Principles of Corporate Finance

Brealey and Myers Sixth Edition

Interactions of Investment and

Financing Decisions

Slides by
Matthew Will Chapter 19
Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000
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Topics Covered
After Tax WACC
Tricks of the Trade
Capital Structure and WACC
Adjusted Present Value

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After Tax WACC

The tax benefit from interest expense
deductibility must be included in the cost of
funds.
This tax benefit reduces the effective cost of
debt by a factor of the marginal tax rate.

D E
WACC rD rE
V V
Old Formula
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After Tax WACC

Tax Adjusted Formula

D E
WACC (1 Tc) rD rE
V V

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After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate of 35%. The cost of

equity is 14.6% and the pretax cost of debt is 8%.
Given the book and market value balance sheets,
what is the tax adjusted WACC?

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After Tax WACC

Example - Sangria Corporation - continued

Balance Sheet (Book Value, millions)

Assets 100 50 Debt
50 Equity
Total assets 100 100 Total liabilities

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After Tax WACC

Example - Sangria Corporation - continued

Balance Sheet (Market Value, millions)

Assets 125 50 Debt
75 Equity
Total assets 125 125 Total liabilities

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After Tax WACC

Example - Sangria Corporation - continued

Debt ratio = (D/V) = 50/125 = .4 or 40%

Equity ratio = (E/V) = 75/125 = .6 or 60%

D E
WACC (1 Tc) rD rE
V V

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After Tax WACC

Example - Sangria Corporation - continued

D E
WACC (1 Tc) rD rE
V V

50 75
WACC (1 .35) .08 .146
125 125
.1084
10.84%

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After Tax WACC

Example - Sangria Corporation - continued

The company would like to invest in a perpetual

crushing machine with cash flows of $2.085
million per year pre-tax.

Given an initial investment of $12.5 million,

what is the value of the machine?

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After Tax WACC

Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with
cash flows of $2.085 million per year pre-tax. Given an initial investment
of $12.5 million, what is the value of the machine?

Cash Flows
Pretax cash flow 2.085
Tax @ 35% 0.73
After-tax cash flow $1.355 million

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After Tax WACC

Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with
cash flows of $2.085 million per year pre-tax. Given an initial investment
of $12.5 million, what is the value of the machine?

C1
NPV C0
rg
1.355
12.5
.1084
0

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After Tax WACC

Preferred stock and other forms of financing
must be included in the formula.

D P E
WACC (1 Tc) rD rP rE
V V V

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After Tax WACC

Example - Sangria Corporation - continued
Calculate WACC given preferred stock is $25 mil of total equity and yields
10%.
Balance Sheet (Market Value, millions)
Assets 125 50 Debt
25 Preferred Equity
50 Common Equity
Total assets 125 125 Total liabilities

50 25 50
WACC (1 .35) .08 .10 .146
125 125 125
.1104
11.04%

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Tricks of the Trade

What should be included with debt?
Long-term debt?
Short-term debt?
Cash (netted off?)
Receivables?
Deferred tax?

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Tricks of the Trade

How are costs of financing determined?
Return on equity can be derived from market data.
Cost of debt is set by the market given the specific
rating of a firms debt.
Preferred stock often has a preset dividend rate.

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Historical WACC

30
Cost of Equity
25 WACC
20 Treasury Rate

15
Percent

10

0
65
68
71
74
77
80
83
86
89
92
95
98
19
19
19
19
19
19
19
19
19
19
19
19
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WACC vs. Flow to Equity

If you 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 the company were 41-equity

financed. The value of interest tax shields is

picked up in the WACC formula.

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WACC vs. Flow to Equity

The company's cash flows will probably not be forecasted

to infinity. Financial managers usually forecast to a

medium-term horizon -- ten years, say -- and add a

terminal value to the cash flows in the horizon year. The

terminal value is the present value at the horizon of post-

horizon flows. Estimating the terminal value requires

careful attention, because it often accounts for the

majority of the value of the company.

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WACC vs. Flow to Equity

Discounting at WACC values the assets and

operations of the company. If the object is to

value the company's equity, that is, its common

stock, don't forget to subtract the value of the

company's outstanding debt.

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Adjusted Present Value

APV = Base Case NPV
+ PV Impact

Base Case = All equity finance firm NPV.

PV Impact = all costs/benefits directly
resulting from project.

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Adjusted Present Value

example:
Project A has an NPV of $150,000. In order
to finance the project we must issue stock,
with a brokerage cost of $200,000.

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Adjusted Present Value

example:
Project A has an NPV of $150,000. In order to
finance the project we must issue stock, with a
brokerage cost of $200,000.

Project NPV = 150,000

Stock issue cost = -200,000
Adjusted NPV - 50,000

dont do the project

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Adjusted Present Value

example:
Project B has a NPV of -$20,000. We can
issue debt at 8% to finance the project. The
new debt has a PV Tax Shield of $60,000.
Assume that Project B is your only option.

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Adjusted Present Value

example:
Project B has a NPV of -$20,000. We can issue
debt at 8% to finance the project. The new debt
has a PV Tax Shield of $60,000. Assume that
Project B is your only option.
Project NPV = - 20,000
Stock issue cost = 60,000
Adjusted NPV 40,000

do the project
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Miles and Ezzell

1 r
WACC r LrDTc
1 rD

Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000