Valuation and Capital

Budgeting for the Levered Firm

Chapter 18

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Understand the effects of leverage on the value

created by a project
• Be able to apply Adjusted Present Value (APV),

the Flows to Equity (FTE) approach, and the

WACC method for valuing projects with leverage
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Outline
• Adjusted Present Value (APV) Approach

• Flows to Equity (FTE) Approach

• Weighted Average Cost of Capital (WACC) Approach

• A Comparison of the APV, FTE, and WACC

Approaches
• Valuation When the Discount Rate Must Be
Estimated
• Beta and Leverage

• Example with perpetual cash flows and permanent

debt
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Adjusted Present Value (APV) 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 net present value of the financing side effects
(NPVF).
• There are four side effects of financing:
• The Tax Subsidy to Debt (PV of interest tax shield)
• The Costs of Issuing New Securities (flotation costs)
• The Costs of Financial Distress (PV of financial distress
cost or bankruptcy cost)
• Subsidies to Debt Financing
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Example
Consider a project of the Pearson 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%.
NPV = -1000+ 125/1.1 + 250/1.1^2 +375/1.1^3 +500/1.1^4
= $-56.5

The project would be rejected by an all-equity firm: NPV < 0.

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Example
• Now, imagine that the firm finances the project with
$600 of debt at RB = 8%.
• Pearson’s tax rate is 40%, so they have an interest
tax shield worth TCBRB = 19.2 each year.
· The net present value of the project under leverage is:
APV = NPV + PV debt tax shield
· PV of interest tax (4 years, discount rate Rb= 8%) = 19.2x [1/0.08 – 1/0.08x(1.08)^4] = 63.59

· So, Pearson should accept the project with debt.

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Flow to Equity (FTE) 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 (LCFs)

• Step Two: Calculate RS

• Step Three: Value the levered cash flows at RS

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Step One: Levered Cash Flows

• Since the firm is using $600 of debt, the equity
holders only have to provide $400 of the initial
$1,000 investment.
• 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 x 8% x (1-40%)=$28.8
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Step One: Levered Cash Flows

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
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Step Two: Calculate RS

B
R S  R0  (1  TC )( R0  R B )
S
B
To calculate the debt-to-equity ratio, , start with V
S

V = $125/(1.1) + $250/(1.1^2) + $375/(1.1^3) +

$500/(1.1^4) + PV of interest tax shield ($63.59) =
$1,007.09

B = $600 when V = $1,007.09 so S = V – B = $407.09

RS = 10% + 600/407.09 x (1-40%)x(10%-8%) = 11.77%
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Step Three: Valuation

• 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

NPV = $28.567 >0

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Weighted Average Cost of Capital

(WACC) Approach

S B
RW ACC  RS  R B (1  TC )
SB SB
• To find the value of the project, discount the
unlevered cash flows at the weighted average cost
of capital (WACC)
• Suppose Pearson’s target debt to equity ratio is 1.50
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WACC Approach

B
1.50   1 .5 S  B
S
B 1 .5 S 1 .5 S
   0 .60  1  0 .60  0 .40
S  B S  1 .5 S 2 .5 SB

RWACC = 7.6%
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WACC Approach

• To find the value of the project, discount the

unlevered cash flows at the weighted average cost of
capital (WACC)

We discount unlevered CF using RWACC as the discount

rate

NPV= -1000 +125/1.076 + 250/1.076^2 +

375/1.076^3 +500/1.076^4 = $6.13 >0
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A Comparison of the APV, FTE, and

WACC Approaches
• All three approaches attempt the same task: valuation
in the presence of debt financing.
• 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. -> to find interest tax shield for APV
Approach
• In the real world, the WACC is, by far, the most widely
used.
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Summary: APV, FTE, and WACC

APV WACC FTE
Initial Investment All All Equity Portion ($400)

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing
side effects Yes No No
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Summary: APV, FTE, and WACC

Which approach is best?
• Use APV when the level of debt is constant.

• Use WACC and FTE when the debt ratio is

constant.
• WACC is by far the most common

• FTE is a reasonable choice for a highly levered firm

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Valuation When the Discount Rate Must

Be Estimated
• A scale-enhancing project is one where the project is similar to the existing
firm. (use the firm’s discount rate for the project)
• In the real world, executives would make the assumption that the business risk
of the non-scale-enhancing project would be about equal to the business risk
of other firms already in the business (same product/service as project). (don’t
use the same b/c has different financial risk) Rs =Ro + B/S(1-Tc) (Ro-R B)

reflect business risk reflect financial risk

-> Non-scale enhancing project: the project is in a different industry, has
different business compared to the firm -> need to find another firm that is in the
same industry, has the similar business as the project and follow 3 steps (in the
explanation) to estimate discount rate of the project.
• No exact formula exists for this. Some executives might select a discount rate
slightly higher on the assumption that the new project is somewhat riskier since
it is a new entrant.
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Beta and Leverage: No Corporate Taxes

• In a world without corporate taxes, and with riskless
corporate debt (betaDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm and
the beta of levered equity is:
• βEquity = βunlevered firm Equity
• βEquity: β of equity in the levered firm
β Asset   β Equity
Asset
· In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship
between the beta of the unlevered firm and the beta of
levered equity is:
Debt Equity
β Asset   β Debt   β Equity
Asset Asset
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Beta and Leverage: With Corporate Taxes

• In a world with corporate taxes, and riskless debt, it can
be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:

 Debt 
β Equity  1   (1  TC ) β Unlevered firm
 Equity 
 Debt 
· Since 1   (1  TC )  be more than 1 for a
must
 Equity
 
levered firm, it follows that betaEquity > betaUnlevered firm
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Beta and Leverage: With Corporate Taxes

• If the beta of the debt is non-zero (i.e., risky debt),

then:
B
β Equity  β Unlevered firm  (1  TC )(β Unlevered firm  β Debt ) 
SL
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Example with perpetual cash flows and

permanent debt
Consider a project of the Pearson Company. The timing and size
of the incremental after-tax cash flows for an all-equity firm are:

–$1,000 $100 $100 $100 $100…

0 1 2 3 4…
The unlevered cost of equity is R0 = 10%:

The project for an all-equity firm: NPV= -1000 + 100/10% =0

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APV Approach
• Now, imagine that the firm finances the project with
$600 of permanent debt at RB = 8%.
• Pearson’s tax rate is 40%, so they have PV of
interest tax shield worth TCB RB =
· The net present value of the project under leverage is:
APV = NPV + PV debt tax shield
= $240>0
· PV of interest tax shield (perpeptual CFs, disount rate
RB =8% == TcBRB / RB = TcB = $240
· So, Pearson should accept the project with debt.
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Flow 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 (LCFs)

• Step Two: Calculate RS

• Step Three: Value the levered cash flows at RS

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Step One: Levered Cash Flows

• Since the firm is using $600 of debt, the equity holders
only have to provide $400 of the initial $1,000 investment

• Thus, CF0 = -$400

• Each period, the equity holders must pay interest

expense. The after-tax cost of the interest is:

B×RB×(1 – TC) = $28.8

Assume Permanent debt

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Step One: Levered Cash Flows

CF3 = $100 – 28.80 CF4 = $100 – 28.80

CF2 = $100 – 28.80
CF1 = $100 – 28.80
–$400 $71.20 $71.20 $71.20 $71.20…

0 1 2 3 4…
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Step Two: Calculate RS

B
R S  R0  (1  TC )( R0  R B )
S
B
To calculate the debt-to-equity ratio, , start with V
S

B = $600 when V = $1,240 so S = V – B = $640

RS = 11.125%
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Step Three: Valuation

• Discount the cash flows to equity holders at RS = 11.125%

–$400 $71.20 $71.20 $71.20 $71.20…

0 1 2 3 4…

NPV = -400 + 71.2/11.125% = $240

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WACC Approach

S B
RW ACC  RS  R B (1  TC )
SB SB
• To find the value of the project, discount the
unlevered cash flows at the weighted average cost
of capital (WACC)
• Use Pearson’s target debt to equity ratio = 600/640
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WACC Approach

B 600

S 640
S= $640
B=$600
RWACC = 8.0645%
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WACC Approach

• To find the value of the project, discount the

unlevered cash flows at the weighted average cost of
capital (WACC)

NPV = -1000 + 100/8.0645% = $240>0

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Summary
1. The APV formula can be written as:
Additional

UCFt Initial
APV    effects of 
t 1 (1  R0 )
t
investment
debt
2. The FTE formula can be written as:


LCFt  Initial Amount 
FTE      
t 1 (1  R S )
t
 investment borrowed 
3. The WACC formula can be written as

UCFt Initial
NPVW ACC   
t 1 (1  RW ACC )
t
investment
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Summary
4 Use the WACC or FTE if the firm's target debt-
to-value ratio applies to the project over its life.
· WACC is the most commonly used.
· FTE has appeal for a firm deeply in debt.
5 The APV method is used if the level of debt is
known over the project’s life.
· The APV method is frequently used for special
situations like interest subsidies, LBOs, and
leases.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.
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Quick Quiz

• Explain how leverage impacts the value created by a

potential project.
• Identify when it is appropriate to use the APV

method? The FTE approach? The WACC approach?