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Prospectus
CHAPTER
4
Recall that there are three questions in corporate
finance.
The first regards what long-term investments the firm
should make (the capital budgeting question).
The second regards the use of debt (the capital structure
Capital Budgeting for question).
the Levered Firm This chapter considers the nexus of these questions.

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Chapter Outline 4.1 Adjusted Present Value Approach

4.1 Adjusted Present Value Approach

APV = NPV + NPVF
4.2 Flows to Equity Approach
The value of a project to the firm can be thought
of as the value of the project to an unlevered firm
4.3 Weighted Average Cost of Capital Method
(NPV) plus the present value of the financing side
4.4 A Comparison of the APV, FTE, and WACC Approaches effects (NPVF):
4.5 Capital Budgeting When the Discount Rate Must Be Estimated There are four side effects of financing:
4.6 APV Example The Tax Subsidy to Debt
4.7 Beta and Leverage The Costs of Issuing New Securities
The Costs of Financial Distress
4.8 Summary and Conclusions
Subsidies to Debt Financing

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APV Example APV Example (continued)

Consider a project of the Pearson Company, the timing and size of Now, imagine that the firm finances the project with
the incremental after-tax cash flows for an all-equity firm are: $600 of debt at rB = 8%.
–$1,000 $125 $250 $375 $500 Pearson’s tax rate is 40%, so they have an interest tax
shield worth TCBrB = .40×$600×.08 = $19.20 each year.
0 1 2 3 4 The net present value of the project under leverage is:
The unlevered cost of equity is r0 = 10%: APV = NPV + NPV debt tax shield

The project would be rejected by an all-equity firm: NPV < 0. So, Pearson should accept the project with debt.

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APV Example (continued) 4.2 Flows to Equity Approach

Note that there are two ways to calculate the NPV of the
loan. Previously, we calculated the PV of the interest tax
shields. Now, let’s calculate the actual NPV of the loan:
APV = NPV + NPVF
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
Step Two: Calculate rS.
Step Three: Valuation of the levered cash flows at rS.

Which is the same answer as before.

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Step One: Levered Cash Flows for Pearson Step Two: Calculate rS for Pearson
Since the firm is using $600 of debt, the equity holders only have
to come up with $400 of the initial $1,000.
Thus, CF0 = –$400
B B
Each period, the equity holders must pay interest expense. The To calculate the debt to equity ratio, , start with
after-tax cost of the interest is B×rB×(1 – TC) = $600×.08×(1 – .40) S V
= $28.80
CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600
CF2 = $250 – 28.80
P V = $943.50 + $63.59 = $1,007.09
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80 B = $600 when V = $1,007.09 so S = $407.09.

0 1 2 3 4

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Step Three: Valuation for Pearson 4.3 WACC Method for Pearson
Discount the cash flows to equity holders at rS =
11.77%
–$400 $96.20 $221.20 $346.20 –$128.80 To find the value of the project, discount the unlevered
cash flows at the weighted average cost of capital.
0 1 2 3 4 Suppose Pearson’s target debt to equity ratio is 1.50

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4.4 A Comparison of the APV, FTE,

Valuation for Pearson using WACC and WACC Approaches
All three approaches attempt the same
To find the value of the project, discount the
task:valuation in the presence of debt financing.
unlevered cash flows at the weighted average cost
of capital 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.
NPV7.58% = $6.68
In the real world, the WACC is the most widely
used by far.

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4.5 Capital Budgeting When the

Summary: APV, FTE, and WACC
Discount Rate Must Be Estimated
APV WACC FTE A scale-enhancing project is one where the project is
Initial Investment All All Equity Portion similar to those of the existing firm.
Cash Flows UCF UCF LCF
In the real world, executives would make the
Discount Rates r0 rWACC rS
assumption that the business risk of the non-scale-
PV of financing effects Yes No No
enhancing project would be about equal to the business
Which approach is best?
risk of firms already in the business.
Use APV when the level of debt is constant No exact formula exists for this. Some executives might
Use WACC and FTE when the debt ratio is constant select a discount rate slightly higher on the assumption
WACC is by far the most common that the new project is somewhat riskier since it is a new
FTE is a reasonable choice for a highly levered firm entrant.

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4.6 APV Example:
Worldwide Trousers, Inc. is considering replacing a $5
million piece of equipment. The initial expense will be
depreciated straight-line to zero salvage value over 5
years; the pretax salvage value in year 5 will be
$500,000. The project will generate pretax savings of
$1,500,000 per year, and not change the risk level of
the firm. The firm can obtain a 5-year $3,000,000 loan
at 12.5% to partially finance the project. If the project
were financed with all equity, the cost of capital would
be 18%. The corporate tax rate is 34%, and the risk-free
rate is 4%. The project will require a $100,000
investment in net working capital. Calculate the APV.
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4.6 APV Example: PV unlevered project
Turning our attention to the second term,
APV = –$4,873,561.25 + PV unlevered + PV depreciation + PV interest
project tax shield tax shield
PV unlevered is the present value of the unlevered cash flows
project discounted at the unlevered cost of capital, 18%.
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4.6 APV Example: Cost
Let’s work our way through the four terms in this equation:
APV = –Cost + PV unlevered + PV depreciation + PV interest
project tax shield tax shield
The cost of the project is not $5,000,000.
We must include the round trip in and out of net working
capital and the after-tax salvage value.
NWC is riskless, so we discount it at rf. Salvage value should
have the same risk as the rest of the firm’s assets, so we use r0.
4.6 APV Example: PV depreciation tax shield
Turning our attention to the third term,
APV = –$4,873,561.25 + $3,095,899 + PV depreciation+ PV interest
tax shield tax shield
PV depreciation is the is the present value of the tax savings due to
tax shield depreciation discounted at the risk free rate: rf = 4%
PV depreciation
tax shield
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4.6 APV Example: PV interest tax shield 4.6 APV Example: Adding it all up
Turning our attention to the last term, Let’s add the four terms in this equation:

APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + PV interest APV = –Cost + PV unlevered + PV depreciation + PV interest
tax shield project tax shield tax shield

PV interest is the present value of the tax savings due to interest

tax shield expense discounted at the firm’s debt rate: rD = 12.5%
APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + $453,972.46

APV = $189,930

Since the project has a positive APV, it looks like a go.

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4.7 Summary and Conclusions 4.7 Summary and Conclusions

1. The APV formula can be written as: 4. Use the WACC or FTE if the firm's target debt
to value ratio applies to the project over its life.
 WACC is the most commonly used by far.
 FTE has appeal for a firm deeply in debt.
2. The FTE formula can be written as:
5 The APV method is used if the level of debt is
known over the project’s life.
 The APV method is frequently used for special
3. The WACC formula can be written as situations like interest subsidies, LBOs, and leases.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.

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Example: Hamilos Worldwide Hamilos Worldwide Using WACC

Hamilos Worldwide is considering a $5 million expansion a) Using the WACC methodology, comment on
of their existing business. The initial expense will be
depreciated straight-line over 5 years to zero salvage value; the desirability of this project.
the pretax salvage value in year 5 will be $500,000. The
project will generate pretax gross earnings of $1,500,000 per
year, and not change the risk level of the firm. Hamilos can
obtain a 5-year 12.5% loan to partially finance the project.
Flotation costs are 1% of the proceeds. If undertaken, this
project should maintain a target D/E ratio of 1.50. If the
project were financed with all equity, the cost of capital
would be 18%. The corporate tax rate is 30%, and the risk-
free rate is 6%. The project will require a $100,000
investment in net working capital.

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Hamilos Worldwide Using WACC Hamilos Worldwide Using APV

a) Using the WACC methodology, comment on
the desirability of this project.
b) Using the APV methodology, comment on the
desirability of this project.
First some preliminaries: The firm wants to finance the project
such that the debt-equity ratio = 1.5.
This implies a debt-to-value ratio of 3/5:

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Hamilos Worldwide Using APV Hamilos Worldwide Using APV

So, let’s find PV unlevered and borrow 3/5 of that value. PV = PV unlevered + PV depreciation + PV interest – PV flotation
project levered
project project tax shield tax shield costs

STEP ONE:
5 UCFt
PV unlevered =
project
S (1 + r )
t=1 0
t

PV levered = PV unlevered + PV depreciation + PV interest – PV flotation

project project tax shield tax shield costs
5 D×TC
PV depreciation = S
tax shield t = 1
(1 + rf)t

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Hamilos Worldwide Using APV Hamilos Worldwide Using APV

PV = PV unlevered + PV depreciation + PV interest – PV flotation PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
levered project project tax shield tax shield costs
project project tax shield tax shield costs
3
3 Recall that the D = × PV unlevered We need to borrow D* such that:
D= × PV unlevered 5 project
5 dollar amount of 3
project
debt depends on D* ×(1 – .01) = × PV unlevered
5 project
5
TC×rD×D the PV levered.
PV interest =
tax shield
S
t=1 (1 + rD)t
project
D* =
1
0.99 5
3
× × PV unlevered
project
3 Our pre-tax flotation costs are one percent of D*
TC×rD× × PV unlevered
5 5
S 0.01 3
project
PV interest = 0.01×D* = × × PV unlevered
tax shield t=1 (1 + rD)t 0.99 5 project

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A digression on floatation costs Hamilos Worldwide Using APV

Oh by the way, flotation costs are deductible. PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs

So the present value of the after-tax flotation costs are 5 D×TC

S
5 UCFt
= S (1 + r )
t=1 0
t +
t=1
(1 + rf)t

3 0.01 3
PV flotation = – (1 – TC) × × × PV unlevered TC×rD× × PV unlevered
0.99 5 5 5
S
costs project project
+
t=1 (1 + rD)t
0.01 3
– (1 – TC) × × × PV unlevered
0.99 5 project

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Hamilos Worldwide Using APV Hamilos Worldwide Using APV

PV levered = PV unlevered + PV depreciation + PV interest – PV flotation PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs project project tax shield tax shield costs

PVlevered= $3,283,529.57 + $1,263,709.14 +

project
0.08011× PVlevered – 0.00424 × PVlevered
project project

PVlevered – 0.08011× PVlevered + 0.00424× PVlevered = $4,547,238.71

project project project

$4,547,238.71 $4,547,238.71
PVlevered = = = $4,920,563.66
project 1 – 0.08011 + 0.00424 0.92413

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Hamilos Worldwide Using APV Hamilos Worldwide Using FTE

c) Using the FTE methodology, comment on the
desirability of this project.
Since the bondholders are financing $2,952,338.20, the
shareholders only have to pony up
$2,047,661.80 = $5,100,000 – $2,952,338

Thus the year-zero levered cash flow is $2,047,661.80 + after-tax

flotation costs

= –$2,147,662 –$20,875.11
LCF0 = –$2,168,536.92

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Hamilos Worldwide Using FTE Summary Hamilos Worldwide

LCF0 = –$2,168,536.92 Using WACC
The LCF for years one through 4 is NPV = –$322,677.06
Using APV
$1,091,670.41 = NPV = $48,277.71
= [$1.5m – $1m – .125×$2,952,338.20 ] ×(1 – .30) + $1,000,000 Using FTE
NPV = –$18,759.67
The LCF for year 5 is Should we accept or reject the project?
If the dollar amount of debt is known over the project’s life, (in
–$1,410,667.79 = $1,091,670.41 – $2,952,338.20 + $100,000 + this example the amount of debt would be $2,952,338.20) then
$500,000(1 – .30) the APV method is appropriate and the firm would accept the
project.
The NPV at rs = 23.775% is –$18,759.67 Otherwise, the firm should reject the project.

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