Chapter 3

CAPITAL BUDGETING
Dr. Nguyen Quynh Tho

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 Key Concepts and Skills

● Understand the effects of leverage on the value created

by a project

● Be able to apply Adjusted Present Value (APV), the

Flow to Equity (FTE) approach, and the WACC method
for valuing projects with leverage

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 Chapter Outline

1. Adjusted Present Value Approach

2. Flows to Equity Approach

3. Weighted Average Cost of Capital Method

4. A Comparison of the APV, FTE, and WACC Approaches

5. Beta and Leverage

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 Part 1.
Adjusted Present Value
Approach

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 Adjusted Present Value Approach
APV = NPV + NPVF

●The value of a project to a levered firm (APV) is equal to the value of the
project to an unlevered firm (NPV) plus the net present value of the
financing side effects (NPVF).

●There are four side effects of financing:

○The Tax Subsidy to Debt

○The Costs of Issuing New Securities

○The Costs of Financial Distress

○Subsidies to Debt Financing

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 APV Example

Consider a project of the Pearson Company. 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

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%,
 APV Example

Consider a project of the P. B. Singer Co. with the following characteristics:

Cash inflows: $500,000 per year for the indefinite future.

Cash costs: 72% of sales.
Initial investment: $475,000.
tC = 34%
R0 = 20%, where R0 is the cost of capital for a project of an all-equity firm.

The firm plans to finance the project with $126,229.50

Should the firm accept the project?

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 Part 2.
Flow to Equity Approach

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 Flow to Equity Approach

● Discount the cash flow from the project to the equity holders of the
levered firm at the cost of levered equity capital, RS.

● There are three steps in the FTE Approach:

○ Step One: Calculate the levered cash flows (LCFs)

○ Step Two: Calculate RS.

○ Step Three: Value the levered cash flows at RS.

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 Example

Consider a project of the Pearson Company. 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

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%,
 Levered Cash Flows

–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

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 Part 3.
Weighted Average Cost of Capital
Method

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 WACC Method

S B
RWACC  RS  RB (1  TC )
SB SB

● To find the value of the project, discount the unlevered cash flows at
the weighted average cost of capital.

● The net present value of the project can be written as:

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 Example

Consider a project of the Pearson Company. 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

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%
Suppose Pearson’s target debt to equity ratio is 1.50
 Part 4.
A Comparison of the APV, FTE,
and WACC Approaches

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 A Comparison of the APV, FTE, and WACC Approaches

● All three approaches attempt the same task: valuation in the

presence of debt financing.

● Guidelines:

○Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project
over the life of the project.

○Use the APV if the project’s level of debt is known over the life of the project.

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 Summary: APV, FTE, and WACC

APV WACC FTE

Initial Investment

Cash Flows

Discount Rates

PV of financing effects

Which approach is
the best?

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 A Comparison of the APV, FTE, and WACC Approaches

● All three approaches attempt the same task: valuation in the

presence of debt financing.

● Guidelines:

○Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project
over the life of the project.

○Use the APV if the project’s level of debt is known over the life of the project.

● In the real world, the WACC is, by far, the most widely used.
 Valuation When the Discount Rate Must Be Estimated

● A scale-enhancing project is one where the project is similar to those

of the existing firm.

● In the real world, executives would make the assumption that the
business risk of the non-scale-enhancing project would be about equal
to the business risk of firms already in the business.

● No exact formula exists for this. Some executives might select a

discount rate slightly higher on the assumption that the new project is
somewhat riskier since it is a new entrant.
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 Part 5.
Beta and Leverage

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 Beta and Leverage: No Corporate Taxes

● In a world without corporate taxes, and with riskless

corporate debt (bDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm and
the beta of levered equity is:
Equity
Asset   Equity
Asset
 In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship
 the beta of the unlevered firm and the beta of
between
levered equity is:
Debt Equity
Asset   Debt   Equity
Asset Asset
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 Beta and Leverage: With Corporate Taxes

● In a world with corporate taxes, and riskless debt, it can

be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:
 Debt 
Equity  1   (1  TC )Unlevered firm
 Equity 
 Debt 
1
 Since  (1  TC )must be more than 1 for a
 Equity 


levered firm, it follows that Equity > Unlevered firm


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 Beta and Leverage: With Corporate Taxes

●If the beta of the debt is non-zero (i.e., not risk free), then:
B
Equity  Unlevered firm  (1  TC )(Unlevered firm  Debt ) 
SL

●If the debt is risk free:

βEquity = [1 + (1 – TC) B/SL]* β Unlevered Firm.

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 Summary
1. The APV formula can be written as:

Additional
UCFt Initial
APV   t  effects of 
t 1 (1  R 0 ) investment
debt
2. The FTE formula can be written as:

LCFt  Initial Amount 
FTE   t    
 t 1 (1  R S ) investment
 borrowed 
3. The WACC formula can be written as

UCFt Initial
 NPVWACC  t 
t 1 (1  RWACC )
investment
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  Explain how leverage impacts the value
created by a potential project.
Quick Quiz
 Identify when it is appropriate to use the APV
method? The FTE approach? The WACC
approach?

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