1) Three moments: start, during, end.

Typical cash flows at the start: Cost of machines (200.000, posses, so on balance sheet,
depreciate in 4 equal parts) Shipping and installation (40.000, income statement: tax
deductable expense, deducted from revenue: less taxes) Investment in inventory (10.000)
Rehabilitation: sunk costs. Costs already made in the past with no impact to profit of the
project. (100.000, not included).

In some countries you can put the shipping/installation costs on the balance sheet. First check
which country. If it Is included on the balance sheet: depreciation. 10.000 per year. Annual
tax saving 4.000 (40% tax rate). One time expense: profit/loss account. Extra tax deductable
expense: 40.000. Tax saving = 16000. Prefer 16000 because of time value of money. So put
on the profit/loss account: 24.000 instead of 40.000 because of the tax savings. So 200 + 24 +
10 = 234.000 initial investment.

During (year 1 till year 4):

Year 1: Revenue (400.000), operating expenses (-300.000) External costs (effect of new
project on old project: -10.000), depreciation (50.000 or 43.750 if not depreciated till 0)

Depreciation: tax authority. What would be the best choice? 50.000: operating cash flow of
40.000 before taxes. Interest costs not included: is included in the discount rate. Never
included interest payments in cash flow for NPV. Subtract taxes. 40%: 16.000. 24.000 net
operating profits after tax. Add depreciation again for cash flow: 74.000.
Forgot working capital. NWC: short term asset – short term liabilities. Inventories (already
included at the start) + accounts receivable (60 days out of 365 days * 400.000 – 20.000,
externality effect on the sales) – accounts payable (credit received from suppliers, 60 days /
365 days * 60% * 300.000 – 10.000 externality effect on the operating expenses). 62.466 –
28.603. = 33.863. Cash flow = 40.137.

NWC year 1: 33.863, NWC year 2: 33.863 NWC year 3: 38.466 NWC year 4: 38.466
Year 2: NWC is 0, because it includes changes/additional investments in working capital.
Year 3: 4.603. Year 4: 0.

End of the project

Salvage value (25.000 market value, 0 book value because it is fully depreciated: capital gain
of 25.000, 40% tax so market value after tax is 15.000) If not fully depreciated: market value
is 25.000 and no taxes on capital gain because cg is 0.
NWC become available again (38.466, NWC during + 10.000 of inventories, NWC at the
start).

2) NPV (NHW(cell of wacc; cash flows year 1-end)+cash flow year 0) and IRR (IR(cash
flow year 0 – end) calculated by using excel.
3) Opportunity cost (extra line in cash flow pretax or calculated NPV and subtract from
answer) NPV in excel: -HW(cell of wacc; aantal termijnen: betalingen)
4) Replacement: mutually exclusive. Only incremental cash flows are important. Look at
difference between cash flows of old and new project.
5) Cash flows and discount rate both nominal or both real = same answers. If inflation is
included, price increase of 5% or 10 cents per year. Revenue, operating expenses
increase so real terms. If revenues and expenses are the same for each year: real
terms. (Depreciation is always in nominal terms) Discount rate is in nominal terms.
(1 + Knom) = (1 + Kreal) * (1+h)
Revenue – expenses in real terms * (1+h)^t to convert to Knominal (build in inflation so it is
in nominal terms). Tax shield of depreciation is already in nominal terms!
Revenue – expenses in nominal terms / (1+h)^t to convert to Kreal. Tax shield of depreciation
is nominal terms, so divide by (1+h)^t.
6) Project has same risk as the rest of the firm
7) Unequal lives: EAC method instead of NPV. First npv than calculate C with annuity
factor.
Week 2

1. Do you agree with an 11% cost of capital for each division?

2. Do you agree with the overall firm‐level cost of capital?

PepsiCo is divided into 3 business segments: ‘’three flagships’’.

8 brands over 1 billion in retail sales, 25 brands with 100 million in retail sales.

- Management uses a 11% cost of capital.

- Pepsico has a target debt ratio of = 20-25%. (B/V), financed with 25% debt, 75%
equity.
- Tax rate = 38%
- Cost of debt = =9.6%
- Historical MRP = 5.6% (10.1% - 4.5%)
- Beta=1.10
- Current risk free rate = 8.3.

Cost of capital should reflect the risk of the cash flow that you want to discount. Therefore,
pick a risk adjusted discount rate.

Discount rate higher than risk level = penalty

Discount rate lower than risk level = accept incorrectly.

First calculate at division level, because risk per division is not equal (information in text).
Look outside the firm to find adequate level of discount rate. Use information of comparable
firms to find cost of equity for division. (Re).

Once you have Re (Cost of equity) for each division and Rd (Cost of debt) you can find the
wacc (Cost of capital) for each division. Then weighted average, reconstruct wacc (Cost of
capital) at the firm level.
Exhibit 5. How comparable the firms are? Search for firms that are similar.

1) Beverage division: Coca-Cola

2) Snack division: Flower, Lance, Golden Enterprises

3) Restaurant division: Wendy’s, Mc Donald’s, National Pizza

Excel:
Cost of equity: CAPM
Equity MV: shares * share price
Total debt in exhibit
Fractions of debt and equity
Take average of beta for each division
Cost of equity: CAPM with new beta
WACC: Cost of equity * fraction of equity + Cost of debt (9.6% at firm level) * fraction of
debt
- WACC: 11.38% beverage
- WACC: 11.96% restaurant
- WACC: 10.65% snack
Weighted average of these three divisions. Weights based on sales, profits or assets.
Based on the assumption that the comparable firms have the same business risk levels.
Restaurant level: same % debt, but snack and beverage have different financial risks.
Correct for differences in financial risk.
Bunlevered = Bequity / 1 + (1-Tc) BL/SL
Then relever the Bunleverd, with the financial risk of Pepsico.
Average of levered beta and calculate wacc for each division again.
Hamada model assumes that the debt of the firms are risk free, or that beta debt is equal to
zero. Other formula can be used.
Beta debt : YTM = RF + MRP * Beta debt
YTM is cost of debt.

Week 3
1) Peatco, Inc., is considering a $2.1 million project that will be depreciated according
to the straight-line method over the three-year life of the project. The project will
generate pretax cash revenues less cash expenses of $900,000 per year, and it will not
change the risk level of the firm. Peatco can obtain a three-year, 12.5 percent loan to
finance the project; the bank will charge Peatco flotation fees of 1 percent of the
gross proceeds of the loan. The fee must be paid up front, not from the loan proceeds.
If Peatco financed the project with all equity, its cost of capital would be 18 percent.
The tax rate is 30 percent, and the risk-free rate is 6 percent.

a) Using the APV method, determine whether or not Peatco should undertake the project.

APV = NPVu + PVFSE

NPVu = -Io + PV(after tax revenue – expenses) + PV(Tax shield after depreciation)
NPVu = -2,100,000 + (900,000)(1-0.30) x annuity factor + (700,000)(1-0.30) x annuity factor
Annuity factor 3 years, 18%
700,000 = 2,1 million / 3
Annuity factor 3 years, 6%
NPVu = -169,050

Flotation costs
Net proceeds = 2,100,000
Gross proceeds = 2,100,000/0.99 = 2,121,212
Flotation costs = 21,212  Amortize (put on balance sheet). Tax deductible expense.
Or profit and loss account: 14,848 after taxes.
Profit and loss account:
APV = -169,040 – 14,848 + Tax shield of interest payments
Tax shield of interest payments:
a) NPV (loan) = 2,121,212 – (0.125*2,121,212)(1-Tc) x AF – 2,121,212 / 1.125^3
Annuity factor: 3 years, 12.5%.
NPV (loan) = 189,490
b) (0.125)(2,121,212)(0.30) * AF
Annuity factor 3 years, 12.5%

APV = -169,040 – 14,848 + 189,490 = 5,592

b) After hearing that Peatco would not be initiating the project in their own town, the city
council voted to subsidize Peatco’s loan. Under the city’s proposals, Peatco will pay the same
flotation costs, but the rate on the loan will be 10 percent. Should Peatco accept the city’s
offer and begin the project?

Government subsidy: below market interest rate. No impact on NPVu and flotation costs.
Only has impact on the tax deductibility of interest payments.

NPV loan = 2,121,212 – (0.10)(2,121,212)(1-Tc) x AF – 2,121,212/1.125^3

AF = 3 years, 12,5%. Does not change, same for discount rate of paying back the loan.
NPV loan = 277,875

APV = 93,977 (goes up)

Subsidy has value because APV goes up.

3. Folgers Air Transport (FAT) is currently an unleveraged firm. It is considering a capital

restructuring to allow $500 in debt. The company expects to generate $151.52 in cash flows
before interest and taxes, in perpetuity. Its cost of debt capital is 10 percent and the
corporate tax rate is 34 percent. Unleveraged firms in the same industry have a cost of
equity capital of 20 percent (unlevered cost of equity capital). Using NPV, APV, and FtE,
what will be the new value of FAT?

Unlevered: all-equity financed firm. Allow debt: become levered firm.

1) APV
First look at cash flows, assuming it is all equity financed. And then add financial side effects.
APV = unlevered NPV + financial side effect
NPVu = 151.52 (1-Tc) / Ku  because it is a perpetuity. 0.20 = Ku (unlevered cost of
equity capital)
NPVu = 500,xx

FSE: value of the tax shield.

(BL x interest x Tc) / interest = tax save from making interest payments. / R because it is an
perpetuity. Therefore (BL x Tc). 500 x 0.34 = 170
APV = 760

2) NPV

OCF: 151.52 * (1-Tc) / WACC

/ WACC because it is a perpetuity.
WACC = (Ke x We) + (Kd x Wd) x (1-Tc)
BL = 500
VL = SL + BL
VL = Vu + Tc * BL
Vu = value unlevered, assuming it is all-equity financed = NPVu
= 500,xx + (0.34)(500)
= 670. Equity = 170, debt = 500

WACC = Ke x (170/670) + (0.10)(500/670)(1-0.34)

Ke = Ku + (Ku – Kd)(1-Tc) * (BL/SL)
Ke = 0.20 + (0.20-0.10)(1-0.34)(500/170)
Ke = 0.3941%
WACC = 14.92% (discount rate)
NPV = 151.520 (1-0.34) / 0.1492 = 670

3) FtE
Position of equity holders
Residual cash flows: what is left over for the shareholders (after paying off debt).
FtE = R(CF / Ke) – (Io – Loan)
Ke = cost of equity capital in a levered firm
(Io – Loan) = subtract investment, but only the part that is financed with equity

RCF = 151.520 – interest payments

Interest payments: 10% x 500= 50
101.520 – taxes
67 annual cash flow
FtE = (67 / 0.3941) – (0 – 500) = 670

2. Milano Pizza Club owns a chain of three identical restaurants popular for their Milan style
pizza. Comparable stores have an equity value of $900,000 and debt-to-equity ratio of 30
percent. The prevailing market interest rate is 9.5 percent. An equivalent all-equity-
financed store would have a discount rate of 15 percent. For each Milano store, the
estimated annual sales are $1,000,000, cost of goods sold $400,000, and general and
administrative costs $300,000. Every cash flow stream is assumed to be a perpetuity. The
marginal tax rate is 40 percent. What is the value of the Milano Pizza Club according to the
Flow-to-Equity Approach?

SL = 900,000
BL = (0.30)(900,000) = 270,000
Kd = 9.5%
Ku = 15% (unlevered cost of equity capital/all-equity)
Tc = 40%
Sales = 1,000,000
COGS = 400,000
G&A = 300,000

RCF / Ke
RCF =
Interest payments: 270,000 x 0.095 = 25,650
1,000,000 – 400,000 – 300,000 – 25,650 = income before taxes = 274,350
After tax: 274,350*0.60 = 164,610

Ke = Ku + (Ku-Kd)(1-Tc)(BL/SL)
Ke = 15% + 15% - 9.5% * 60% * 270/900
Ke = 15.99%

FtE = 164,610 / 0.1599 – (0 – 270,000)

FtE = 1,299,456 for one store
Times 3 for total firm value.

If depreciation not riskfree: unlevered cost of equity capital