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Valuation and Capital Budgeting
for the Levered firm

(Chapter 18)

Key Concepts and Skills

Understand the effects of leverage on the value created by a project

Be able to apply Adjusted Present Value (APV), the Flows to Equity (FTE) approach, and the WACC method for valuing projects with leverage

APV = NPV + NPVF

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:

The Tax Subsidy to Debt

The Costs of Issuing New Securities

The Costs of Financial Distress

Subsidies to Debt Financing

APV Example

Consider a project of the Pearson Company. The timing and size of the incremental after-tax cash flows for an all-equity firm are:

–\$1,000

\$125

\$250

\$375

\$500

0

1

2

3

4

The unlevered cost of equity is R 0 = 10%:

NPV

10%

NPV

10%

=−

\$1,000

+

=− \$56.50

\$125

(1.10)

+

\$250

(1.10)

2

+

\$375

(1.10)

3

+

\$500

(1.10)

4

The project would be rejected by an all-equity firm: NPV < 0.

18-3

APV Example

Now, imagine that the firm finances the project with \$600 of debt at R B = 8%.

Pearson’s tax rate is 40%, so they have an interest tax shield worth T C BR B = .40

Flow to Equity Approach

Discount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital, R S .

There are three steps in the FTE Approach:

Step One: Calculate the levered cash flows (LCFs)

Step Two: Calculate R S .

Step Three: Value the levered cash flows at

R S .

Step One: Levered Cash Flows

Since the firm is using \$600 of debt, the equity holders only have to provide \$400 of the initial \$1,000 investment.

Thus, CF 0 = –\$400

Each period, the equity holders must pay interest expense. The after-tax cost of the interest is:

B

Step One: Levered Cash Flows

CF 3 = \$375 – 28.80 CF 2 = \$250 – 28.80 CF 1 = \$125 – 28.80

–\$400

\$96.20

\$221.20

CF 4 = \$500 – 28.80 – 600

\$346.20

–\$128.80

0

1

2

3

4

Step Two: Calculate R S

R

S

= R +

0

B

S

(1

T

C

)(

R

0

R

B

)

To calculate the debt to equity ratio,

B

S

PV =

\$125

(1.10)

+

\$250

(1.10)

2

+

\$375

(1.10)

3

+

\$500

(1.10)

4

+

4

t

= 1

19.20

(1.08)

t

B

V

P V = \$943.50 + \$63.59 = \$1,007.09 B = \$600 when V = \$1,007.09 so S = \$407.09.

R

S

= .10 +

\$600

\$407.09

(1

.40)(.10

.08)

=

11.77%

Note: This assumes we know the value created by the project. A more straightforward assumption is to assume that the ratio is 600/400, based on the amount provided by each source to fund the project. With these values,

R S =11.80%.

Step Three:Valuation

Discount the cash flows to equity holders at R S = 11.77%

–\$400

\$96.20

\$221.20

\$346.20

–\$128.80

0

NPV =−

\$400 +

1

\$96.20

(1.1177)

NPV = \$28.56

2

\$221.20

+

(1.1177)

2

3

\$346.20

+

(1.1177)

3

4

\$128.80

(1.1177)

4

Note that the chapter examples work out nicely with the perpetuity assumption, in that each approach provides the same value. With a finite life project, the values will deviate based on assumptions made, for example, the repayment of the \$600.

WACC Method

S

S

+

B

B R

+

R

R

S

=

+

W ACC

S

B

B

(1

T

C

)

To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital.

Suppose Pearson’s target debt to equity ratio is 1.50

WACC Method

B

1.50 =

1.5S = B

S

 B 1.5 S 1.5 = = S + B S + 1.5 S 2.5

= 0.60

R

W ACC

R

W ACC

(0.40)

=

= 7.58%

×

(11.77%)

S

= 10.60 = 0.40

 S + B + (0.60) × (8%) × (1 − .40)

Note, when calculating B/S, we are using the target ratio, not the market value which is different from FTE approach

WACC Method

To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital

NPV = −\$1,000 +

\$125

(1.0758)

+

\$250

(1.0758)

2

+

\$375

(1.0758)

3

+

\$500

(1.0758)

4

NPV 7.58% = \$6.68

A
Comparison
of
the
WACC Approaches

APV, FTE, and

All three approaches attempt the same task:

valuation in the presence of debt financing.

Guidelines:

Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over the life of the project.

Use the APV if the project’s level of debt is known over the life of the project.

In the real world, the WACC is, by far, the most widely used.

18-13

Summary:APV, FTE, and WACC

APV WACC

FTE

 All All Equity UCF UCF LCF R 0 R WACC R S Yes No No

Initial Investment Portion

Cash Flows

Discount Rates

PV of financing effects

Summary:APV, FTE, and WACC

Which approach is best?

Use APV when the level of debt is constant

Use WACC and FTE when the debt ratio is constant

WACC is by far the most common

FTE is a reasonable choice for a highly levered firm

Capital Budgeting When the Discount Rate Must Be Estimated

A scale-enhancing project is one where the project is similar to those of the existing firm.

A scale-enhancing project does not diversify the company's risk in any way. However, it may be beneficial, as the project is likely within the company's core competence.

In the real world, executives would make the assumption that the business risk of the non-scale-enhancing project would be about equal to the business risk of firms already in the business.

No exact formula exists for this. Some executives might select a discount rate slightly higher on the assumption that the new project is somewhat riskier since it is a new entrant.

Beta and Leverage

Recall that an asset beta would be of the form:

Asset

=

Cov UCF Market

(

,

)

2

Market

Beta and Leverage: No Corporate Taxes

In a world without corporate taxes, and with

corporate debt (

relationship between the beta of the unlevered firm and the beta of levered equity is:

0 ), it can be shown that the

β

=

debt

=

Asset

Equity

Asset

×

Equity

In a world without corporate taxes, and with corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

Asset

=

Debt

×

Asset

Debt

+

Equity

Asset

×

Equity

Beta and Leverage:With Corporate Taxes

In a world with corporate taxes, and riskless debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

Equity

= 

1

+

Debt

Equity

(1

× − T

C

)

Unleveredfirm

Since

1 +

Debt

Equity

×(1T )

C

must be more than 1 for a

levered firm, it follows that β Equity > β Unlevered firm

Beta and Leverage:With Corporate
Taxes

If the beta of the debt is non-zero, then:

Equity

=

Unleveredfirm

+ (1T )(•

C

Unleveredfirm

Debt

) ×

B

S

L

1.
Summary

The APV formula can be written as:

=

t= 1

UCF

t

Initial

investment

APV

+

effects of

debt

(1

+ R

0

)

t

2. The FTE formula can be written as:

− 

=

t = 1

LCF

t

Initial

investment

Amount

FTE

(1

+ R

S

)

t

borrowed

3. The WACC formula can be written as

NPV

W ACC

=

t= 1

UCF

t

Initial

(1

+ R

W ACC

)

t investment

4
Summary

Use the WACC or FTE if the firm's target debt to value ratio applies to the project over its life.

WACC is the most commonly used by far.

FTE has appeal for a firm deeply in debt.

5 The APV method is used if the level of debt is known over the project’s life.

The APV method is frequently used for special situations like interest subsidies, LBOs, and leases.

6 The beta of the equity of the firm is positively related to the leverage of the firm.

Suggested Problems

5, 9, 13