Review: Capital Structure Theory

The Main Topics:

Do capital structure decisions influence firm value?

MM Proposition I & II (assume no taxes)

MM Proposition I & II (with corporate tax)

The role of corporate tax in corporate structure

decisions
Static trade-off theory
Optimal capital structure
 Valuation and Capital Budgeting for
the Levered Firm
Main Topics
Understand the effects of leverage on the value
created by a project

Be able to apply the Adjusted Present Value

(APV) approach, the Flows to Equity (FTE)
approach, and the Weighted Average Cost of
Capital (WACC) method for valuing projects
with leverage
 Valuation and Capital Budgeting for
the Levered Firm
1 Adjusted Present Value (APV) Approach
2 Flows to Equity (FTE) Approach
3 Weighted Average Cost of Capital Method
4 A Comparison of the APV, FTE, and WACC
approaches
5 Some in-depth discussion on Adjusted Present
Value (APV) approach
 A Review of NPV

NPV is the net present value of the project to

an all-equity firm (i.e., unlevered firms):

As discussed before:
NPV = PVUCF Initial investment for entire
project

PVUCF: PV of Unlevered Cash Flows (UCF)

Discount rate: R0 (Unlevered cost of capital)

n
UCFt
Initial invesment C0 +
NPV =
t =1 (1 + R0 ) t
 Example 1(a)
Lets use one example to illustrate the NPV approach.
Consider a project of the Pearson Company. The initial
investment is $1,000. 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
Assume the unlevered cost of equity is R0 = 10%.

How much is the NPV of this project? Should we

accept or reject this project?
 FYI: How to calculate NPV using BAII Plus
calculator?
CF
2nd {CLR Work}
-1000 Enter
125 Enter
250 Enter
375 Enter
500 Enter
NPV I = 10
CPT NPV = ?
Adjusted Present Value Approach
The APV approach determines value by adding
the net present value of a project as if it were
financed solely by equity plus the present value
of any financing costs or benefits (e.g., the
additional effects of debt).
Specifically, the Adjusted Present Value (APV)
for a project with debt financing is:
APV = NPV + NPVF
The value of a project to the firm (APV) 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).
 APV = NPV + NPVF
NPVF is the net present value of financial side effects,
which include:
- tax subsidy to debt (i.e., debt-interest tax shield benefit)
- the costs of issuing new debt and equity securities
(i.e., so-called floatation cost)
- the costs of financial distress arising from the use of
debt (i.e., bankruptcy-related costs)
- subsidies to debt financing. For example, corporation
can obtain financing from a municipality at a (lower)
tax-exempt rate because municipality can borrow at
this rate. This subsidy adds value.
NOTE: If we assume that there is only the 1st effect
(debt-interest tax shield benefit), APV is defined as
APV = NPV + PV of tax shield
 APV Example 1(b)
Lets use the same info in APV Example 1(a).
Now, imagine that the firm finances the project
with $600 of debt at RB = 8% and with 4 years
to maturity.
Pearsons tax rate is 40%, so they have an
(annual) interest tax shield worth TCBRB = ?
[Recall our discussion on MM Proposition II
with Tax]
The net present value of the project under
leverage is:
APV = NPV + NPV debt tax shield = ?
So how much is the APV after we consider
the tax subsidy to debt (i.e., tax shield benefit
of debt financing)?
 Adjusted Present Value Approach
Based on the discussion, the following
Adjusted Present Value (APV) formula
APV = NPV + NPVF
can be specified as:

n
UCFt
APV = Initial invesment C0 + t
+ NPVF
t =1 (1 + R0 )

where
= the
UCF ' project s cash flowto equityholder in anunlevered firm
;
R0 = Cost
of capital for project in anunlevered firm
NPVF = net present value of financial side effects
 Cash Flow Calculation
NOTE:
<1> For a project, UCF = ( Sales cash
costs/expenses ) * (1 - Tc) [ A simplified
equation. ]

<2> For a whole firm, UCF (i.e., FCF to the

firm) = EBIT * (1 tax rate) + Depreciation -
Changes in Working Capital - Capital
expenditure
 APV Example 2: A perpetuity case
Consider a project of a firm with the following characteristics:
Sales: $500,000 per year forever
Cash costs/expenses: $360,000 per year forever
Initial investment of the project: $475,000
Corporate tax rate Tc = 34%
R0 = 20% (R0 is cost of capital for all-equity/0-debt
unlevered firm).
(i) Please compute the NPV of the project.
(ii) Now, assume this firm finances the project with
$126,229.50 in debt. Assume the debt will mature
after many years (i.e., the interest payment of the debt is
a perpetuity). How much is the APV of this project?
For a project: UCF = ( Sales cash costs/expenses ) * (1 - Tc)
 APV method to estimate firm value
MM Proposition I (with corporate tax)
Assumption:
Assume there is corporate tax.
No transaction cost, agency cost, bankruptcy, etc.
Individual and corporations borrow at same rate.
VL > VU
MM Proposition I (with tax): (Value of
levered firm is greater than value of unlevered firm.)
tC RB B
V= U + tax
shield benefit = VU +
L VSpecifically, ( for perpetuity case)
RB
Conclusion: As we can see, the equation above about
MM Proposition I (with corporate tax) is an application
of APV method when there is only the 1st financial
side effect (debt-interest tax shield benefit).
 Flow to Equity (FTE) Approach
Flow to Equity (FTE) Approach: Discounting the cash
flow from the project to the equity holders of the
levered firm at the cost of levered equity capital, RS.
present value of project ( FTE approach )
Net

LCFt
= Initial
investment of equityholder
t =1 (1 + RS )
t

LCFt
= ( Initial investment Amount borrowed )
t =1 (1 + RS )
t

There are three steps in the FTE Approach:

Step 1: Calculate the levered cash flows (LCFs)
Step 2: Calculate RS.
Step 3: Value the levered cash flows at RS.
 The 3 steps of FTE method
Step 1: Calculate the levered cash flows (LCFs)
for a specific year (Note: Not including year 0)
LCF = UCF (1-tax rate) * (annual) interest payment
+ Net borrowing (if any in a specific year)

Step 2: Calculate RS.

This step is based on MM Proposition II with tax
B
RS =R0 + (1 tC )( R0 RB )
S
Step 3: Value the levered cash flows at RS.

LCFt
FTE = ( Initial investment Amount borrowed )
t =1 (1 + RS ) t

LCFt
Perpetuity case FTE =
For : ( Initial investment Amount borrowed )
RS
 FTE Example 1
Consider a project of a firm with the following
characteristics:
Sales: $500,000 per year forever
Cash costs/expenses: $360,000 per year forever
Initial investment of the project: $475,000
Corporate tax rate Tc = 34%
R0 = 20% (R0 is cost of capital for all-equity/0-debt
firm).
- Assume this firm finances the project with
$126,229.50 in debt. Assume this firms (target)
B/SL ratio is 1/3. The debts interest rate is 10%.
- Please use FTE method to compute the value of
the project.
 FTE Example 1
<Answer>
There are three steps in the FTE Approach:
Step 1: Calculate the levered cash flows to the equity
holders (LCFs) for a specific year:
LCF = UCF (1-tax rate) * (annual) interest payment
+ Net borrowing (if any in a specific year)
LCF = ? (In this example, we evaluate a project)
______________________________________________
NOTE:
<1> For a project, UCF = ( Sales cash
costs/expenses ) * (1 - Tc) [ A simplified equation. ]
<2> For a whole firm, UCF (i.e., FCF to the firm) =
EBIT * (1 tax rate) + Depreciation - Changes in
Working Capital - Capital expenditure
 FTE Example 1
<Answer>
There are three steps in the FTE Approach:
Step 2: Calculate RS.
This step is based on MM Proposition II with tax
B
RS =R0 + (1 tC )( R0 RB )
S

Step 3: Value the levered cash flows at RS.

LCFt
FTE = ( Initial investment Amount borrowed )
t =1 (1 + RS )
t

LCFt
Perpetuity case FTE =
For : ( Initial investment Amount borrowed )
RS
 Weighted Average Cost of Capital
(WACC) Approach
As we know, the WACC formula is as follows.
S B
RWACC = RS + RB (1 tC ),
where firm value VL =
B + S.
VL VL
According to the WACC approach, the NPV of a
project can be computed as follows.
n
UCFt
=
NPV of project Initial investment
t =1 (1 + RWACC )
t

UCF = Unlevered Cash Flows to equity holders (UCF)

NOTE: All these methods (i.e., APV, FTE, and WACC)
not only can be used to evaluate a project, but also could
possibly be used to evaluate the entire firm (firm value).
 WACC and the Evaluation of an Entire Firm

Net operating Required investments

profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF

Value = + + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average Firms debt/equity

cost of capital Mix =
(WACC) Capital Structure

Market interest rates Cost of debt

Cost of equity
Market risk aversion Firms business risk
 3 Steps of WACC Approach
There are three steps in the WACC Approach:
Step 1: Calculate the Unlevered Cash Flows to
equity holders (UCF)
Step 2: Calculate RWACC.
Step 3: Value the unlevered cash flows (UCF) at
RWACC.

n
UCFt
=
NPV of project
Initial investment
t =1 (1 + RWACC )
t

UCFt
For Perpeuity :case
=
NPV of project Initial investment
RWACC
 WACC Example 1
Consider a project of a firm with the following
characteristics:
Sales: $500,000 per year forever
Cash costs/expenses: $360,000 per year forever
Initial investment of the project: $475,000
Corporate tax rate Tc = 34%
R0 = 20% (R0 is cost of capital for all-equity/0-debt
firm).
- Assume this firm finances the project with
$126,229.50 in debt. Assume this firms (target)
B/SL ratio is 1/3. The debts interest rate is 10%.
- Please use WACC method to compute the value of
the project.
 WACC Example 1
<Answer>
Step 1: Calculate the Unlevered Cash Flows to
equityholders (UCF) Just like assume its an all-equity
firm.
(After-tax) Unlevered cash flow (UCF) = ( Sales
cash costs/expenses ) * (1 - Tc)
__________________________________________
NOTE: If we use WACC method to estimate the value of
an entire firm, the UCF calculation is more complicated.
<1> For a project, UCF = ( Sales cash
costs/expenses ) * (1 - Tc) [ A simplified equation. ]
<2> For a whole firm, UCF (i.e., FCF to the firm) =
EBIT * (1 tax rate) + Depreciation - Changes in
Working Capital - Capital expenditure
 WACC Example 1
Step 2: Calculate RWACC.
Calculate RS.
This step is based on MM Proposition II with tax
B
RS =R0 + (1 tC )( R0 RB )
S
Then, compute
S B
RWACC = RS + RB (1 tC )
VL VL
Step 3: Value the unlevered cash flows (UCF) at
RWACC.
n
UCFt
=
NPV of project Initial investment
t =1 (1 + RWACC )
t
 Comparison: APV, FTE, and WACC
1. The APV formula can be written as:
n
UCFt
APV = invesment C0 +
Initial t
+ NPVF ( financing sideeffe
ct )
t =1 (1 + R0 )

2. The FTE formula can be written as:

LCFt
FTE = ( Initial investment Amount borrowed )
t =1 (1 + RS )
t

LCFt
Perpetuity case FTE =
For : ( Initial investment Amount borrowed )
RS
3. The WACC formula can be written as
n
UCFt
=
NPV project
of Initial investment
t =1 (1 + RWACC )
t

UCFt
For Perpeuity :case
=
NPV of project Initial investment
RWACC
Comparison: APV, FTE, and WACC
All three approaches attempt the same task:
valuation in the presence of debt financing.
APV WACC FTE
Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

Add PV of financing
side effects? Yes No No
Summary: APV, FTE, and WACC
Which approach is the best? Guidelines
(1) Use WACC and FTE when the debt ratio is
constant (that is, a firm has a target capital
structure) & if the firms target debt-to-value ratio
applies to the project over the life of the project.
WACC is commonly used. (Because it is often
easy to obtain estimates of RS, RB, B and S. For
a publicly traded firm, the market values of debt
and equity can be obtained from news media.)
(2) Use APV when the level of debt (of this
specific project) is constant and known over the
life of the project.
More thorough discussion on APV method
 Net present value of the financing
side effects (NPVF).
What are the common side effects of debt financing?
(i) Tax subsidy (i.e., debt-interest tax shield benefit)
(ii) The cost of issuing new securities (floatation cost)

We have discussed the 1st financing side effect at the

beginning of the lecture.
As for the floatation cost, the flotation cost can be
amortized and expensed over the life of the debt. That
is, just like depreciation can generate a depreciation
tax shield benefit, the annual floatation expense also
can generate a tax shield benefit.
 Net present value of the financing
side effects (NPVF).
The formula to compute the net present value of the
financing side effects (NPVF) based on these 2 financing
side effects (i.e., debt-interest tax shield & floatation cost
tax shield):
NPVF = Proceeds of debt issue (Net of flotation cost)
PV(After tax Interest Payments) PV(Principal
Payments of debt) + PV(Flotation Costs Tax Shield)

where Flotation Costs Tax Shield = Annual floatation

expense * tax rate.

NOTE: Cash flow from floatation costs tax shield has

greater certainty, thus we discount it using the cost of
debt.
 APV Example Question
Compute NPVF when there is floatation cost
Assume a firm is planning to invest in a new project with
initial investment of $300,000, that will be depreciated
according to the straight-line method over the projects ten-
year life. This firm can obtain a ten-year, 5% debt to fund
the entire project. All principal (i.e., $300,000) will be
repaid in one balloon payment at the end of the ten year.
The bank will charge the firm $20,000 floatation cost, which
will be amortized over the life of the project. If the company
financed the project entirely with equity, the firms cost of
capital would be 10%. Corporate tax rate is 33%. What is
the net present value of the financing side effects (NPVF)?
NPVF = Proceeds of debt issue (Net of flotation cost )
PV(After tax Interest Payments) PV(Principal
Payments of debt) + PV(Flotation Costs Tax Shield)
 Summary
1. The APV formula can be written as:
n
UCFt
APV = invesment C0 +
Initial t
+ NPVF ( financing sideeffe
ct )
t =1 (1 + R0 )

2. The FTE formula can be written as:

LCFt
FTE = ( Initial investment Amount borrowed )
t =1 (1 + RS )
t

LCFt
Perpetuity case FTE =
For : ( Initial investment Amount borrowed )
RS
3. The WACC formula can be written as
n
UCFt
=
NPV project
of Initial investment
t =1 (1 + RWACC )
t

UCFt
For Perpeuity :case
=
NPV of project Initial investment
RWACC
Summary
4 Use the WACC or FTE if the firm's target
debt to equity (B/S) ratio applies to the
project over its life.
WACC is the widely 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 projects life.
The APV method is frequently used for special
situations like interest subsidies, LBOs, and
leases.