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Capital budgeting with the Net Present Value rule 3. Impact of financing

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Capital budgeting with the Net Present Value rule 3. Impact of financing

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## Capital budgeting with the Net Present Value rule 3. Impact of financing

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**Capital budgeting with the Net Present Value rule3. Impact**of financing Professor André Farber Solvay Business School University of Brussels, Belgium Hanoi April 2000**Capital budgeting for the levered firm**• With debt and equity, decision depends on financing mix. • Why? • Tax subsidy to debt • Cost of issuing new securities • Subsidies to debt financing • Cost of financial distress • 3 methods: • Adjusted-Present Value • Flow-to-equity • Weighted-average cost of capital Hanoi April 2000**Adjusted-Present-Value**• Divide and conquer! • Step 1: Calculate NPV for unlevered project NPV • Step 2: Calculate NPV of financing side NPVF • Step 3: Add up. APV = NPV + NPVF Hanoi April 2000**APV - example**• Initial investment = 500 • Expected future EBIT = 140 per year for indefinite future • Corporate tax rate = 40% • Cost of capital, all equity r0 = 20% • Unlevered cash flow (UCF) = 140 (1 - 0.40) = 84 • Present value of UCF = 84 / 0.20 = 420 • NPV = -500 + 420 = -80 • Unlevered project would be rejected! Hanoi April 2000**APV example: Introducing debt**• Now imagine the company borrows 300 • Remaining investment (500 - 300 = 200) financed with equity. • Borrowing rate = 10% • Income statement unlevered levered EBIT 140 140 Interest 0 30 Taxes 56 44 Earnings 84 66 Cash to investors 84 96 Tax saving = 56 - 44 = 12 = 40% x 30 Hanoi April 2000**Valuing the Tax Shield**• Annual tax shield from debt = TaxRate Interest rate Value of debt = TC rB B • Present value (perpetuity) = (TC rB B)/rB =TC B • In our example: PV(TaxShield) = 0.40 300 = 120 Hanoi April 2000**APV calculation (finished)**• We now have the following for our project: • Net Present Value (all equity) - 80 • Present Value of Tax Shield +120 • Adjusted Present Value + 40 Hanoi April 2000**Flow-to-Equity Approach**• Valuation of cash flows from the project to the equityholders of levered firm (levered cash flow LCF). • LCF = UCF - (1-TC) x rB x B = UCF - rB x B + TCx rB x B InterestTaxShield • In our example: LCF = 84 - 30 + 12 = 66 Hanoi April 2000**Discounting Levered Equity Cash Flows**• Because of debt, equity is more risky. Discount rate should take this additional risk into account. • The formula for the discount rate is: rS = r0 + (r0 - rB) x L/(1-L) • with L : debt-to-value ratio • In our example: L = 300 /(420 + 120) = 0.5555 • rS = 0.20 + (0.20 - 0.10) x 0.60 x 1.25 = 27.50% • Present value of levered cash flows = 66/.275 = 240 • NPVfor stockholders = 240 - 200 = 40 … same as APV Hanoi April 2000**Weighted-Average-Cost-of-Capital Approach**• Discount unlevered cash flow using adjusted cost of capital. • rWACC = rs(1-L) + rB(1-TC) L • (Remember: L = B/V so 1-L = S/V) • In our example: • rWACC = 0.275 x 0.445 + 0.10 x 0.60 x .555 = 15.57% • Net present value = -500 + 84 / 0.1557 = 40 Hanoi April 2000**Alternative WACC formulas**• Modigliani Miller : rWACC = r0(1-TCL) • perpetuity • debt level constant • Miles-Ezzel: rWACC = r0 - L rB TC(1+r0)/(1+rB) • any set of cash flows • debt ratio constant Bt = L x Vt Hanoi April 2000**Comparing APV, FTE and WACC**• Which approach is best? • APV • any type of side effect • unbundles present value • use APV when level of debt known • WACC, FTSE • takes into account interest tax shield • use WACC or FTSE when debt ratio constant Hanoi April 2000