BF3203:

Equity Securities
Lecture 5

DCF Valuation IV – Firm Evaluation Models (WACC vs. APV)

Lecturer: Nick Orlic

Dr. Nick Orlic @ Nanyang Business School, NTU. Thanks to Dr. Hong Ru and Dr. Aswath Damodaran for precedent materials 1
Recap: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
prior to any debt payments
but after firm has
reinvested to create growth
assets
Discount rate reflects the cost
of raising both debt and equity
financing, in proportion to their
use
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

Firm Valuation Models

§ Weighted-Average Cost of Capital (WACC) Model
§ Adjusted Present Value (APV) Model
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 WACC Model
o Firm value=Equity value + Debt value V
E D
A = D+ E
D E
rA = rD + rE
D+ E D+ E
o A firm’s cost of capital is the required rate of return on its assets 𝑟!
o It equals the weighted average of
§ Required rate of return on the firm’s debt 𝑟"
§ Required rate of return on the firm’s equity 𝑟#

When a firm is financed by both debt and equity, its cost of capital (rA ) equals
the weighted average of its costs of debt (rD) and equity (rE):
D E
WACC = rD + r E = wD r D + wE r E
D+ E D+ E

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Assumption of WACC
o Firm value=Equity value + Debt value
o Both debt and equity holders can claim the net cash inflow
of the firm.
o Equity holders require return rate 𝑟!
o Debt holders require return rate 𝑟"
n Debt has the benefit of reducing tax we need to pay (1−𝑇𝑎𝑥)
o The weighted average cost of capital (WACC):
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟" + 𝑟# 1 − 𝑇𝑎𝑥
𝑉 𝑉
#$%&'()* ,) -./0,1 $23 3-4, &)(3-5% '5--#$%&'()*,) '05:
o Firm value=∑ ∑
(785-./05-3 5-,/52 5$,-)! (78;<##)!

o WACC model assumes that capital structure remains the

same over time.
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WACC Model (with tax)

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟! + 𝑟" 1 − 𝑇𝑎𝑥
𝑉 𝑉

o Cost of equity 𝑟! : use CAPM to estimate (bottom-up)

o Leverage D/V: assumes firm leverage stays the same

overtime

o Tax: corporate tax rate

o Cost of debt 𝑟" : way to reduce WACC? Cheap debt

fallacy!

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 Cheap debt fallacy
“Debt is better because debt is cheaper than equity”:

q Because (for essentially all firms) debt is safer than equity, investors
demand a lower return for holding debt than for holding equity, i.e., rD
≤ rE . (True)

q The difference is significant: 4% vs. 13% in expected return!

q So, companies should always finance with debt because they have
to give away less returns to investors, i.e., debt is cheaper.

Is this argument correct?

6
 Cheap debt fallacy
q This reasoning ignores the “hidden” cost of debt:
q Raising more debt makes existing equity more risky!
q Given investments (assets), rA is fixed (because βa is fixed)
q Therefore, increasing wD increases risk of equity and rE
q This is unrelated to default risk, i.e., true even if debt is risk-free
Example. Assume CAPM holds. Suppose βD = 0. We have

q Given βA, increasing wD will increase βE and consequently rE

q Milk analogy: Whole milk = Cream + Skimmed milk

q Don’t confuse the two meanings of “cheap”:

q Low cost
q Good deal

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Estimating the Cost of Debt
o The cost of debt is the rate at which you can borrow long-term
currently. It will reflect not only your default risk but also the
level of interest rates in the market.

o The two most widely used approaches to estimating cost of debt

are:
n Looking up the yield to maturity (YTM) on a straight bond
outstanding from the firm. Limitations: very few firms have long
term straight bonds that are liquid and widely traded; tenor will vary.

n Looking up the rating for the firm and estimating a default spread
based upon the rating. While this approach is more robust, different
bonds from the same firm can have different ratings. You have to
use a median rating for the firm.
o Cost of debt = risk free rate + default spread

o When in trouble (either because you have no ratings or multiple

ratings for a firm), estimate a synthetic rating for your firm and
the cost of debt based upon that rating.

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Estimating Synthetic Ratings
o The rating for a firm can be estimated using the financial
characteristics of the firm. In its simplest form, the rating
can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses

o To compute an aerospace company - Embraer’s interest

coverage ratio, we used the interest expenses from 2003
and the average EBIT from 2001 to 2003. (The aircraft
business was badly affected by 9/11 and its aftermath. In
2002 and 2003, Embraer reported significant drops in
operating income)
n Interest Coverage Ratio = 462.1 /129.70 = 3.56

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Interest Coverage Ratios, Ratings and Default Spreads

Interest Interest Estimated Bond Rating Default Spread(Jan 2023) Default Spread(2004)
Coverage Coverage
Ratio for Ratio for
Large firms Small Firms

> 8.50 (>12.50) AAA 0.74%

6.50 - 8.50 (9.5-12.5) AA 0.80%
5.50 - 6.50 (7.5-9.5) A+ 1.17%
4.25 - 5.50 (6-7.5) A 1.36%
3.00 - 4.25 (4.5-6) A– 1.54% 1.00%
2.50 - 3.00 (4-4.5) BBB 1.89%
2.25- 2.50 (3.5-4) BB+ 2.20%
2.00 - 2.25 (3-3.5) BB 2.74%
1.75 - 2.00 (2.5-3) B+ 3.81%
1.50 - 1.75 (2-2.5) B 4.35%
1.25 - 1.50 (1.5-2) B– 6.04%
0.80 - 1.25 (1.25-1.5) CCC 9.43%
0.65 - 0.80 (0.8-1.25) CC 12.81%
0.20 - 0.65 (0.5-0.8) C 14.0%
< 0.20 (<0.5) D 16.0%

The first number under interest coverage ratios is for larger market cap companies and
the second in brackets is for smaller market cap companies. For Embraer, we use the
interest coverage ratio table for large firms.

Source: https://pages.stern.nyu.edu/~adamodar/
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Cost of Debt computations
¨ Based on the interest coverage ratio of 3.56, the synthetic rating
for Embraer is A-, giving it a default spread of 1.00%
¨ Companies in countries with low bond ratings and high default risk
might bear the burden of country default risk, especially if they are
smaller or have all of their revenues within the country.
¨ If we can assume that Embraer bears all of the country risk burden, we
would add on the country default spread for Brazil in 2004 of 6.01%.
Cost of debt
= Riskfree rate + Brazil country default spread + Company default spread
=4.29% + 6.01%+ 1.00% = 11.30%

o IF the valuation is in a currency with much higher inflation, the

spreads will need to be adjusted
1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐸𝑀
𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑𝐸𝑀 = 1 + 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑 −1
1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑈𝑆

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Weights for the Cost of Capital Computation
o In computing the cost of capital for a publicly traded firm,
the general rule for computing weights for debt and equity
is that you use market value weights (and not book value
weights). Why?

n Because the market is usually right

n Because market values are easy to obtain

n Because book values of debt and equity are meaningless

n None of the above

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Weights for the Cost of Capital Computation
o The weights used to compute the cost of capital
should be the market value weights for debt and
equity.
n Market value of equity = share price × the number of
shares outstanding
n Market value of debt is usually more difficult to obtain
directly.

o There is an element of circularity that is introduced

into every valuation by doing this, since the values
that we attach to the firm and equity at the end of
the analysis are different from the values we gave
them at the beginning.

o As a general rule, the debt that you should subtract

from firm value to arrive at the value of equity should
be the same debt that you used to compute the cost
of capital.

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Market value of debt
o Many firms have non-traded debt, such as bank debt which is specified in
book value terms.
n A simple way to convert book value debt into market value debt is to treat the
entire debt on the books as one coupon bond, with a coupon set equal to the
interest expenses on all the debt and the maturity set equal to the face-value
weighted average maturity of the debt, and then to value this coupon bond at
the current cost of debt for the company.

o For Boeing, the book value of debt is $6,972 million, the interest expense
on the debt is $453m, the average maturity is 13.76 years, and the pretax
cost of debt is 6.00%. The estimated market value is:
13.76
453 6,972
= å (1 + 0.06)
t =1
t
+
(1.06)13.76
ì 1 ü
1 -
ï 1.0613.76 ï 6,972
= 453 í ý+ 13.76
= $7, 291
ï 0.06 ï (1.06)
î þ
o When in trouble, use book value of debt as a proxy for its market value.

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Tax rate?
o The choice really is between the effective and the
marginal tax rate.
n Effective tax rate = taxes paid/taxable income
n Marginal tax rate: the tax rate the firm faces on its
last dollar of income.
o In U.S., the federal corporate tax rate on marginal
income is 21%. With the additional of state and local
taxes, most firm face a marginal corporate tax rate of
21-27%.
o In Australia, corporate income is taxed at 30% flat
rate.
o In Singapore, a company is taxes at 17% from 2010
onwards.
o Better to use marginal tax rate since
n Interest benefit is realized at the marginal rate
n Effective tax rate is easy to be manipulated by managers in
accounting books.
o For computing FCFF, you can start with the effective
tax rate in Y1 and move towards the marginal rate

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WACC Model
¥
FCFFt T
FCFFt FCFFT (1 + g ) 1
Value of Operating Assets = å = å + ´
t =1 (1 + WACC ) t =1 (1 + WACC ) (WACC - g ) (1 + WACC )T
t t

n CF to Firms (FCFF)
o The residual cash flows after meeting all operating expenses,
taxes, but prior to debt payments
o CF to Firms (FCFF) = EBIT(1-t) + Depreciation – CapEx – ∆WC
n An answer to a hypothetical question: what would this firm’s cash
flow be if it had no debt (and associated payments)?
n FCFF doesn’t incorporate any of tax benefits due to interest
payments.

n Don’t forget to add back cash and marketable securities to arrive at

the total firm value.

n Be cautious about using the model for firms that have high leverage
ratios.
o The calculation of WACC is much more difficult in these cases
because of the volatility induced by debt payment (or new
issues).
o The WACC approach is easier when firms are maintaining stable
debt proportions.
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Leverage and financial risk
Let V
E D

o V: Value of a firm’s assets

o D: Value of debt
o E: Value of equity
o 𝑟! : required rate of return on assets
o 𝑟$ : required rate of return on equity
o 𝑟% : required rate of return on debt

In absence of taxes, Miller Modigliani implies that 𝑉 = 𝐸 + 𝐷. Thus,

o A firm’s asset can be viewed as a portfolio of its debt and equity
o Asset return equals weighted average of debt and equity returns

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Leverage and financial risk

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Business vs. financial risks
Comparing two firms, U and L:
q They have the same assets
q U is 100% equity financed (unlevered)
q L is financed by equity and debt (levered)
V V
E D 100% E

From MM II, we have

o L’s required rate of return on equity differs from U’s
o Required rate of return on equity of U compensates for business
risk
o In addition to business risk, L’s equity involves an additional
financial risk, which arises from leverage
o The difference between the required rate of return on L and U
compensates for the financial risk of L’s equity
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Business vs. financial risks
If CAPM holds, we have

o βA captures asset’s business risk, independent of financing

o βE – βA ≠ 0, depending only on financing, captures financial risk of
equity
o If D = 0, βE = βA
o Typically, βD is small and βA > 0. Thus, βE > βA
o If βD = 0 (debt is riskless), then

which increases with D/E

o Firms with similar businesses can have very different equity

betas if they have different capital structures. Bottom-up
beta estimation.
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 Leverage with taxes
As in the case without taxes, leverage increases financial risk of equity
We can view the project with leverage in two equivalent ways:
VL = E + D = VU + τ D

1. A portfolio of debt and equity

2. A portfolio of two assets:
a) an asset with payoff identical to the project (after tax)
b) an asset with payoff identical to the tax shield

Thus,

Re-arranging things, we have

MM II with taxes. The cost of equity of a levered firm with corporate taxes is

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 Adjusted Present Value (APV) Model
1. Find a traded firm with the same business risk
q Debt to equity ratio D/E
q Equity return rE (by CAPM)
q Debt return rD
q Tax rate τ

2. Uncover rA (the discount rate without leverage): MM II with taxes

3. Apply rA to the after-tax cash flow of the project to get VU

4. Compute PV of debt tax shield

5. Compute APV

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WACC vs. APV
q APV divides the after tax CF from a project into
§ CF (after-tax) from the project without leverage
§ CF from tax benefit of leverage
and values each component separately:

q WACC considers after tax CF from the project without leverage and discount
it at a single rate adjusted for the tax benefit of leverage:

What should WACC be?

§ Tax-adjusted cost of debt (1-τ)rD
§ Cost of equity rE

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Example: APV
Want to buy SuperSoft, a software company:
q Currently privately held and 100% equity financed
q Projected annual pre-tax cash flow $1.5M perpetually
q Effective corporate tax rate is 30%
q SuperSoft’s assets can sustain permanent debt level of $0.2M
without significant expected distress cost
q There are two publicly traded software companies, 1 and 2:

rE (%) rD (%) D/E τ

Firm 1 22.34 6.95 0.5 0.34
Firm 2 25.93 9.88 1.2 0.30

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Example: APV
q Using MM II with taxes, we obtain the required rate of return for firm
1 and 2:

q Take the average, we have rA = 18.56%

q The value for SuperSoft if unlevered:
VU = (1-0.3)(1.5)/0.1856 = $5.66M

q The value if levered:

VL = VU + PV (tax shield) = 5.66 + (0.3)(0.2) = $5.72M

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 WACC vs. APV
Pros of WACC: Widely used
q Less computations needed (important before computers)
q More literal, easier to understand and explain (?)

Cons of WACC:
q Mixes up effects of assets and liabilities. Errors/approximations in
effect of liabilities contaminate the whole valuation
q Not very flexible:
q Cost of hybrid securities (e.g., convertibles)?
q Other effects of financing (e.g., costs of distress)?
q Non-constant debt ratios?
q Personal taxes?

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WACC vs. APV
Advantages of APV:
q No contamination
q Clearer: Easier to track down where value comes from
q More flexible: Just add other effects as separate terms

Cons of APV:
q Almost nobody uses it. But…

Overall:
q For complex, changing or highly leveraged capital structure (e.g.,
LBO), APV is much better
q Otherwise, it doesn’t matter much which method you use

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 Adjusted Present Value (APV) Model and
LBO Valuation

q The adjusted-present-value (APV) approach is more practical than the

weighted-average-cost-of-capital (WACC) approach when capital
structure is changing over time.
q In a leveraged buyout (LBO), the equity investors are expected to pay off
outstanding principal according to a specific timetable. The owners know
that the firm’s debt-equity ratio will fall and need to forecast the dollar
amount of debt needed to finance future operations.

Value of Firm = Value of Unlevered firm + Effects of Borrowing

¥ ¥
FCFFt Interest Tax Shield t
=å + å + PV of Expected Bankruptcy Cost
t =1 (1 + rA ) t
t =1 (1 + rD ) t

D
b A = b E / [1 + (1 - t ) ] Hard to measure…
E
rA = rf + b A [ E (rm ) - rf ]

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LBO Valuation: The RJR Nabisco Buyout
o In the summer of 1988, the price of RJR stock was hovering
around $55 a share. The firm had $5 billion of debt.
n The firm’s CEO, acting in concert with some other senior
management of the firm, announced a bid of $75 per share to
take the firm to private in a management buyout.

n Within days of management’s offer, Kohlberg, Kravis and

Roberts (KKR) entered the fray with a $90 bid of their own.

n By the end of November, KKR emerged from the ensuing bidding

process with an offer of $109 a share, or $25 billion total.

o How did KKR come up with the offer of $109 a share?

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LBO Valuation: RJR Nabisco
KKR planned to sell several of RJR’s food divisions and operate the
remaining parts of the firm more efficiently.
VL =VU +PVTS
¥
FCFFt ¥ TC rD Dt-1
=å t å
+ t
t=1 (1+ rA ) t=1 (1+ rD )

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RJR Nabisco: Projected Interest Tax Shields
KKR planned a significant increase in leverage to achieve tax benefits.
Specifically, KKR issued almost $24 billion of new debt to complete the
buyout, raising annual interest costs to more than $3 billion.

Debt will be reduced over time…

After 1993, RJR will use 25% debt in it capital structure forever.

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 RJR Nabisco: Unlevered Value of the Firm
Step 1: Calculating the present value of unlevered cash flows (FCFF) for 1989-93

5.404 4.311 2.173 2.336 2.536 the required return on assets

+ + + + = $12.224billion
1.14 1.142 1.143 1.144 1.145 rA was approximately 14% at
the time of buyout.

Step 2: Calculating the present value of the unlevered cash flows beyond 1993
(unlevered terminal value)
assume the unlevered cash flows grow at the
2.536(1.03) modest annual rate of 3 percent after 1993
= $23.746 billion
0.14-0.03
The present value of the unlevered terminal value
23.746/(1+0.14)5 = $12.333 billion

Total unlevered terminal value (VU) = 12.224+12.333 = $ 24.557 billion.

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 RJR Nabisco: PV of Interest Tax Shields
Step 3: Calculating the present value of interest tax shields for 1989-93

1.151 1.021 1.058 1.120 1.184

+ 2
+ 3
+ 4
+ 5
= $3.877billion the pretax average cost of debt,
1.135 1.135 1.135 1.135 1.135 which was approximately 13.5%.

Step 4: Calculating the present value of interest tax shields beyond 1993
qAssume that debt will be reduced and
maintained at 25% of the value of the firm from
2.536(1.03)
= $26.654 billion 1993 onwards.
0.128-0.03 qUnder the above assumption, it is appropriate to
use the WACC method to calculate a terminal
value for the firm at the target capital structure.

Value of tax shields (end 1993) = VL (end 1993) - VU (end1993)= $26.654 billion - $23.746 billion
=$2.908 billion
2.908
Value of tax shileds (end 1988) = = $1.544 billion
1.1355
The total value of interest tax shields = $3.877 + $1.544 = $5.421 billion 33
RJR Nabisco
o The total value of RJR under KKR’s buyout
proposal is $29.978 billion.
n 12.224+12.333+3.877+1.544 = $ 29.978 billion.
n Deducting the $5 billion market value of assumed debt
yields a value for equity of $24.978 billion, which
amounts to $109.07 per share.

o Epilogue
n The deal failed to generate gains for the contest
winners, and KKR eventually sold off their interest in the
company after experiencing disappointing returns.

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Measuring Cash Flows

Cash flows can be measured to

Just Equity Investors

All claimholders in the firm

EBIT (1- tax rate) Net Income Dividends

- ( Capital Expenditures - Depreciation) - (Capital Expenditures - Depreciation) + Stock Buybacks
- Change in non-cash working capital - Change in non-cash Working Capital
= Free Cash Flow to Firm (FCFF) - (Principal Repaid - New Debt Issues)
- Preferred Dividend

35
Steps in Cash Flow Estimations
o Estimate the current earnings of the firm
n If looking at cash flows to equity, look at earnings after
interest expenses - i.e. net income.
n If looking at cash flows to the firm, look at operating earnings
after taxes.

o Consider how much the firm invested to create future

growth
n If the investment is not expensed, it will be categorized as
capital expenditures. To the extent that depreciation provides
a cash flow, it will cover some of these expenditures.
n Increasing working capital needs are also investments for
future growth.

36
Additional Note: Update Earnings
o When valuing companies, we often depend upon financial
statements for inputs on earnings and assets. Annual reports are
often outdated and can be updated by using-
n Trailing 12-month data, constructed from quarterly earnings reports.
n Informal and unofficial news reports, if quarterly reports are
unavailable.

o Updating makes the most difference for smaller and more volatile
firms, as well as for firms that have undergone significant
restructuring.

o To get a trailing 12-month number, all you need is one 10K and
one 10Q (example third quarter). Use the Year to date numbers
from the 10Q:
Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from first
3 quarters of last year + Revenues from first 3 quarters of this year.

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