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LEVERAGE
Introduction
Discuss three approaches to valuing a risky asset for
which both debt and equity financing are used.
Initial Assumptions
The project has average risk.
For simplicity the betas or costs of capital used will be for the
existing firm rather than being project specific. Iffy.
The firms debt-equity ratio is held constant.
This simplifies the application in that we dont need to worry
about changing costs of capital over time and identifies the
proper the adjustment of our risk measure for leverage. It is a
realistic and common policy.
Corporate taxes are the only imperfection relevant for
capital structure.
No agency, bankruptcy or issuance costs to quantify. Clearly
not!
The Weighted Average Cost
of Capital Method
Because the WACC incorporates the tax savings
from debt, we can compute the levered value (V for
enterprise value, L for leverage, 0 for current or time
0) of an investment, by discounting its future
expected free cash flow using the WACC.
(1 )
wacc E D c
E D
r r r
E D E D
t = +
+ +
3 1 2
0
2 3
1 (1 ) (1 )
L
wacc wacc wacc
FCF FCF FCF
V
r r r
= + + +
+ + +
Valuing a Project with WACC
Ralph Inc. is considering introducing a new
type of chew toy for dogs.
Ralph expects the toys to become obsolete after
five years when it will be discovered that chew
toys actually encourage dogs to eat shoes.
However, the marketing group expects annual
sales of $40 million for the first year, increasing by
$10 million per year for the following four years.
Manufacturing costs and operating expenses
(excluding depreciation) are expected to be 40%
of sales and $7 million, respectively, each year.
Valuing a Project with WACC
Developing the product will require upfront R&D
and marketing expenses of $8 million. The fixed
assets necessary to produce the product will
require an additional investment of $20 million.
The equipment will be obsolete once production
ceases and (for simplicity) will be depreciated via the
straight-line method over the five year period.
Ralph expects no incremental net working capital
requirements for the project.
Ralph has a target of 60% Equity financing.
Ralph pays a corporate tax rate of 35%.
Expected Future Free Cash
Flow
"Income Statement:" Year 0 1 2 3 4 5
Sales 40.00 50.00 60.00 70.00 80.00
COGS 16.00 20.00 24.00 28.00 32.00
Gross Profit 24.00 30.00 36.00 42.00 48.00
Operating Expenses 8.00 7.00 7.00 7.00 7.00 7.00
Depreciation Exp 4.00 4.00 4.00 4.00 4.00
EBIT -8.00 13.00 19.00 25.00 31.00 37.00
Tax (35%) -2.80 4.55 6.65 8.75 10.85 12.95
Unlevered NI -5.20 8.45 12.35 16.25 20.15 24.05
Free Cash Flow:
Unlevered NI -5.20 8.45 12.35 16.25 20.15 24.05
Plus Deprecition Exp 0.00 4.00 4.00 4.00 4.00 4.00
Less Net Cap Ex 20.00 0.00 0.00 0.00 0.00 0.00
Less Changes in NWC 0.00 0.00 0.00 0.00 0.00 0.00
Free Cash Flow -25.20 12.45 16.35 20.25 24.15 28.05
Market Value Balance Sheet
Without the project ($millions):
The firm is currently at its target leverage:
Equity to Net Debt plus Equity ratio is:
$510.00/($510.00 + $390.00 - $50.00) = 60.0%
Excess Cash 50.00 $ Debt 390.00 $ Debt 5%
Existing Assets 850.00 $ Equity 510.00 $ Equity 12%
Total Liabilities Risk Free 4%
Total Assets 900.00 $ and Equity 900.00 $
Assets Liabilities Cost of Capital
Valuing a Project with WACC
Ralph intends to maintain a similar (net) debt-
equity ratio for the foreseeable future,
including any financing related to the project.
Thus, Ralphs WACC is:
(1 )
510 340
(12%) (5%)(1 0.35)
850 850
8.5%
wacc E D c
E D
r r r
E D E D
t = +
+ +
= +
=
Valuing a Project with WACC
The value of the project, including the tax
shield from debt, is calculated as the present
value of its future free cash flows discounted at
the WACC.
The NPV (value added) of the project is $52.10 million
$77.30 million $25.20 million = $52.10 million
It is important to remember the difference between value
and value added.
0
2 3 4 5
12.45 16.35 20.25 24.15 28.05
+
1.085 1.085 1.085 1.085 1.085
$77.30 million
L
V = + + +
=
Summary of the WACC Method
1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital.
3. Compute the value of the investment, including
the tax benefit of leverage, by discounting the
free cash flow of the investment using the
WACC.
a. Note that only the tax benefit of debt is explicitly valued
via this method.
4. The WACC can be used throughout the firm as
the companywide cost of capital for new
investments that are of comparable risk to the
rest of the firm and that will not alter the firms
debt-equity ratio.
Implementing a Constant Debt-Equity
Ratio
By undertaking the project, Ralph adds new
assets to the firm with an initial market value
$77.30 million.
Therefore, to maintain the target debt-to-value
ratio, Ralph must initially add $30.92 million in
new debt.
40% $77.30 = $30.92
60% $77.30 = $46.38 (compare to $52.10)
Implementing a Constant Debt-Equity
Ratio
Ralph can add (net) debt in this amount either
by reducing cash and/or by borrowing and
increasing actual debt.
Suppose Ralph decides to spend $25.20 million
(cover the negative FCF in year 0) in cash to initiate
the project.
This increases net debt by $25.20 million
Excess Cash 24.80 $ Debt 390.00 $ Debt 39.4%
Existing Assets 850.00 $ Equity 562.10 $ Equity 60.6%
New Project 77.30 $
Total Liabilities
Total Assets 952.10 $ and Equity 952.10 $
Assets Liabilities % of Total Value
New Market Value Balance
Sheet
We need an increase in net debt of $30.92 and
equity of $46.38. So
Spend $25.20 million on the project and pay a
$5.72 million dividend so $30.92 million in
cash goes out (the dividend further increases
net debt and reduces equity by the required
amount).
Excess Cash 19.08 $ Debt 390.00 $ Debt 40.0%
Existing Assets 850.00 $ Equity 556.38 $ Equity 60.0%
New Project 77.30 $
Total Liabilities
Total Assets 946.38 $ and Equity 946.38 $
Assets Liabilities % of Total Value
Implementing a Constant Debt-Equity
Ratio
The market value of Ralphs equity increases by
$46.38 million.
$556.38 $510.00 = $46.38 (60% of $77.30)
Adding the dividend of $5.72 million into the mix,
the shareholders total gain is $52.10 million.
$46.38 + 5.72 = $52.10
Which is exactly the NPV calculated for the project
The first try: without the dividend the equity increased
by the projects NPV of $52.10 = $562.10 - $510.00.
This is too large an increase in equity, given an
increase in net debt of $25.20, if Ralph is to maintain
60% equity.
Implementing a Constant Debt-Equity
Ratio
Debt Capacity
The amount of debt at a particular date that is
required to maintain the firms target debt-to-value
ratio
The debt capacity at date t is calculated as:
Where d is the firms target debt-to-value ratio and V
L
t
is the projects levered continuation value on date t
(i.e. the present value of all future FCF as of time t).
L
t t
D d V =
Debt Capacity
In order to maintain the target financing, the
amount of new debt must fall over the life of
the project.
This is true because the value of the project
depends upon the future cash flow at each
point in time. Since the project ends, value
decreases. Since value decreases, debt must
also decrease.
year 0 1 2 3 4 5
Free Cash Flow (25.20) $ 12.45 $ 16.35 $ 20.25 $ 24.15 $ 28.05 $
Levered Value 77.30 $ 71.42 $ 61.14 $ 46.09 $ 25.85 $ - $
Debt Capacity d = 40% 30.92 $ 28.57 $ 24.46 $ 18.43 $ 10.34 $ - $
The Adjusted Present Value
Method
Adjusted Present Value (APV)
A valuation method to determine the levered
value
of an investment by first calculating its unlevered
value and then adding the value of the interest tax
shield and deducting any costs that arise from
other market imperfections
(Interest Tax Shield)
(Financial Distress, Agency, and Issuance Costs)
L U
V APV V PV
PV
= = +