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Styring og Fondsmegling Dr.

oecon Per B Solibakke


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Impact of Financing on Real Asset Valuation
Two Valuation Methods:
1. Adjusted present value (APV) method
i. Forecasting a firms unlevered cash flows
ii. Valuing cash flows assuming that the project is financed entirely with
equity.
iii. Adding to the value obtained in step ii) the value generated as a result of
the tax shield and other subsidies from the projects debt financing
2. Weighted Average Cost of Capital (WACC) method
i. Estimating a projects expected unlevered cash flows
ii. Valuing expected cash flows from i) by discounting them at a single risk-
adjusted discount rate that varies with the degree of debt financing that can
be attributed to the project.
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Impact of Financing on Real Asset Valuation
Result
Investment analyst use APV and the WACC methods to evaluate capital investment projects.
Both methods uses as their starting points the unlevered cash flows generated by the
project, assuming that the project is financed entirely with equity.
The APV method calculated the NPV of the all-equity-financed projects and adds the value
of tax shield (and any other) benefits of debt.
The WACC method accounts for any benefits of debt by adjusting the discount rate.
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Impact of Financing on Real Asset Valuation
Unlevered and WACC
The unlevered cost of capital ( ) is the expected return on equity of the firm if it was
financed entirely with equity.
The WACC is the weighted average of the after-tax expected return paid by the firm on its
debt and equity. In absence of a debt tax shield, debt subsidy, or other market frictions
that favour one form of financing over another, the WACC is the expected return of the
firms assets.
Viewing the asset of the firm with value A as a portfolio of unlevered assets with
value UA and debt tax shields with value TX implies that the beta of the assets:
UA
r
A UA TX
A UA TX
UA TX
and
D E D E
UA TX
r r r where
D E D E

| | | |
= +
| |
+ +
\ . \ .
| | | |
= +
| |
+ +
\ . \ .
UA
TX
UA
TX
r
r

=
=
=
=
beta risk of the unlevered assets
beta risk of the debt tax shield
expected return of the unlevered assets
expected return of the debt tax shields
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Present value of tax saving (perpetuity) and assumed risk less.
Thus, the beta of the debt tax shield in this model is zero, yielding:
c
c
TX T D and
UA D E T D where
=
= +
c
T =
c f
c
f
T D r
T D
r

=
Inducing that
A
(asset + debt) must decline with an increase in leverage to reflect
the addition of the risk-free tax savings.
Note the key assumptions:
1. The debt is perpetual, 2. The debt is default-free and pays the risk-free rate, and
3. the face value of the debt and the tax rate do not change over time.
Impact of Financing on Real Asset Valuation
Now defining Hamada model, 1972
The effective corporate tax rate
c
A UA
D E T D
D E

+
(
=
(
+

Styring og Fondsmegling Dr.oecon Per B Solibakke
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Assuming that
UA
does not change with leverage (asymmetric information may
however change this value), this equation states that, for a given debt increase,
the beta of a firms equity increases less the larger is the corporate tax rate,
and increases the most when there are no taxes.
(1 )
E A
D
E
= +
1
1 (1 )
c
E UA
E c UA
D E T D D
E D E
D
T
E


+
( | |
= +
|
(
+
\ .
(
= +
(

The formula for unlevering the equity betas in the presence of corporate taxes:
Giving us the basis for the unlevered cost of
capital.
Impact of Financing on Real Asset Valuation
Equity betas are affected by betas. The starting point is as before the formula:
Substituting for the result of
A
1 (1 )
E
UA
c
D
T
E

=
(
+
(

Styring og Fondsmegling Dr.oecon Per B Solibakke
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1. If the firm issues debt as the value of unlevered assets rises and retires debt as
the value of the unlevered assets falls, then equity betas will move more in
response to leverage changes. In the extreme (perfect positive correlation) the
betas are the same as in the no-tax case.
2. If firms tend to retire debt when they are doing well, then the Hamada formula
overstates the impact of leverage on equity betas (Kaplan & Stein, 1990)
Impact of Financing on Real Asset Valuation
The Hamada model (72) is not always correct:
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Start with the unlevered assets and discount expected unlevered cash flows at
(risk equal to
UA
). Then value the debt tax shield with a different discount rate.
Finally, add these two components together.
Three sources of Value Creation for shareholders
1. The PV of the projects unlevered cash flows
2. The PV of subsidies due to financing of the project (i.e. the debt tax shield)
3. Transfer to shareholders from existing debt holders due to financing of the project
Impact of Financing on Real Asset Valuation
The Adjusted Present Value Method
UA
r
Debt Tax Shield (TX)
Unlevered Assets (UA)
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Firms should be financed with enough debt to eliminate their tax liabilities. However, limits
and costs exist because the probability of bankruptcy increases when D/E increases.
A firms debt capacity is the marginal amount by which a firms debt capacity increases as a
direct result of taking on the project. Dynamic debt capacity suggest a preference of the
APV method relative to the WACC method.
Issues important for determining a firms optimal debt capacity will be discussed later!
Debt Capacity
Transfer to shareholders from existing debt holders due to financing of the project
The selection of high-risk projects can benefit equity holders at the expense of debt holders,
while selection of safe projects can do the reverse.
New debt financing can sometimes reduce the value of existing debt financing to the benefit
of equity holders.
Impact of Financing on Real Asset Valuation
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Combining the APV and the Real Option Approach: Valuation of a project.
Ekornes has an option to expand it plants capacity during good times. The initial cost of the plant was
140 mill kroner. The risk-free rate is 5% per period. Now we assume the following:
For tax purposes, Ekornes will expense at year 2 (income realised), both the initial 140 mill and,
provided it expands capacity additional
Ekornes is generating plenty of taxable earnings over the next few years and will be able to take
advantage of any tax loss if the projects turns out to be unprofitable.
Ekornes is financed initially with 100 mill in debt, but it can issue and additional 200 mill in debt
if the good state of the economy occurs and the firm expands capacity.
Interest rate on the debt is 10% and the marginal tax rate is 50%.
Impact of Financing on Real Asset Valuation
Summary of the APV method:
Firms can easily use the APV method with a variety of valuation methods, including
those of risk-adjusted rates and real option approaches
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Combining the APV and the Real Option Approach: Valuation of a project.
Impact of Financing on Real Asset Valuation
Answer: Risk-neutral probabilities: good node: 0,53 and 0,47. Bad node: 0,35 and 0,65. Year 0: 0,5.
Year 0 Year 1 Year 2 Unlevered Year 2 Debt Tax Shields
140
-140
Good
Bad
400-(400-280)0,5=340 15
300-(300-280)0,5=290 15
5
5
150-(150-140)0,5=145
100-(100-140)0,5=120
Unlevered value at good node:
Unlevered value at bad node:
Unlevered value at initial node:
0, 5 15 0, 5 5 10
9, 07
(1, 05)(1, 05) (1, 05)(1, 05)
+
= =
0, 35 145 0, 65 120
0 122, 62
1, 05
+
+ =
0, 53 340 0, 47 290
140 161, 43
1, 05
+
+ =
0, 5 161, 43 0, 5 ( 122, 62)
140 4, 74
1, 05
+
=
NPV of project is negative inducing rejection. However PV of the tax shield is:
In summary this becomes:
NPV = -4,74 + 9,07 = 4,33 mill
Styring og Fondsmegling Dr.oecon Per B Solibakke
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The WACC computes only unlevered cash flows and accounts for the debt tax
subsidy by adjusting the discount rate that is applied to the unlevered cash
flows. That is:
Impact of Financing on Real Asset Valuation
The WACC Valuation Method
(1 ) 1
c c
A UA D UA c
T D T D D
r r r and WACC r T
D E D E D E
(
= + =
(
+ + +

Styring og Fondsmegling Dr.oecon Per B Solibakke
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In a number of instances, the maximisation of the total value (debt + equity)
conflicts with the objective of maximising the value of firms equity.
Impact of Financing on Real Asset Valuation
Discounting Cash Flow to Equity Holders
1. Positive NPV projects can reduce Share Prices when Transfer to Debt holders Occur
Ex. Project IRR = 12% (close to risk free project). Risk free rate 10%. However due to BBB rating: 13%
lending rate. Maximising share price: Reject project ; Maximising firm value: Accept project.
The project creates value for the firms debt holders, while its negative for the firms equity holders.
Cash Flow to Equity Holders
For the firm as a whole, cash flow to equity holders is the pretax unlevered cash
flows less payments to debt holders less taxes.
However, note that with non-recourse debt (project financing), the cash flows that
accrue to the equity holders can never be negative and thus have option-like
characteristics.
When a firm finances a project with corporate debt (claims on all assets) cash flow
to equity holders can be negative.
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Impact of Financing on Real Asset Valuation
Cash Flow to Equity Holders cont.
In this case correlation between existing and new projects becomes important.
A low correlation implies a decrease of overall risk of the firm (diversification)
inducing that a large portion of the value created by the project accrues to the
firms debt holders.
A high correlation coupled with a risky project implies that the cash flow to equity
holders will often be higher, and the implementation of the project may hurt the
debt holders.
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Impact of Financing on Real Asset Valuation
Valuing Cash Flow to Equity Holders example:
UP
Down
=1/2
1-=1/2
110
71,5
| |
110 0, 5 71, 5 0, 5
82, 5
1,1
+
=
| |
0, 5 77 0, 5 71, 5
67, 5
1,1
+
=
| |
0, 5 (110 77) 0, 5 {max(71, 5 77, 0)}
15
1,1
+
=
Date 0 Date 1
Ekornes has debt maturing at date 1 with a face value of 77 mill. And a date 0
market value of 67,5:
and equity with a date 0 market value of 15:
Ekornes has indentified a new risk less project that will cost 28.23 mill and will produce
CF of 31,62 at date 1, providing a 12% return. The project will be financed with debt
that is equal in seniority to Ekornes existing debt.
Styring og Fondsmegling Dr.oecon Per B Solibakke
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For 28,23 to be the fair market price of the new debt, the promised payments on the new
debt, F, which capture the fraction F/(F+77) of the firms asset in default, must satisfy
28,23
implying F = 31,9, and a debt yield of 13% ([31,9-28,23]/28,23). However with promised
payments to debt holders at 108,9 (77 + 31,9) if the project is adopted, the value of the
shares for the equity holders is only 14,87 {0,5*(141,62-108,90)+0,5*(max(103,12-
108,90;0)))/1.1}. The 0,13 is transferred to the existing debt holders along with the .52
positive NPV. NPV to equity: rejection; NPV to the firm: adopt the project.
Existing debt and equity holders now have claims worth:
The additional 0,52 mill in value (83,02 -82,5) is simply the net present value of
the project ([-28,23 + 31,62]/1,1).
Impact of Financing on Real Asset Valuation
After adoption of the project
UP
Down
=1/2
1-=1/2
110 +31,62 = 141,62
71,5 + 31,62 = 103,12
| | 141, 62 0, 5 103,12 0, 5
111, 25
1,1
+
=
111, 25 28, 23 83, 02 =
(0, 5 0, 5 103,12) /1,1
77
F
F
F
| |

|
+
\ .
Date 0 Date 1
Styring og Fondsmegling Dr.oecon Per B Solibakke
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However, project present values computed with WACC method and those computed by
DCF to equity holders are identical in absence of such default considerations.
The example points out the importance of using real option approach when wealth
transfers, generated by debt default, are significant considerations in project
evaluation.
Impact of Financing on Real Asset Valuation
Real Options versus the Risk adjusted Discount Rate method
Styring og Fondsmegling Dr.oecon Per B Solibakke
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In case of bankruptcy risk a change in a firms debt-equity mix can affect its share
price even if the change does not affect the sum of the firms debt and equity
values.
Capital Structure and Wealth Transfer
Capital Structure: Leverage increases and Wealth transfer
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Assume: Ekornes issues $50.000 in debt and uses the proceeds to repurchase 500 shares at
$100. Existing debt $10.000 is senior to new debt. Hence r
DJ
> r
DS
. An investor A can
undo the effect by selling 50 shares (100(10%)-50=50) and buying $5000 new debt.
Capital Structure: Leverage increases and Wealth transfer
If a new debt issue is subordinated to the old debt, shareholders will continue to be
indifferent to a capital structure change that does not affect the assets of the firm.
Capital Structure and Wealth Transfer
Styring og Fondsmegling Dr.oecon Per B Solibakke
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In this case new and existing debt holders proportionally share the assets of the
bankrupt firm. The new debt holders greater claim to bankrupt assets makes the
existing debt holders worse off, but it allows the new debt to attract investors
with a lower promised yield than if it were junior to the existing debt.
Capital Structure: Leverage increases and Wealth transfer
If a new debt issue is not subordinated to the old debt, the new debt can generate a
transfer of wealth from the existing shareholder to the equity shareholders:
Capital Structure and Wealth Transfer
Styring og Fondsmegling Dr.oecon Per B Solibakke
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Summary and Conclusions
Capital Structure and Wealth Transfer
The Real option approach seems to prefer the APV-method.
Wealth transfer problems when issuing new debt.