Capital Budgeting for

the Levered Firm

 Prospectus

 Recall that there are three questions in corporate finance.

 The first regards what long-term investments the firm should make (the
capital budgeting question).
 The second regards the use of debt (the capital structure question).
 This chapter considers the nexus of these questions.
 Adjusted Present Value Approach

APV = NPV + NPVF

 The value of a project to the firm can be thought of as the value of
the project to an unlevered firm (NPV) plus the present value of
the financing side effects (NPVF):
 There are four side effects of financing:
 The Tax Subsidy to Debt
 The Costs of Issuing New Securities
 The Costs of Financial Distress
 Subsidies to Debt Financing
APV Example
Consider a project of the Pears Company, the timing and size of the incremental after-
tax cash flows for an all-equity firm are:

–$1,000 $125 $250 $375 $500

0 1 2 3 4

The unlevered cost of equity is r0 = 10%:

$125 $250 $375 $500
NPV10%  $1,000    
(1.10) (1.10) (1.10) (1.10) 4
2 3

NPV10%  $56.50
The project would be rejected by an all-equity firm: NPV < 0.
APV Example (continued)
 Now, imagine that the firm finances the project with $600 of debt at rB = 8%.
 Pear’s tax rate is 40%, so they have an interest tax shield worth TCBrB = .40×$600×.08 =
$19.20 each year.

The net present value of the project under leverage is:

APV = NPV + NPV debt tax shield
4
$19.20
APV  $56.50   t
t 1 (1 . 08)
APV  $56.50  63.59  $7.09
So, Pears should accept the project with debt.
APV Example (continued)
 Note that there are two ways to calculate the NPV of the loan. Previously, we calculated
the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:

$600  .08  (1  .4) $600

4
NPVloan  $600   t
 4
t 1 (1 . 08) (1 . 08)
NPVloan  $63.59
APV = NPV + NPVF
APV  $56.50  63.59  $7.09
Which is the same answer as before.
 Flows to Equity Approach

 Discount the cash flow from the project to the equity holders of
the levered firm at the cost of levered equity capital, rS.
 There are three steps in the FTE Approach:
 Step One: Calculate the levered cash flows
 Step Two: Calculate rS.
 Step Three: Valuation of the levered cash flows at rS.
Step One: Levered Cash Flows for Pears
 Since the firm is using $600 of debt, the equity holders only have
to come up with $400 of the initial $1,000.
 Thus, CF0 = –$400
 Each period, the equity holders must pay interest expense. The
after-tax cost of the interest is B×rB×(1 – TC) = $600×.08×(1 – .40)
= $28.80
CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600
CF2 = $250 – 28.80
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4
Step Two: Calculate rS for Pears

B
rS  r0  (1  TC )( r0  rB )
S
B B
To calculate the debt to equity ratio, , start with
S V
4
$125 $250 $375 $500 19.20
PV   2
 3
 4
 t
(1.10) (1.10) (1.10) (1.10) t 1 (1 . 08 )
P V = $943.50 + $63.59 = $1,007.09
B = $600 when V = $1,007.09 so S = $407.09.
$600
rS  .10  (1  .40)(. 10  .08)  11.77%
$407.09
Step Three: Valuation for Pears
 Discount the cash flows to equity holders at rS = 11.77%

–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

$96.20 $221.20 $346.20 $128.80

PV  $400    
(1.1177) (1.1177) (1.1177) (1.1177) 4
2 3

PV  $28.56
 APV Example:
Worldwide Trousers, Inc. is considering replacing a $5 million piece of
equipment. The initial expense will be depreciated straight-line to zero
salvage value over 5 years; the pretax salvage value in year 5 will be
$500,000. The project will generate pretax savings of $1,500,000 per year,
and not change the risk level of the firm. The firm can obtain a 5-year
$3,000,000 loan at 12.5% to partially finance the project. If the project were
financed with all equity, the cost of capital would be 18%. The corporate tax
rate is 34%, and the risk-free rate is 4%. The project will require a $100,000
investment in net working capital. Calculate the APV.
APV Example: Cost
Let’s work our way through the four terms in this equation:
APV = –Cost + PV unlevered + PV depreciation + PV interest
project tax shield tax shield
The cost of the project is not $5,000,000.
We must include the round trip in and out of net working
capital and the after-tax salvage value.
NWC is riskless, so we discount it at rf. Salvage value should
have the same risk as the rest of the firm’s assets, so we use r0.
100,000 500,000  (1  .34)
Cost  $5.1m  
(1  r f ) 5
(1  r0 ) 5
 $4,873,561.25
APV Example: PV unlevered project

Turning our attention to the second term,

APV = –$4,873,561.25 + PV unlevered + PV depreciation + PV interest

project tax shield tax shield

PV unlevered is the present value of the unlevered cash flows

project discounted at the unlevered cost of capital, 18%.

5
UCFt 5
$1.5m  (1  .34)
PVunlevered  
project t 1 (1  ro ) t
t 1 (1 . 18) t

PVunlevered  $3,095,899
project
APV Example: PV depreciation tax shield

Turning our attention to the third term,

APV = –$4,873,561.25 + $3,095,899 + PV depreciation + PV interest

tax shield tax shield

PV depreciation is the is the present value of the tax savings due to

tax shield depreciation discounted at the risk free rate: rf = 4%

PV depreciation   D  TC t
5

tax shield t 1 (1  r f )
5
$1m  .34
 t
$1,513,619
t 1 (1.04)
APV Example: PV interest tax shield
Turning our attention to the last term,

APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + PV interest

tax shield

PV interest is the present value of the tax savings due to interest

tax shield expense discounted at the firm’s debt rate: rD = 12.5%
5
TC  rD  $3m 5 0.34  0.125  $3m
PV interest   
tax shield t 1 (1  rD ) t
t 1 (1 . 125) t

5
127,500
PV interest   t
 453,972.46
tax shield t 1 (1.125)
APV Example: Adding it all up

Let’s add the four terms in this equation:

APV = –Cost + PV unlevered + PV depreciation + PV interest

project tax shield tax shield

APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + $453,972.46

APV = $189,930

Since the project has a positive APV, accept the project