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Chapter 18: Financing and Valuation
Chapter 18: Financing and Valuation
AND VALUATION
Effects of leverage on the value created by a project
Adjusted Present Value (APV),
Flows to Equity (FTE), and
WACC method for valuing projects with leverage
Beta and leverage
KEY CONCEPTS AND SKILLS
CASH FLOWS AND DISCOUNT RATES
Numerators
Denominators
Components of NPVF
Costs of issuing new securities: investment banking costs, legal fees, etc.
Project: Cash inflows = $500,000 per year for the indefinite future
Cash costs = 72% of sales
Initial investment = $475,000, TC = 34%, r0=20%
Expected annual sales $500,000
Expected annual cash costs -$360,000
Operating income $140,000
Assuming this is the only benefit/cost from financing then:
$42, 918
NPVF = -13,000 + 42,918 = $29,918
APV =
What will the firm’s debt-to-market-value ratio be?
B = $126, 229.50
475,000
V = Initial project cost + APV of project + 29,918 = 504,918
V=
.25
debt-to-value-ratio = B/V =
18.2 A CLOSER LOOK AT THE FLOW-TO-EQUITY
APPROACH
Basic idea:
(1) Calculate expected cash flow that will accrue to
equityholders after taxes and interest payments
-- levered cash flow (LCF)
(2) Calculate cost of equity capital rS including the effect of
leverage
(3) Calculate NPV to equityholders
STEP 1 – CALCULATE LCF
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.
In the real world, the WACC is, by far, the most widely used.
PV of financing
effects Yes No No
EXAMPLE 1:
Mojito Mint Company has a debt-equity ratio of 0.35. The required
return of the company’s unlevered equity is 13%, and the pretax cost
of the firm’s debt is 7%. Sales revenue for the company is expected to
remain stable indefinitely at last year’s level of $17,500,000. Variable
costs amount to 60% of sales. The tax rate is 40%, and the company
distributes all its earnings as dividends at the end of each year
Sales $17,500,000
Cost of goods (60% of sales) 17,500,000*0.6
=10,500,000
Operation Income 7,000,000
Tax (40%) 2,800,000
Net Income 4,200,000
B
rs r0 (1 Tc ) (r0 rB )
S
0.13 0.35 (1 0.4) (0.13 0.07)
14.26%
C. Value of the firm using WACC
B S
rWACC (1 Tc ) rB rs
V V
35 100
(1 0.4) 0.07 0.1426
100 35 100 35
11.65%
100
Value of Equity =VL $26, 700,572.16
100 35
35
Value of Debt =VL $9,345, 200.25
100 35
D. Value of equity using FTE method
Sales $17,500,000
Cost of goods (60% of sales) 17,500,000*0.6
=10,500,000
Interest (7%, 26% of VL) 9,345,200.25*0.07
=654,164
Operation Income 6,345,836
Tax (40%) 2,538,334
Net Income 3,807,502
LCF 3,807,502
Value of Equity =
rs 0.1426
26, 700,572.16
18.5 CAPITAL BUDGETING WHEN THE DISCOUNT RATE
MUST BE ESTIMATED
Example
Rf=8%
Rm-Rf=8.5%
Step 1: determining AW’s cost of equity capital using CAPM
Step 3: Determining the cost of equity capital for WWE’s widget venture
B 0.25
RSWWE R0 (1 TC ) ( R0 RB ) 18.25% (1 0.40) (18.25 10%) 19.9%
SL 1 0.25
5,152 1
5
5
396, 000 1 7, 500, 000
NPV ( Loan) 7, 500, 000 [1 ]
1.10
5
0.10 1.10
1, 341, 939
APV=all-equity value NPV(loan)
= -1,058,070+1,341,939
=$283,869
18.7 BETA AND LEVERAGE
CAPM:
(2)
(3)
Debt
β Equity 1 (1 TC ) β Asset
Equity
Debt
β equity 1 (1 TC ) β unlevered
Equity
Equity
unlevered equity 1.5
Equity (1 TC ) Debt
RS R f unlevered ( RM R f ) 22.75%
EXAMPLE 2
Debt
β equity 1 (1 TC ) β unlevered [1 1 (1 0.34)] 1.3 2.16
Equity
Step 3: cost of equity of the project using CAPM
rs rf (rm rf ) 0.05 2.16 0.09 0.244