Topic 10 - Investment & Financing Interaction

The University of Sydney

 Topics Covered
The Weighted Average Cost of Capital Method
The Adjusted Present Value Method
The Flow-to-Equity Method
Project-Based Costs of Capital
A P V with Other Leverage Policies
Other Effects of Financing

The University of Sydney

 Assumptions

• The project has average risk.

• The firm’s debt-equity ratio is constant.
• Corporate taxes are the only imperfection.

The University of Sydney

 Weighted Average Cost of Capital Method
For now, it is assumed that the firm maintains a constant
debt-equity ratio and that the WACC remains constant
over time E D
rwacc  rE  rD (1   c )
ED ED

Because the WACC incorporates the tax savings from

debt, we can compute the levered value of an
investment, by discounting its future free cash flow using
the WACC FCF FCF FCF
V0L  1
 2
 3
 ....
1  rwacc (1  rwacc ) 2
(1  rwacc ) 3

The University of Sydney

 Using WACC to Value a Project
Assume Avco is considering introducing a new line of packaging,
the R F X 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 and operating expenses are expected to be $25 million and
$9 million, respectively, per year.
• Developing the product will require upfront R&D and marketing expenses of
$6.667 million, together with a $24 million investment in equipment.
• The equipment will be obsolete in four years and will be depreciated using the
straight-line method over that period.
• Avco expects no net working capital requirements for the project.
• Avco pays a corporate tax rate of 25%.

The University of Sydney

 Using WACC to Value a Project

The University of Sydney

 Using WACC to Value a Project

The University of Sydney

 Using 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 R F X project. Thus, Avco’s WACC is
E D 300 300
rwacc = rE  rD (1  τ c )  (10%)  (6%)(1  0.25)
E+D E+D 600 600
= 7.25%

Note that net debt (D) = 320 − 20 = $300 million.

The University of Sydney

 Using 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
21 21 21 21
𝑉 = + + + = $70.73 million
1.0725 1.0725 1.0725 1.0725

The N P V of the project is $41.73 million.

$70.73 million $29 million  $41.73 million

The University of Sydney

 Weighted Average Cost of Capital Method
1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital.
3. Compute the value of the investment, including the tax benefit
of leverage, by discounting the free cash flow of the
investment using the WACC.
The WAC C can be used throughout the firm as the
companywide 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.

The University of Sydney

 Constant Debt-Equity Ratio
By undertaking the R F X project, Avco adds new assets to
the firm with initial market value $70.73 million.
• Therefore, to maintain its debt-to-value ratio, Avco must add 50% × 70.73 =
$35.365 million in new debt.

Avco can add this debt either by reducing cash or by

borrowing and increasing debt.
• Assume Avco decides to spend its $20 million in cash and borrow an additional
$15.365 million.
• Because only $29 million is required to fund the project, Avco will pay the
remaining $35.365 million − $29 million = $6.365 million to shareholders
through a dividend (or share repurchase).

The University of Sydney

 Constant Debt-Equity Ratio
The market value of Avco’s equity
increases by $35.365 million.
$335.365 $ 300 $35.365
Adding the dividend of $6.365
million, the shareholders’ total gain
is 35.365 + 6.365 = $41.73 million,
which is exactly the N P V we
calculated for the R F X project.

The University of Sydney

 Constant Debt-Equity Ratio

Debt Capacity
• The amount of debt at a particular date that is required to maintain the
firm’s target debt-to-value ratio
• The debt capacity at date t is calculated as
Dt  d  Vt L
• Where d is the firm’s target debt-to-value ratio and VLt is the levered
continuation value on date t
Value of FCF in year t + 2 and beyond
• VtL is calculated as 
FCF  V L
Vt L  t 1 t 1

1  rwacc

The University of Sydney

 Constant Debt-Equity Ratio

The University of Sydney

 Adjusted Present Value Method

Adjusted Present Value (A P V )

• A valuation method to determine the levered value of an investment by first
calculating its unlevered value and then adding the value of the interest tax
shield
V L = APV = V U + PV (Interest Tax Shield)

The first step in the A P V method is to calculate the value

of the free cash flows using the project’s cost of capital if
it were financed without leverage.

The University of Sydney

 Adjusted Present Value Method
Unlevered Cost of Capital
• The cost of capital for a firm if were it unlevered
• 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.

E D
rU = rE + rD = Pre-tax WACC
ED ED
The firm’s unlevered cost of capital equals its pretax WACC because it represents
investors’ required return for holding the entire firm (equity and debt).
This argument relies on the assumption that the overall risk of the firm is independent of
the choice of leverage.

The University of Sydney

 Adjusted Present Value Method

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.

For Avco, its unlevered cost of capital is calculated as

rU  0.50  10.0%  0.50  6.0%  8.0%
The project’s value without leverage is calculated as
21 21 21 21
V 
U
    $69.55 million
1.08 1.082 1.083 1.084

The University of Sydney

 Adjusted Present Value Method

Valuing the Interest Tax Shield

• The value of $69.55 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
Interest paid in year t  rD  Dt  1
• The interest tax shield is equal to the interest paid multiplied by the
corporate tax rate.

The University of Sydney

 Adjusted Present Value Method
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.
0.53 0.41 0.28 0.15
PV (interest tax shield)      $1.18 million
1.08 1.082 1.083 1.084
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
V L  V U  PV (interest tax shield)  69.55  1.18  $70.73 million
• The NPV of the project is $41.73 million.
• $70.73 million − $29 million = $41.73 million
• This is exactly the same value found using the WACC approach.
The University of Sydney
 Adjusted Present Value Method
1. Determine the investment’s value without leverage.
2. Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield.
b. Discount the interest tax shield.
3. Add the unlevered value to the present value of the interest tax shield to determine
the value of the investment with leverage.
The APV method has some advantages.
• It can be easier to apply than the WACCmethod when the firm does not maintain a constant debt-equity ratio.
• The APVapproach also explicitly values market imperfections and therefore allows managers to measure their contribution to value.

We can easily extend the APV approach to include other market imperfections such as
financial distress, agency, and issuance costs.

The University of Sydney

The University of Sydney
 Flow-to-Equity
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.
Free Cash Flow to Equity (F C F E )
• The free cash flow that remains after adjusting for interest payments, debt issuance, and debt repayments.

The first step in the F T E method is to determine the project’s free cash
flow to equity.

The University of Sydney

 Flow-to-Equity

The University of Sydney

 Flow-to-Equity

The F C F E can also be calculated, using the free

cash flow, as
FCFE  FCF  (1  τ c ) × (Interest Payments) + (Net Borrowing)
 
After-tax interest expense

The University of Sydney

 Flow-to-Equity
Because the F C F E 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 Avc
o’s equity cost of capital of 10.0% to discount the project’s FCFE

11.47 11.25 11.02 10.77

NPV ( FCFE )  6.37   2
 3
 4
 $41.73 million
1.10 1.10 1.10 1.10

The value of the project’s F C F E represents the gain to

shareholders from the project, and it is identical to the N P V
computed using the WACC and AP V methods.

The University of Sydney

 Flow-to-Equity

1. Determine the free cash flow to equity of the

investment.
2. Determine the equity cost of capital.
3. Compute the equity value by discounting the
free cash flow to equity using the equity cost of
capital.
The University of Sydney
 Flow-to-Equity
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.
The FTE method has a disadvantage
• One must compute the project’s debt capacity to determine the
interest and net borrowing before capital budgeting decisions can
be made.

The University of Sydney

 Project Leverage and the 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 follows:
D
rE  rU  (rU  rD )
E

The University of Sydney

 Project Leverage and the 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 an unlevered cost of capital estimate of 9.5%, the plastics division’s equity
cost of capital is estimated to be
0.50
rE  9.5%  (9.5%  6%)  13.0%
0.50
The division’s W A C C can now be estimated to be
rwacc  0.50  13.0%  0.50  6.0%  (1  0.25)  8.75%

The University of Sydney

 Comparison of Methods
WACC method easiest when firm will maintain fixed debt-
to-value ratio over life of investment
For alternative leverage policies, APV method simplest
approach
FTE method used in complicated settings where values in
firm’s capital structure or interest tax shield difficult to
determine

The University of Sydney

The University of Sydney
 Valuing Businesses
Sometimes a financial manager has to estimate what an entire business
is worth. For example:
• If firm A is about to make a takeover offer for firm B, then A’s financial
managers have to decide how much the combined business A + B is
worth under A’s management. This task is particularly difficult if B is a
private company with no observable share price.
• If firm C is considering sale of one of its divisions, it has to decide
what the division is worth in order to negotiate with potential buyers.
• When a firm goes public, investment bank must evaluate how much
firm is worth in order to set issue price.

The University of Sydney

 Valuing Businesses
• Use WACC to value company financed by mixture of debt and equity
• Debt ratio is expected to remain approximately constant
• Treat company as if it were one big project

Forecast company’s cash flows, discount to present value. But be sure to remember:
1. If discount at WACC, cash flows have to be projected just as you would for a capital investment
project. Do not deduct interest. Calculate taxes as if company were all-equity-financed.
2. Unlike most projects, companies are potentially immortal. Financial managers usually forecast to a
medium-term horizon and add a terminal value to cash flows in horizon year. Terminal value is
present value at horizon of all subsequent cash flows. Estimating terminal value requires careful
attention because it often accounts for majority of company’s value.
3. Discounting at WACC values assets and operations of company. If object is to value company’s
equity, that is, its common stock, don’t forget to subtract value of company’s outstanding debt.

The University of Sydney

 Valuing Businesses
Value of a business or project is usually computed as discounted value of FCF
out to valuation horizon (H)
Valuation horizon is sometimes called terminal value:
FCF1 FCF2 FCFH PVH
PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

PV (free cash flow) PV (horizon value)

In this case, r = WACC

The University of Sydney

 Percent of Sales Method
Financial forecasting model in which all of a business's accounts (financial line items)
like costs of goods sold, inventory, and cash, are calculated as percentage of sales.
Those percentages are then applied to future sales estimates to project each line
item's future value.

1. Determine estimated growth and most recent annual sales figures.

2. Determine line item balances and their percentages relative to sales.
3. Calculate forecasted sales.
4. Apply line items' relative percentages to your forecasted sales figure.

The University of Sydney

 Valuing Rio Corporation
Sangria is tempted to acquire Rio Corporation. Rio has developed a special weight-loss
program called the Brazil Diet.
Rio - U.S. company, privately held, so Sangria has no stock-market price to rely on.
Rio has 1.5 million shares outstanding and debt with market and book value of $36
million.
Rio is in same line of business as Sangria, so assume that it has same business risk as
Sangria and can support same proportion of debt. Therefore can use Sangria’s WACC.
Free cash flow is calculated assuming firm is all-equity-financed. Discounting free cash
flows at after-tax WACC gives total value of Rio (debt plus equity). To find the value of its
equity, you will need to subtract $36 million of debt.
The University of Sydney
 Valuing Rio Corporation
Start with projection of sales. In year just ended Rio had sales of $83.6 million.
In recent years sales have grown by between 5% and 8% a year.
Forecast sales will grow by 7% a year next three years. Growth will then slow
to 4% for years 4 to 6 and to 3% starting in year 7.
Other components of cash flow are driven by these sales forecasts.
Increasing sales are likely to require further investment in fixed assets and
working capital. Rio’s net fixed assets are currently $0.79 for each dollar of
sales.
Every dollar of sales growth requires an increase of $0.79 in net fixed assets.
Assume working capital grows in proportion to sales.

The University of Sydney

Assumptions - see supplementary Excel sheet
Proforma
 Valuing Rio Corporation
Estimating Horizon Value
To find the present value of the cash flows in years 1 to 6, we
discount at the 9.4% WACC:

The year 7 free cash flow is $8.5 million so,

The University of Sydney

 Valuing Rio Corporation

This is the total value of Rio. To find the value of the

equity, we simply subtract the 40% of the firm value that
will be financed with debt.

The University of Sydney