CAPITEC BUDGETING

CORPORATE TAXES AND THE IMPACT ON REAL

ASSET VALUATION

LECTURE 4

Exercises 13.1–13.7 make use of the following data.

In 1985, General Motors (GM) was evaluating the acquisition of Hughes Aircraft
Corporation.
Recognizing that the appropriate WACC for discounting the projected cash flows for
Hughes was
different from General Motors’ WACC, GM assumed that Hughes was of
approximately the same risk
as Lockheed or Northrop, which had low-risk defence contracts and products that were
similar to those
of Hughes. Specifically, assume the Hamada model of debt interest tax shields and the
inputs in the table.
13.1 Analyse the Hughes acquisition by first computing the betas of the comparison
firms,
Lockheed and Northrop, as if they were all equity financed. (Hint: use equation (13.7) to
obtain βUA from βXE.)
Compute βUA, the beta of the unlevered assets of the Hughes acquisition, by taking the
average
of the betas of the unlevered assets of Lockheed and Northrop.
Comparison firm βE D/E
GM 1.20 0.40
Lockheed 0.90 0.90
Northrop 0.85 0.70
Target D/E for acquisition of Hughes 1
Hughes’ expected unlevered cash flow next year $300 million
Growth rate of cash flows for Hughes 5% per year
Marginal corporate tax rate 34%
Appropriate discount rate on debt: riskless rate 8%
Expected return of the tangency portfolio 14%
13.3 Compute the βE for the Hughes acquisition at the target debt level.
13.4 Compute the WACC for the Hughes acquisition.
13.5 Compute the value of Hughes with the WACC from exercise 13.4.
13.6 Compute the value of Hughes if the WACC of GM at its existing leverage ratio is
used
instead of the WACC computed from the comparison firms (see exercise 13.4).

To solve exercises 13.1–13.7, we'll follow the steps outlined in each question. Let's start with
exercise 13.1:

13.1 Analyze the Hughes acquisition by first computing the betas of the comparison firms,
Lockheed and Northrop, as if they were all equity financed.

We can use equation (13.7) to obtain βUA from βXE:

βUA = βE / (1 + (1 - tax rate) * (D/E))

For Lockheed:
βE = 0.90
D/E = 0.90 / (1 - 0.90) = 9
Tax rate = 0.34

βUA_Lockheed = 0.90 / (1 + (1 - 0.34) * 9) = 0.53

For Northrop:
βE = 0.85
D/E = 0.70 / (1 - 0.70) = 2.33
Tax rate = 0.34
βUA_Northrop = 0.85 / (1 + (1 - 0.34) * 2.33) = 0.45

Now, we can compute βUA, the beta of the unlevered assets of the Hughes acquisition, by
taking the average of the betas of the unlevered assets of Lockheed and Northrop:

βUA = (βUA_Lockheed + βUA_Northrop) / 2 = (0.53 + 0.45) / 2 = 0.49

Moving on to exercise 13.3:

13.3 Compute the βE for the Hughes acquisition at the target debt level.

To compute the βE for the Hughes acquisition, we'll use the Hamada model of debt interest
tax shields:

βE = βUA * (1 + (1 - tax rate) * (D/E))

Given:
βUA = 0.49
D/E (target) = 1
Tax rate = 0.34

βE = 0.49 * (1 + (1 - 0.34) * 1) = 0.49 * (1 + 0.66) = 0.49 * 1.66 = 0.8114

Next, let's move on to exercise 13.4:

13.4 Compute the WACC for the Hughes acquisition.

The WACC (Weighted Average Cost of Capital) can be calculated using the following
formula:
WACC = (E/V) * βE + (D/V) * βD * (1 - tax rate)

Given:
βE (Hughes acquisition) = 0.8114
βD = 0 (since the riskless rate is used for debt)
Tax rate = 0.34

We need to determine the weights for equity (E/V) and debt (D/V). Since the target D/E for
the acquisition of Hughes is 1, the weights can be calculated as follows:

E/V = 1 / (1 + D/E) = 1 / (1 + 1) = 1/2 = 0.5

D/V = D/E / (1 + D/E) = 1 / (1 + 1) = 1/2 = 0.5

Now we can compute the WACC:

WACC = (0.5) * (0.8114) + (0.5) * (0) * (1 - 0.34) = 0.4057

To compute the value of Hughes with the WACC from exercise 13.4, we'll use the formula
for the value of a firm:

Value of Hughes = Unlevered Cash Flow / (WACC - Growth Rate)

Given:
Unlevered Cash Flow = $300 million
WACC = 0.4057 (from exercise 13.4)
Growth Rate = 5% per year

Value of Hughes = $300 million / (0.4057 - 0.05) = $300 million / 0.3557 = $842.80 million

Now, let's move on to exercise 13.6:

13.6 Compute the value of Hughes if the WACC of GM at its existing leverage ratio is used
instead of the WACC computed from the comparison firms (see exercise 13.4).

To compute the value of Hughes using GM's existing leverage ratio, we'll need to calculate
GM's WACC first.

Given:
GM's βE = 1.20
GM's D/E = 0.40
Tax rate = 0.34
Riskless rate = 8%
Expected return of the tangency portfolio = 14%

To calculate GM's WACC, we'll use the formula:

WACC = (E/V) * βE + (D/V) * βD * (1 - tax rate)

We need to determine the weights for equity (E/V) and debt (D/V). Using GM's existing D/E
ratio:

E/V = 1 / (1 + D/E) = 1 / (1 + 0.40) = 1/1.40 ≈ 0.7143

D/V = D/E / (1 + D/E) = 0.40 / (1 + 0.40) = 0.40/1.40 ≈ 0.2857

Now, let's calculate GM's βD using the Hamada model:

βD = βE * (1 + (1 - tax rate) * (D/E))

βD = 1.20 * (1 + (1 - 0.34) * 0.40) = 1.20 * (1 + 0.66 * 0.40) = 1.20 * (1 + 0.264) = 1.20 *

1.264 = 1.5168

Now, we can compute GM's WACC:

WACC_GM = (0.7143) * (1.20) + (0.2857) * (1.5168) * (1 - 0.34) = 0.8571 + 0.3669 = 1.224

Finally, we can compute the value of Hughes using GM's WACC:

Value of Hughes_GM_WACC = Unlevered Cash Flow / (WACC_GM - Growth Rate)

Value of Hughes_GM_WACC = $300 million / (1.224 - 0.05) = $300 million / 1.174 =
$255.73 million

Therefore, the value of Hughes using GM's WACC at its existing leverage ratio is
approximately $255.73 million.

13.7 Apply the APV method. First, compute the value of the unlevered assets of the
Hughes acquisition. Next, compute the present value of the tax shield. Finally, add the
two numbers.
13.7 Apply the APV method. First, compute the value of the unlevered assets of the Hughes
acquisition. Next, compute the present value of the tax shield. Finally, add the two numbers.

To compute the value of the unlevered assets of the Hughes acquisition, we can use the
formula:

Unlevered Asset Value = Unlevered Cash Flow / (WACC - Growth Rate)

Given:
Unlevered Cash Flow = $300 million
WACC = 0.4057 (from exercise 13.4)
Growth Rate = 5% per year

Unlevered Asset Value = $300 million / (0.4057 - 0.05) = $300 million / 0.3557 = $842.80
million

Next, let's compute the present value of the tax shield. The formula for the present value of
the tax shield is:
Present Value of Tax Shield = Tax Shield per Year / WACC

To calculate the tax shield per year, we multiply the debt amount by the tax rate:

Debt = D/E * Unlevered Asset Value

Debt = 1 * $842.80 million = $842.80 million

Tax Shield per Year = Debt * Tax Rate

Tax Shield per Year = $842.80 million * 0.34 = $286.792 million

Finally, we can compute the present value of the tax shield:

Present Value of Tax Shield = $286.792 million / 0.4057 = $706.23 million

To find the total value using the APV method, we add the unlevered asset value and the
present value of the tax shield:

Total Value = Unlevered Asset Value + Present Value of Tax Shield

Total Value = $842.80 million + $706.23 million = $1,549.03 million

Therefore, the total value of Hughes using the APV method is approximately $1,549.03
million.

13.9 GT Associates have plans to start a widget company financed with 60 per cent debt
and 40
per cent equity. Other widget companies are financed with 25 per cent debt and 75 per
cent
equity, and have equity betas of 1.5. GT’s borrowing costs will be 14 per cent, the risk-
free
rate is 6 per cent, and the expected rate of return on the market is 10 per cent. The tax
rate
is 28 per cent. Compute the equity beta and WACC for GT Associates.
To compute the equity beta (βE) for GT Associates, we can use the formula:

βE = βU [1 + (1 - Tax Rate) * (D/E)]

Given:
Debt = 60% of total financing
Equity = 40% of total financing
Other widget companies' equity beta (βU) = 1.5
Tax rate = 28%

First, let's calculate the D/E ratio for GT Associates:

D/E = Debt / Equity

D/E = 60% / 40% = 1.5

Next, we can substitute the values into the formula:

βE = 1.5 [1 + (1 - 0.28) * 1.5]

βE = 1.5 [1 + 0.72]
βE = 1.5 * 1.72
βE = 2.58

The equity beta (βE) for GT Associates is 2.58.

To compute the WACC for GT Associates, we'll use the formula:

WACC = (E/V) * βE + (D/V) * βD * (1 - Tax Rate)

Given:
Debt = 60% of total financing
Equity = 40% of total financing
Borrowing cost = 14%
Risk-free rate = 6%
Expected rate of return on the market = 10%
Tax rate = 28%
Other widget companies' equity beta (βD) = 1.5

We need to determine the weights for equity (E/V) and debt (D/V):

E/V = Equity / (Equity + Debt) = 40% / (40% + 60%) = 0.4

D/V = Debt / (Equity + Debt) = 60% / (40% + 60%) = 0.6

Now, let's calculate the cost of equity (Ke) using the Capital Asset Pricing Model (CAPM):

Ke = Risk-free rate + βE * (Expected rate of return on the market - Risk-free rate)

Ke = 6% + 2.58 * (10% - 6%)
Ke = 6% + 2.58 * 4%
Ke = 6% + 10.32%
Ke = 16.32%

Now, we can compute the WACC:

WACC = (E/V) * Ke + (D/V) * Borrowing cost * (1 - Tax rate)

WACC = 0.4 * 16.32% + 0.6 * 14% * (1 - 28%)
WACC = 6.528% + 5.376% * 0.72
WACC = 6.528% + 3.868%

WACC = 10.396%
The WACC for GT Associates is approximately 10.396%.

13.10 The HTT Company is considering a new product. The new product has a five-year
life. Sales
and net income after taxes for the new product are estimated in the following table.
Year Net sales (in (000s) Net income after taxes (in (000s)
1 1,000 40
2 2,000 75
3 4,000 155
4 6,000 310
5 2,000 75
The equipment to produce the new product costs &500,000. The &500,000 would be
borrowed at a risk-free interest rate of 5 per cent. However, the expected return of
machine adds only &300,000
to the firm’s debt capacity in years 1, 2 and 3, and only &200,000 in years 4 and 5.
Although net income includes the depreciation deduction, it does not include the interest
deduction (that is, it assumes that the equipment is financed with equity). The
equipment
can be depreciated on a straight-line basis over a five-year life at &100,000 per year.
The
equipment is expected to be sold for &100,000 in five years.
Net working capital (NWC) required to support the new product is estimated to be
equal to
10 per cent of net sales of the new product. The NWC will be needed at the start of the
year.
This means that if sales were &1 in year 1, the NWC needed to support this one euro of
sales
would be committed at the beginning of year 1. The company’s discount rate for the
unlevered
cash flows associated with this new product is 18 per cent, and the tax rate is 37.3 per
cent.
What is the NPV of this project?
13.11 Compute the NPV of the online air ticket purchasing scheme in Example 13.4,
assuming
that the debt capacity of the project is zero.
13.12 Use the risk-neutral valuation method to directly show that the risk-neutral
discounted
value of the existing debt of Glastron is &636,000 higher if the project in Example 13.17
is
adopted.

13.13 Applied Micro Devices (AMD) currently spends £213,333 a year leasing office
space in Leeds,
UK. Because lease payments are tax deductible at a 28 per cent corporate tax rate, the
firm
spends about £153,600 per year [ £213,333(1
0.28)] on an after-tax basis to lease the
building. The firm has no debt, and has an equity beta of 2. Assuming an expected
market
return of 12 per cent and a risk-free rate of 6 per cent, its CAPM-based cost of capital is
18
per cent. Suppose that AMD has the opportunity to buy its office space for £1 million.
The
office building is a relatively risk-free investment. The firm can finance 100 per cent of
the
purchase with tax-deductible mortgage payments. The mortgage rate is only slightly
higher
than the risk-free rate. How does AMD determine whether to buy the building or
continue
to lease it?

13.13 Applied Micro Devices (AMD) currently spends £213,333 a year leasing office space
in Leeds, UK. Because lease payments are tax-deductible at a 28% corporate tax rate, the
firm spends about £153,600 per year (£213,333 * (1 - 0.28)) on an after-tax basis to lease the
building. The firm has no debt and has an equity beta of 2. Assuming an expected market
return of 12% and a risk-free rate of 6%, its CAPM-based cost of capital is 18%. Suppose
that AMD has the opportunity to buy its office space for £1 million. The office building is a
relatively risk-free investment. The firm can finance 100% of the purchase with tax-
deductible mortgage payments. The mortgage rate is only slightly higher than the risk-free
rate. How does AMD determine whether to buy the building or continue to lease it?

To determine whether AMD should buy the building or continue leasing, we need to compare
the after-tax cost of leasing to the after-tax cost of owning.

After-Tax Cost of Leasing:

The after-tax cost of leasing is £153,600 per year.

After-Tax Cost of Owning:

To calculate the after-tax cost of owning, we need to consider the mortgage payments, tax
deductibility, and the cost of financing.

Let's assume the mortgage rate is also 6% (slightly higher than the risk-free rate). Since the
building can be financed with tax-deductible mortgage payments, the after-tax cost of owning
is:

£1 million * 6% = £60,000 per year (mortgage payments before tax)

£60,000 * (1 - 0.28) = £43,200 per year (mortgage payments after tax)

Comparison:
Since the after-tax cost of leasing (£153,600) is higher than the after-tax cost of owning
(£43,200), it would be more beneficial for AMD to buy the building rather than continuing to
lease it.
13.14 SL is currently an all-equity-firm with a beta of equity of 1. The risk-free rate is 6
per cent
and the market risk premium is 11 per cent. Assume the CAPM is true, and that there
are no
taxes. What is the company’s WACC? If management levers the company at a debt to
equity
ratio of 5 to 1, using perpetual riskless debt, what will the WACC become? How would
your
WACC answer change if the government raised the tax rate from zero to 28 per cent?
To calculate the WACC for SL, we need to consider the cost of equity and the weights of
equity and debt in the capital structure.

Given:

Equity beta (βE) = 1

Risk-free rate = 6%
Market risk premium = 11%
WACC without debt:
Since SL is currently an all-equity firm, the WACC is equal to the cost of equity.
WACC = Cost of Equity
= Risk-free rate + βE * Market risk premium
= 6% + 1 * 11%
= 6% + 11%
= 17%

The company's WACC without debt is 17%.

WACC with debt (debt-to-equity ratio of 5 to 1):

If management leverages the company at a debt-to-equity ratio of 5 to 1 using perpetual
riskless debt, we need to calculate the cost of equity and the cost of debt, considering the
weights of equity and debt in the capital structure.
Let's assume the cost of debt is equal to the risk-free rate of 6%.

Debt-to-Equity ratio = 5 to 1
Debt weight = 5 / (5 + 1) = 5/6 ≈ 0.833
Equity weight = 1 / (5 + 1) = 1/6 ≈ 0.167

WACC = (Equity weight * Cost of Equity) + (Debt weight * Cost of Debt)

= (0.167 * 17%) + (0.833 * 6%)
= 2.839% + 4.998%
= 7.837%

The WACC with a debt-to-equity ratio of 5 to 1 is approximately 7.837%.

Impact of tax rate increase to 28%:

If the government raises the tax rate from zero to 28%, it would affect the cost of debt and the
overall WACC calculation. However, since it is stated that there are no taxes in this scenario,
the WACC remains the same at 7.837%. The tax rate has no impact when it is zero.
Therefore, the WACC with a debt-to-equity ratio of 5 to 1, assuming a tax rate of 28%, would
still be 7.837%.

13.15 Akron plc consists of £50 million in perpetual riskless debt and £50 million in
equity. The
current market value of its assets is £100 million and the beta of its equity return is 1.2.
Assume the risk-free rate is 6 per cent, the expected return of the market portfolio is 13
per
cent per year, and the CAPM is true. Compute the expected return of Akron’s equity
and its
WACC assuming a 28 per cent corporate tax rate.
13.16 Akron, from the last example, is considering an exchange offer where half of
Akron’s outstanding debt (£25 million) is retired. The purchase of this debt would be
financed by issuing
£25 million in equity to the debt holders of Akron. Assuming debt policy that is
consistent
with the Hamada model, what will Akron’s new WACC be after the exchange offer?

13.15 To compute the expected return of Akron's equity and its WACC, we can use the
CAPM formula.

Given:

Perpetual riskless debt = £50 million

Equity value = £50 million
Market value of assets = £100 million
Equity beta (βE) = 1.2
Risk-free rate = 6%
Expected return of the market portfolio = 13%
Corporate tax rate = 28%
Expected return of Akron's equity:
Expected return of equity = Risk-free rate + βE * Market risk premium
= 6% + 1.2 * (13% - 6%)
= 6% + 1.2 * 7%
= 6% + 8.4%
= 14.4%
The expected return of Akron's equity is 14.4%.

WACC:
To calculate the WACC, we need to consider the weights of equity and debt in the capital
structure and the cost of equity and cost of debt.
Debt weight = Debt value / Total value
= £50 million / (£50 million + £50 million)
= £50 million / £100 million
= 0.5 or 50%

Equity weight = Equity value / Total value

= £50 million / (£50 million + £50 million)
= £50 million / £100 million
= 0.5 or 50%

Cost of equity = Expected return of equity = 14.4%

Cost of debt = Risk-free rate * (1 - Tax rate)

= 6% * (1 - 28%)
= 6% * 0.72
= 4.32%

WACC = (Equity weight * Cost of Equity) + (Debt weight * Cost of Debt)

= (0.5 * 14.4%) + (0.5 * 4.32%)
= 7.2% + 2.16%
= 9.36%

The WACC of Akron, assuming a 28% corporate tax rate, is 9.36%.

13.16 After the exchange offer, where half of Akron's outstanding debt (£25 million) is retired
and £25 million in equity is issued, we need to recalculate the WACC.

Given:

Debt value after exchange offer = £25 million

Equity value after exchange offer = £75 million (original equity value of £50 million + £25
million new equity issued)
Debt weight = Debt value / Total value
= £25 million / (£25 million + £75 million)
= £25 million / £100 million
= 0.25 or 25%

Equity weight = Equity value / Total value

= £75 million / (£25 million + £75 million)
= £75 million / £100 million
= 0.75 or 75%

The beta of equity remains the same at 1.2.

WACC = (Equity weight * Cost of Equity) + (Debt weight * Cost of Debt)

= (0.75 * 14.4%) + (0.25 * 4.32%)
= 10.8% + 1.08%
= 11.88%

After the exchange offer, Akron's new WACC is 11.88%.