Assumptions: Corporate taxes are the only imperfection

Financial Management
Valuation

Topics (Tentative): Pre-Readings (BD Chapters) The Weighted Average Cost of Capital Method
Topic 1: Type of Firms (BD: Chapter 1) It is assumed that the firm maintains a constant debt-to-equity ratio
Topic 2: Time Value of Money (BD: Chapters 3-5) and that the WACC remains constant over time
Topic 8: Valuations
BD: Chapters 2, 18-19 Topic 3: Valuation of Bonds (BD: Chapter 6)

Topic 4: Capital Budgeting (BD: Chapters 7 and 8)

Topic 5: Valuation of Stocks (BD: Chapter 9)

Topic 6: Risk and Return (BD: Chapters 10-13)

Topic 7: Capital Structure (BD: Chapters 14-16)

Topic 8: Valuations (BD: Chapters 2, 18-19)

The Weighted Average Cost of Capital Method

The Weighted Average Cost of Capital Method
Because the WACC incorporates the tax savings from debt, we can
The Adjusted Present Value (APV) Method
compute the levered value of an investment, by discounting its
The Flow-to-Equity Method future free cash flow using the WACC
Project-Based Costs of Capital

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Using the WACC to Value a Project
Assume Avco is considering introducing a new line of packaging, the
RFX Series
Avco expects the technology used in these products to become
obsolete after four years
However, the marketing group expects annual sales of $60 million
per year over the next four years for this product line
Manufacturing costs are expected to be $25 million per year
Operating expenses are expected to be $9 million per year
Using the WACC to Value a Project
Developing the product will require upfront R&D and marketing
expenses of $6.67 million, together with a $24 million investment in
equipment
The equipment will be obsolete in four years and will be depreciated
via the straight-line method over that period
Avco expects no net working capital requirements for the project
Avco pays a corporate tax rate of 40 percent
Expected Free Cash Flow from Avco’s RFX Project
Using the WACC to Value a Project
Avco intends to maintain a similar (net) debt-equity ratio for the
foreseeable future, including any financing related to the RFX project
Thus, Avco’s WACC is
Note that net debt = D = 320 – 20 = $300 million
Using the WACC to Value a Project
The value of the project, including the tax shield from debt, is
calculated as the present value of its future free cash flows
The NPV of the project is $33.25 million
$61.25 million – $28 million = $33.25 million
Summary of the WACC Method
Determine the free cash flow of the investment
Compute the weighted average cost of capital
Compute the value of the investment, including the tax benefit of
leverage, by discounting the free cash flow of the investment using
the WACC
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Summary of the WACC Method
The WACC can be used throughout the firm as the companywide Avco’s Current Market Value Balance Sheet ($ million) with the RFX Project
cost of capital for new investments that are of comparable risk to the
rest of the firm and that will not alter the firm’s debt-equity ratio

Implementing a Constant Debt-Equity Ratio Implementing a Constant Debt-Equity Ratio

By undertaking the RFX project, Avco adds new assets to the firm The market value of Avco’s equity increases by $30.625 million
with initial market value $61.25 million
$330.625 − $300 = $30.625
Therefore, to maintain its debt-to-value ratio, Avco must add
$30.625 million in new debt
Adding the dividend of $2.625 million, the shareholders’ total gain is
50% × 61.25 = $30.625
$33.25 million

$30.625 + 2.625 = $33.25

Which is exactly the NPV calculated for the RFX project

Implementing a Constant Debt-Equity Ratio Implementing a Constant Debt-Equity Ratio

Avco can add this debt either by reducing cash or by borrowing and Debt Capacity
increasing debt
Assume Avco decides to spend its $20 million in cash and borrow an The amount of debt at a particular date that is required to maintain
additional $10.625 million the firm’s target debt-to-value ratio

Because only $28 million is required to fund the project, Avco will The debt capacity at date t is calculated as:
pay the remaining $2.625 million to shareholders through a dividend
(or share repurchase)
$30.625 million − $28 million = $2.625 million
Where d is the firm’s target debt-to-value ratio and VLt is the levered
continuation value on date t

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Implementing a Constant Debt-Equity Ratio The Unlevered Value of the Project
Debt Capacity The first step in the APV method is to calculate the value of the free
cash flows using the project’s cost of capital if it were financed
VLt calculated as: without leverage

The Unlevered Value of the Project

Continuation Value and Debt Capacity of the RFX Project over Time Unlevered Cost of Capital

For a firm that maintains a target leverage ratio, it can be estimated

as the weighted average cost of capital computed without taking
into account taxes (pre-tax WACC)

We value the interest tax shield separately

The Adjusted Present Value Method The Unlevered Value of the Project
Adjusted Present Value (APV) The firm’s unlevered cost of capital equals its pretax WACC because
it represents investors’ required return for holding the entire firm
A valuation method to determine the levered value of an investment (equity and debt)
by first calculating its unlevered value and then adding the value of
the interest tax shield This argument relies on the assumption that the overall risk of the
firm is independent of the choice of leverage
Tax shield will have the same risk as the firm if the firm maintains a
target leverage ratio

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The Unlevered Value of the Project
Target Leverage Ratio
When a firm adjusts its debt proportionally to a project’s value or its
cash flows (where the proportion need not remain constant)
A constant market debt-equity ratio is a special case
The Unlevered Value of the Project
For Avco, its unlevered cost of capital is calculated as:
The project’s value without leverage is calculated as:
Valuing the Interest Tax Shield
The value of $59.62 million is the value of the unlevered project and
does not include the value of the tax shield provided by the interest
payments on debt
The interest tax shield is equal to the interest paid multiplied by the
corporate tax rate
Expected Debt Capacity, Interest Payments, and Tax Shield for Avco’s RFX
Project
Valuing the Interest Tax Shield
The next step is to find the present value of the interest tax shield
When the firm maintains a target leverage ratio, its future interest
tax shields have similar risk to the project’s cash flows, so they
should be discounted at the project’s unlevered cost of capital
Valuing the Interest Tax Shield
The total value of the project with leverage is the sum of the value of
the interest tax shield and the value of the unlevered project
The NPV of the project is $33.25 million
$61.25 million – $28 million = $33.25 million
This is exactly the same value found using the WACC approach
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APV Method
Summary -
Determine the investment’s value without leverage

Determine the present value of the interest tax shield

• Determine the expected interest tax shield
• Discount the interest tax shield

Add the unlevered value to the present value of the interest tax
shield to determine the value of the investment with leverage

The Adjusted Present Value Method

The APV method has some advantages The APV approach can be extended to include other market
imperfections such as financial distress, agency, and issuance costs
It can be easier to apply than the WACC method when the firm does
not maintain a constant debt-equity ratio

The APV approach also explicitly values market imperfections and

therefore allows managers to measure their contribution to value

The Flow-to-Equity Method

Flow-to-Equity Method

A valuation method that calculates the free cash flow available to

equity holders taking into account all payments to and from debt
holders

The cash flows to equity holders are then discounted using the
equity cost of capital

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Calculating the Free Cash Flow to Equity
Free Cash Flow to Equity (FCFE)
The free cash flow that remains after adjusting for interest
payments, debt issuance and debt repayments
The first step in the FTE method is to determine the project’s free
cash flow to equity
Expected Free Cash Flows to Equity from Avco’s RFX Project
Free Cash Flow to Equity
Two changes in the calculation of the free cash flows
Interest expenses are deducted before taxes
The proceeds from the firm’s net borrowing activity are added in
These proceeds are positive when the firm issues debt and are
negative when the firm reduces its debt by repaying principal
Free Cash Flow to Equity
The FCFE can also be calculated, using the free cash flow, as
After-tax interest expense
FCFE from FCF for Avco’s RFX Project
Valuing Equity Cash Flows
Because the FCFE represent payments to equity holders, they should
be discounted at the project’s equity cost of capital
Given that the risk and leverage of the RFX project are the
same as for Avco overall, we can use Avco’s equity cost of
capital of 10.0% to discount the project’s FCFE
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Valuing Equity Cash Flows Flow-to-Equity Method
The value of the project’s FCFE represents the gain to shareholders The FTE method has a disadvantage
from the project and it is identical to the NPV computed using the
WACC and APV methods One must compute the project’s debt capacity to determine the
interest and net borrowing before capital budgeting decisions can be
made

Flow-to-Equity Method
Determine the free cash flow to equity of the investment

Determine the equity cost of capital

Compute the equity value by discounting the free cash flow to equity
using the equity cost of capital

Flow-to-Equity Method
The FTE method offers some advantages

It may be simpler to use when calculating the value of equity for the
entire firm, if the firm’s capital structure is complex and the market
values of other securities in the firm’s capital structure are not
known

It may be viewed as a more transparent method for discussing a

project’s benefit to shareholders by emphasizing a project’s
implication for equity

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Project-Based Costs of Capital
In the real world, a specific project may have different market risk
than the average project for the firm
In addition, different projects may vary in the amount of leverage
they will support
Estimating the Unlevered Cost of Capital
Suppose Avco launches a new plastics manufacturing division that
faces different market risks than its main packaging business
The unlevered cost of capital for the plastics division can be
estimated by looking at other single-division plastics firms that have
similar business risks
Estimating the Unlevered Cost of Capital
Assume two firms are comparable to the plastics division and have
the following characteristics:
Estimating the Unlevered Cost of Capital
Assuming that both firms maintain a target leverage ratio, the
unlevered cost of capital for each competitor can be estimated by
calculating their pretax WACC
Estimating the Unlevered Cost of Capital
Based on these comparable firms, we estimate an unlevered cost of
capital for the plastics division is approximately 9.5 percent
With this rate in hand we can use APV approach
To use WACC or FTE method we need to estimate the project’s
equity cost of capital, which depends on the incremental debt the
company will take on as a result of the project
Project Leverage and the Equity Cost of Capital
A project’s equity cost of capital may differ from the firm’s equity
cost of capital if the project uses a target leverage ratio that is
different than the firm’s
The project’s equity cost of capital can be calculated as:
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Project Leverage and the Equity Cost of Capital
Now assume that Avco plans to maintain an equal mix of debt and
equity financing as it expands into plastics manufacturing, and it
expects its borrowing cost to be 6%

Given the unlevered cost of capital estimate of 9.5%, the plastics

division’s equity cost of capital is estimated to be:

Project Leverage and the Equity Cost of Capital Determining the Incremental Leverage of a Project
The division’s WACC can now be estimated to be: To determine the equity or weighted average cost of capital for a
project, the incremental financing that results if the firm takes on
the project needs to be calculated

Determining the Incremental Leverage of a Project

In other words, what is the change in the firm’s total debt (net of
cash) with the project versus without the project

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Determining the Incremental Leverage of a Project
Table 18.9 Typical Issuance Costs for Different Securities, as a Percentage of
The following important concepts should be considered when Proceeds
determining a project’s incremental financing

Cash Is Negative Debt

A Fixed Payout Policy Implies 100% Debt Financing

Optimal Leverage Depends on Project and Firm Characteristics

Safe Cash Flows Can Be 100% Debt Financed

A Comparison of Methods Financial Distress and Agency Costs

Typically, the WACC method is the easiest to use when the firm will
maintain a fixed debt-to-value ratio over the life of the investment
For alternative leverage policies, the APV method is usually the
simplest approach
Financial distress and agency costs also impact the cost of capital
For example, financial distress costs tend to increase the sensitivity
of the firm’s value to market risk, raising the unlevered cost of capital
for highly levered firms

The FTE method is typically used only in complicated settings where

the values in the firm’s capital structure or the interest tax shield are
difficult to determine

Other Effects of Financing Financial Distress and Agency Costs

Issuance and Other Financing Costs The free cash flow estimates for a project should be adjusted to
include expected financial distress and agency costs
When a firm raises capital by issuing securities, the banks that
provide the loan or underwrite the sale of the securities charge fees

These fees should be included as part of the project’s required

investment, reducing the NPV of the project

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Firms’ Leverage Policies

Source: J. R. Graham and C. Harvey, “The Theory and Practice of Corporate Finance:
Evidence from the Field,” Journal of Financial Economics 60 (2001): 187–243.

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