew Will - PowerPoint PPT Presentation

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

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Presentation Transcript

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
• Capital Structure and 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 WACC

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 WACC

Example - Sangria Corporation - continued

After Tax WACC

Example - Sangria Corporation - continued

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 WACC

Example - Sangria Corporation - continued

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

Example - Sangria Corporation - continued

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

• What should be included with debt?
• Long-term debt?
• Short-term debt?
• Cash (netted off?)
• Receivables?
• Deferred tax?
• 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
• 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 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 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.

APV = Base Case NPV

+ PV Impact

• Base Case = All equity finance firm NPV.
• PV Impact = all costs/benefits directly resulting from project.

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.

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

don’t do the project

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.