Project Valuation - Leverage

APV approach to Valuing Leveraged

Projects
 Project Valuation - Leverage
• This lecture uses Project X as an example.
• Read lecture in conjunction with Project X
excel sheet.
 NPV Approach Summary
D/E ratio is assumed to be constant
• Determine incremental project free cash flow
• Estimate WACC at target capital structure
• Discount FCFs at WACC. The value of the tax
benefits of leverage are incorporated by using
an after-tax WACC.
 Adjusted Present Value (APV) approach to
valuing leveraged projects
• APV approach separates the value of leverage
(the tax benefit) from the unlevered value of
the project.
• No assumption that leverage ratio is stable
• The first step is to establish the level of debt
and interest financing the project throughout
its life.
 APV Approach – Value of the Unlevered
Project
• The
  APV approach is an alternative to the
WACC approach
• First values the project as if it was unlevered:
Vu
• Separately adds the value of the tax benefit of
borrowing.
APV Approach – Value of the Tax Shield
•• In
  the second step of the APV method we compute the
present value of the interest tax shield.
• From the debt outstanding estimate the annual interest
payments.
• Because interest in a given year is based on the debt
balance at the end of the previous year:

• The interest tax shield is equal to the interest paid

multiplied by the corporate tax rate.
APV – Non-constant Leverage Ratio
• APV can be used to value a project with a
constant D/E ratio (and will give same result as
WACC approach) but WACC is more
straighforward in this circumstance
• APV is particularly useful where D/E ratio
varies through life of the project. In these
cases WACC/NPV will not give the true value
of the project.
 APV – Project with Known Debt Repayment
Schedule
• Project X is to be financed (at t=0) using debt of
€4m, with capital repayments of €1m in each of
the following 4 years.
• The project has the same risk as the firm
• Corporate taxes are the only market imperfection
(agency, information and bankruptcy costs are
ignored)
• Corporate debt is risk free
• All figures used in examples are in ‘000s
 Project X
Forecasted Incremental Income Statement for Project X
Year (n) 0 1 2 3 4 5
Year 2019 2020 2021 20 2019 2020
€'000 €'000 €'000 €'000 €'000 €'000
Sales 0 2,000 2,500 3,125 3,125 2,500
COGS 0 600 750 938 938 750
Gross Profit 0 1,400 1,750 2,188 2,188 1,750
Operating Expenses 0 300 375 469 469 375
Cap Allowances/Depr. 0 650 650 650 650 650
EBIT 0 450 725 1,069 1,069 725
Tax 0 56 91 134 134 91
Net Profit/Net Income 0 394 634 935 935 634
- CapEX 3,250 0 0 0 0 0
- Increase in NWC 1,000 0 0 0 0 0
+ Depr/Cap Allow 0 650 650 650 650 650
Free Cash Flow -4,250 1,044 1,284 1,585 1,585 1,284
 APV Approach – Value of the
Unlevered Project
•• In the first step, the APV method determines the unlevered
 value of the firm, by discounting the FCFs at the unlevered
cost of equity (or Pre-Tax WACC)*

• In the Project X example:

* M&M proposition 1: ke = pre tax WACC

 APV – Project with Known Debt Repayment
Schedule
• Second, Value Tax Shield
• Forecast Project Capital Structure, Interest and Tax Shield.

Capital Structure
VL (PVFCFs) 5,756 5,028 4,020 2,656 1,217 0
Debt 4,000 3,000 2,000 1,000 0 0
Debt Repayment   1,000 1,000 1,000 1,000 0
Equity 1,756 2,028 2,020 1,656 1,217 0
D/E Ratio 2.28 1.48 0.99 0.60 0.00 0.00
D/V Ratio 0.69 0.60 0.50 0.38 0.00 0.00
Interest 0 120 90 60 30 0
Interest Tax Shield 0 15 11 8 4 0
 APV – Project with Known Debt
Repayment Schedule
• Value the Tax Shield:
 + + + = €34

• Discount rate is the Ke ul / WACCpre-tax

Adjusted Present Value  

PV UnLevered Cash flows 1,506
PV Tax Shield 34
APV 1,540
Second Example – Non-Constant debt
ratio
• Initial Debt of €5m, all free cash-flows (after
interest charges) used to redeem debt.
• Unlevered Value of Project is as in the first
example: €1,506
• Value of Tax Shield
– Forecast leverage and interest charges
– Value interest tax shield
Second Example – Non-Constant debt ratio

Free Cash Flow -4,250 1,044 1,284 1,585 1,585 1,284

Capital Structure

VL (PVFCFs) 5,756 5,028 4,020 2,656 1,217 0

Debt 5,000 4,088 2,910 1,402 0 0
Debt Repayment   913 1,177 1,509 1,402 0
Equity 756 941 1,110 1,255 1,217 0
D/E Ratio 6.62 4.34 2.62 1.12 0.00 0.00
D/V Ratio 0.87 0.81 0.72 0.53 0.00 0.00

Interest 0 150 123 87 42 0

Interest Tax Shield 0 19 15 11 5 0
Second Example – Non-Constant debt
ratio
• Value the Tax Shield:
 + + + = €45

• Discount rate is the WACCpre-tax

Adjusted Present Value  

PV UnLevered Cash flows 1,506
PV Tax Shield 45
APV 1,551
 Non-Constant Leverage Ratio – APV
Summary
• For projects with a non-constant leverage
ratio, WACC/NPV approach is not appropriate.
Must use APV
• Two stages
– Value unlevered project
– Value tax shield
• Forecast debt, interest, tax shield
• Discount tax shield