Chapter 19

Financing and Valuation

19-1 after-tax weighted-average

cost of capital

Capital Project Adjustments

o Discount rate
 Modify to reflect capital structure, bankruptcy risk, other factors
o Present value
 Assume firm financed entirely by equity, make adjustments to value based on
financing

Tax-Adjusted Formula

WACC=r D×(1−T C )× ( DV )+(r × VE )

E

• The after-tax weighted average cost of capital is determined by adding the

weighted average after tax cost of debt to the weighted average cost of equity.
• Weighted average cost of capital (WACC) formula assumes the project is a
carbon copy of the firm.

Cash flows after tax by the unlevered equity rate – is the method to determine the net
present value for an all equity firm discounts .

Required rate of return on the company’s stock – is the cost of common equity for a
firm.

Example: Sangria Corporation

Firm has marginal tax rate of 35%. Cost of equity is 12.4%, pretax cost of debt is 6%. Given
book and market-value balance sheets, what is tax-adjusted WACC?
 Debt ratio = (D/V) = 500/1,250 = .4, or 40%

Equity ratio = (E/V) = 750/1,250 = .6, or 60%

WACC=.06×(1−.35)(.40 )+.124 (.60)

=.090
=9.0 %

Example, Continued

Sangria wants to invest in machine with cash flows of $1.731 million per year pre-tax. What
is value of machine, given initial investment of $12.5 million?

C1
NPV=C 0 +
r −g
1. 125
¿−12 . 5+
. 09
¿0

After tax interest =r D (1−T C )D=.06×(1−.35 )×5=.195

Expected equity income=C−r D (1−T C )D=1.125−.195=0 . 93

 expected equity income
Expected equity return=r E =
equity value
0 . 93
¿ =. 124 , or 12. 4%
7 .5

19-2 valuing businesses

Business value usually computed as discounted value of future cash flows (FCF) to a valuation
horizon (H)

Valuation horizon is also called terminal value

Free cash flow = Profit after tax + depreciation – investment in fixed assets – investment in
working capital

FCF 1 FCF 2 FCF H PV H

PV = 1
+ 2
+. ..+ H
+
(1+ r ) ( 1+ r ) ( 1+r ) ( 1+ r ) H

free-cash-flow projections,
rio corporation ($ Millions)

PV (free cash PV (horizon

flows) value)
Example: Rio Corporation

FCF = 8.7 + 9.9 – (109.6 – 95) – (11.6 – 11.1) = $3.5 million

3 .5 3 . 2 3.4 5.9 6.1 6.0

PV(FCF)= + + + + +
1. 09 ( 1 . 09 )2 ( 1 . 09 )3 ( 1 . 09 )4 ( 1. 09 )5 ( 1. 09 )6
¿ 20 .3

FCFH +1 6. 8
Horizon value = PV H = =
WACC−g . 09−.03 (
=113. 4 )
1
PV( horizon value )= ×113. 4=$ 67 .6
( 1 .09 )6

PV( business )=PV( FCF)+PV(horizon value)

=20 . 3+67. 6
=$87 .9 million

• Flow-to-Equity Method

• Discount cash flows to equity at cost of equity capital, after interest and taxes

• If firm has constant debt ratio over time, flow to equity will give same answer as
discounting total cash flows at WACC and subtracting debt
 APV method to value a project should be used when the financing feedbacks are numerous and
important.
o Total capitalization - sum of long-term financing

APV = base-case NPV + sum of PVs of financing side effects

Using WACC in Practice

• Tricks of the Trade

• What should be included with debt?
• Long-term debt
• Short-term debt
• Cash (netted off)
• Receivables
• Deferred tax

• After-Tax WACC
• Preferred stock and other forms of financing must be included in formula

WACC=(1−T C ) ( DV ×r )+( VP ×r )+( VE ×r )

D P E

Example:

Calculate WACC for Sangria Corporation given preferred stock is $25 million of total equity and
yields 10%

Balance Sheet (Market Value, millions)

Assets 125 50 Debt
25 Preferred equity
50 Common equity
Total assets 125 125 Total liabilities

WACC=(1−.35 ) (50125 ×. 08)+(25125 ×.10)+( 50125 ×. 146)

=. 1104
=11. 04 %
 Determining Costs of Financing

• Derive return on equity from market data

• Cost of debt set by market, rating of firm’s debt

• Preferred stock often has preset dividend rate

Example

Sangria Corporation at 20% D/V

Step 1: r at current debt

r = .06(.4) + .124(.6) = .0984

Step 2: D/V changes to 20%

r E =. 0984+(. 0984−. 06 )(.25 )=. 108

Step 3: New WACC

WACC=. 06(1−. 35 )(. 2 )+. 108(. 8)=. 0942

=9. 42 %

Adjusted Present Value

• Adjusted Cost of Capital

• Modigliani and Miller formula

 • r = Cost of equity @ all equity

• Tc = Corporate tax rate

• rMM = r(1 − TcD/V)

• Adjusted Cost of Capital

• Miles and Ezzell

D 1+r A
WACC=r −
V
rD T c
( )
1+r D

• Adjusted Discount Rate

• Modify to reflect capital structure, bankruptcy risk, other factors

• Adjusted Present Value

• Assume all-equity-financed firm, adjust value based on financing

• APV = Base Case NPV + PV Impact

• Base case: All-equity-financed firm NPV

• PV impact: All costs/benefits directly resulting from project

Example

Project A has $150,000 NPV. Firm must issue stock to finance project, with $200,000 brokerage
cost

• Project NPV = 150,000

• Stock issue cost = −200,000

• Adjusted NPV = −50,000

• Do not invest in Project A

• Example

• Project B has −$20,000 NPV. Firm can issue debt at 8% to finance project. New debt
has PV tax shield of $60,000. Assume Project B is only option
 • Project NPV = −20,000

• Stock issue cost = 60,000

• Adjusted NPV = 40,000

• Invest in Project B

• Example

Rio Corporation APV

APV=Base case NPV + PV( interest tax shields)

=84 .3+5 . 0=$ 89 . 3 million

Some answers for the Quiz:

8. B

11. A

13. B