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Session 22 Financing and valuation

30017 Corporate Finance

Lecture Slides
Session 22: Financing and valuation

This version: 30-Apr-21

30017 Corporate Finance -1- © Hannes Wagner
 Session 22 Financing and valuation

After tax WACC in detail—Valuing a business

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 Session 22 Financing and valuation

Valuing a Business: An M&A example

• One of the frequent applications of valuing a business are mergers and acquisitions (M&A)
• We will consider a (simplified) M&A example: Sangria Corp is tempted to acquire Rio Corp
› Sangria is publicly traded, while Rio is privately held (no market price to rely on)
› Rio Corp’s parameters
- 1.5 million shares outstanding
- Debt market (=book) value of $36 million
- Same line of business as Sangria (we can assume same business risk) and we can use
Sangria’s WACC
- Both companies are US based
• There are many other applications where whole firms need to be value—for example:
› a firm selling a division (The Children’s Place sells the Disney Stores to The Walt Disney
Company in 2007)
› a firm going public (Facebook’s IPO in 2012)
› mutual funds’ stakes in “unicorns” (Fidelity Advisor Equity Growth’s stake in Uber in 2019)
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 Session 22 Financing and valuation

Recall after Tax WACC

We will use an example to see how to obtain and use after tax WACC:
D  E
WACC = rD × (1 − Tc) ×   +  rE × 
V   V
Consider Sangria Corporation, a U.S. based company which aims to
promote “happy and low-stress lifestyles’

Note: The calculations in this session are detailed and follow current US
regulations. For different jurisdictions (and earlier time-periods) some
assumptions would need to be adjusted (e.g. corporate tax rate)

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 Session 22 Financing and valuation

After Tax WACC – Getting started: How Sangria Corp uses

WACC for an investment project

The firm has a marginal tax rate of 21%. The cost of equity is 12.4% and
the pretax cost of debt is 6%. Given the book and market value balance
sheets, what is the tax adjusted WACC?

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 Session 22 Financing and valuation

After Tax WACC—Example - Sangria Corporation -

continued

We have: …so we get for WACC:

D  E
WACC = rD × (1 − Tc) ×   +  rE × 
V   V
= .06 × (1 − .21) (.40 ) + .125 (.60 )
= 9.4%

How can we use this WACC for Sangria? Let’s see!

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 Session 22 Financing and valuation

After Tax WACC

Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine
with cash flows of $1.487 million per year pre-tax.
Given an initial investment of $12.5 million, what is the value of the
machine? (the machine never depreciates)

preTaxCashFlow = $1.487 million

Tax @ 21% = 0.312
afterTaxCashFlow = $1.175million
C1 1.175
NPV =
C0 + =
−12.5 + =
0
r−g .094

Q: So, what return does this project offer to investors?

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 Session 22 Financing and valuation

Do the previous calculations make sense?

• They make sense if, and only if, we are happy with the implicit assumptions that are
hard-wired into WACC:
› The risk of the project must be the same as the average of all existing
assets/projects of Sangria, and remain so during the life of the project
› The project supports the same fraction of debt to value that Sangria’s overall capital
structure supports—and it will remain so during the life of the project
› The only “side effects” of financing that we need to consider are the tax benefits of
debt financing
• These assumptions are unlikely to be met in reality by most projects.
› Note that small and temporary deviations from these assumptions are ok…
› It is big and permanent deviations we need to worry about—they result in WACC
being at best only approximately correct

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 Session 22 Financing and valuation

Can we use WACC to value an entire firm?

Yes. We already know:

› The value of a business or project can be computed as the
discounted value of FCF out to a valuation horizon (H).
› “Valuation horizon” = “terminal value”.
Then, you calculate the value of the firm as:
FCF1 FCF2 FCFH PVH
=PV + + ... + +
(1 + WACC )1
(1 + WACC ) 2
(1 + WACC ) H
(1 + WACC ) H

PV(free cash PV(horizon

flow) value)
Consider the example of Yahoo http://www.bloomberg.com/news/articles/2016-04-07/verizon-said-to-proceed-with-yahoo-bid-as-google-weighs-offer

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 Session 22 Financing and valuation

Our M&A example implemented

Consider a (simplified) M&A example: Sangria Corp is tempted to acquire Rio Corp
Recall the parameters:
› Sangria is publicly traded, while Rio is privately held (no market price to rely on)
› Rio Corp’s parameters
- 1.5 million shares outstanding
- Debt market (=book) value of $36 million
- Same line of business as Sangria (we can assume same business risk) and we can use
Sangria’s WACC
- Both companies are US based

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 Session 22 Financing and valuation

Valuing a Business

Free cash flow projections—

note some key points that are now
familiar:
• Growth projections are tricky
• We ignore interest expenses
(why, again?)
• The “Ocean Carriers critique”
• Size of years 1-6 relative to
horizon value is deeply
worrying

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 Session 22 Financing and valuation

Valuing a Business: Rio Corporation – continued

=PV(Rio) PV(FCF years 1-6) + PV(horizon value)

= 29.0 + 77.4
= $106.4 million
What’s the value of equity then?
• First: Total value of debt is 0.40 x $106.4 = $42.6 million
• Therefore: Total value of equity = $106.4 - $42.6=$63.8 million
• And: Value per share is $63.8/1.5=$42.53

[Note: We skip flow to equity in BMA]

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 Session 22 Financing and valuation

Using WACC in practice and unlevering and relevering betas

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 Session 22 Financing and valuation

Tricks of the Trade

What sources of financing should WACC be based on?

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 Session 22 Financing and valuation

After Tax WACC

• Multiple forms of financing must be included in the formula , e.g. preferred stock
D  P  E 
WACC = (1 − Tc ) × rD  +  × rP  +  × rE 
• Long-term debt - yes V  V  V 
• Short-term debt – it depends
• Other current liabilities – netted out with current assets (incl. cash)
• How to obtain expected rates of return for all forms of financing? E.g. preferred stock,
high yield debt, private loans?
• Use firm-specific WACC or industry WACC?
• What tax rate to use?

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 Session 22 Financing and valuation

WACC & Debt Ratios

Q: What if D/V is only 20%?
A: Calculate new WACC by first unlevering and then relevering the firm as follows:
Step 1 – r at current debt of 40% r =.06(.4) + .125(.6) =.099

Step 2 – D/V changes to 20% rE =.099 + (.099 − .06)(.25) =.109

20/80=D/E

Step 3 – New WACC WACC =

.06(1 − .21)(.2) + .109(.8) =
.097

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 Session 22 Financing and valuation

Unlevering and relevering betas

• Of course, we can alternatively unlever and relever the equity beta to obtain the new WACC at
D/V=20%
• Assume in our example that debt beta is 0.135, equity beta is 1.07, the risk-free rate is 5%,
market risk premium is 7%.
• Then we get:
= β A βD (D / V ) + βE (E / V )
Step 1: Unlever beta, obtain asset beta
= β A 0.135(0.4) + 1.07(0.06)
D
Step 2: Recalculate equity beta using MM 2 β E =β A + ( β A − β D )
E
β E =0.696 + (0.696 − 0.135)0.25 =0.836
Step 3: Recalculate cost of equity and WACC
rE =rf + (rm − rf ) β E =0.05 + 0.07(0.836) =0.109
WACC =
0.06(1 − 0.21)(0.2) + 0.8(0.109) =
0.097

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 Session 22 Financing and valuation

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 Session 22 Financing and valuation

Adjusted Present Value (APV)

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 Session 22 Financing and valuation

Alternative: Adjusted Present Value

APV = Base Case NPV

+ sum of PVs of financing side effects

• Base Case = NPV of the all equity financed firm

• PV(Financing side effects) = all costs/benefits directly resulting from
project’s financing. Examples:
› Government subsidies (e.g. Boeing tax subsidies received from US, Airbus
launch aid from EU, both were ruled to be illegal by WTO…)
› Government guarantees (e.g. government guarantees of major financial
institutions during 2007/2008)
› Issuing costs of external financing (e.g. IPO costs, bond issue costs)
› …
• APV is in principle very flexible—exactly the opposite of WACC
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 Session 22 Financing and valuation

Adjusted Present Value

Example:
• Project A has an NPV of $150,000.
• In order to finance the project we must issue stock, with a brokerage cost of
$200,000.

Project NPV = 150,000

Stock issue cost = -200,000
Adjusted NPV - 50,000
Conclusion: Don’t do the project!

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 Session 22 Financing and valuation

APV for Rio

• What’s unchanged?
• What’s different now?

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 Session 22 Financing and valuation

Leveraged buyouts and private equity

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 Session 22 Financing and valuation

Application: Leveraged buyouts and private equity (1)

A leveraged buyout (LBO) perfectly illustrates the tension between the use of
WACC and APV in valuation.
• LBO: purchase of a firm by an outside investor, another firm, or incumbent
management, using large amounts of debt to finance the purchase.
› Private equity investors are the most frequent LBO buyers (e.g. Blackstone, Carlyle, KKR).
› Their expertise lies in arranging the financing for the LBO
• In an LBO, debt is combined with equity to purchase a firm. LBO transactions
therefore generate a capital structure of large amounts of debt and small
amounts of equity.
› Debt is typically arranged in tranches, ranging from senior to junior, and to
maximize leverage, loans and bonds are frequently combined; see e.g.
Colla, Ippolito and Wagner (2016)
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 Session 22 Financing and valuation

Application: Leveraged buyouts and private equity (2)

• Importantly, the capital structure of an LBO is designed to be transient by

nature. The debt is initially high, to force changes in the company, and then
paid off as operating performance improves.
• As debt is paid off, the firm’s leverage ratio changes, usually drastically, thus
violating a basic assumption of the WACC method.
• WACC is therefore not a well-suited tool for LBO valuation. APV instead is
suitable, since it can (relatively easily) incorporate sharply changing debt levels
during the lifetime of the investment.
› E.g. Kaplan and Ruback (1995) show that APV valuation gets pretty close to
market transaction values for LBO

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 Session 22 Financing and valuation

Some questions

1. Which COC formula do managers actually use?

Industry WACC
2. When should I use APV instead of WACC?
Whenever tax shield is not sufficient! Think about subsidies, issuing costs,
fluctuating debt, restructurings
3. WACC is correct only for “average” projects. What if the project financing is
not average?
Adjust WACC accordingly!
4. Adjusting for debt ratios seems easy, but how to adjust for differences in
business risk?
This is hard to get right, since you are trying to adjust for differences in
business models. Generally: Market data are preferable to rules of thumb.
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