Advanced Corporate Finance

4. From Company to Project Valuation

 Objectives of the session

• So far, NPV concept and possibility to move from accounting data to cash
flows. Influence on taxation on firm value: OK. But necessity to go further
and understand the impact of the capital structure on project and
company valuation in general.

• This sessions’ objectives

1. Show the ways to analyze the impact of capital structure on investment

decisions (APV, WACC and FTE) => but also expand methods to value
companies

2. Determine values of the WACC in function of capital structure objectives

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 Company valuation
• Key questions
‒ What is the market value of the company?
‒ What price to pay to buy a company?
∞
𝐹𝐶𝐹𝑡
Company value = ෍
(1 + 𝑟)𝑡
𝑡=1

Company value = 𝐸 + 𝐷

• E = Equity market value = market capitalization

• D = Debt market value
• Company Value = Company market value

→ Which price should you pay for a company?

→ Which FCFs?
→ Which discount rate (r)?
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 Possible discount rates
Discount rate Notation Possible proxies / computation Beta
Risk-free rate rf • US government bond YTM (T-bill / note / bond) 0
Cost of debt rD • Average YTM on corporate debt βD
• YTM of corporate bonds of similar rating and
similar maturity (imperfect proxy)
Cost of equity rE • Required return on equity of listed companies with βE
same activity and same leverage (estimate the β
and use the CAPM)

Cost of capital of an all- rA • Required return on equity of listed companies with βA

equity firm (cost of assets) same activity and no leverage (estimate the β and (sometimes
use the CAPM) also noted βU)

𝐸 𝐷
Weighted Average Cost of WACC • 𝑊𝐴𝐶𝐶 ≡ 𝑟𝐸 × + 𝑟𝐷 × (1 − 𝑇𝐶 ) × βWACC
Capital 𝑉 𝑉

• Which discount rate should we use?

• With which cash flows?

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 Interactions between capital budgeting and financing

• The NPV for a project could be affected by its financing:

(1) Transactions costs
(2) Interest tax shield
(3) …

• There are several ways to proceed, one relies on adjusting the NPV for the
financing cost, the others adjust the discount rate:

• The Adjusted Present Value (APV) Approach:

– Compute a base-case NPV, and add to it the NPV of the financing
decision ensuing from project acceptance
• APV = Base-case NPV + NPV(Financing Decisions)

• The Adjusted Cost of Capital Approach:

– Adjust the discount rate to account for the financing decisions
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 Basis of reasoning
• Do you remember this expression?

𝑉𝐿 = 𝑉𝑈 + 𝑃𝑉(Financing Effects) = 𝐸 + 𝐷

𝐹𝐶𝐹𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝐶𝐹𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 ෍
𝑇𝑐 × (𝑟𝑑 × 𝐷) 𝐹𝐶𝐹𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦
(1 + 𝑟𝑑 )𝑡
𝑊𝐴𝐶𝐶 𝑟𝑎
𝑡=1 𝑟𝑒

WACC way APV Flow to Equity : FTE

• Three methodologies that should be consistent under certain

assumptions and context!
– Simple context: everything can be summarized in a rate
– Constant Perpetuity! → there is a single discount rate up to infinity

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 For a given project, three methods

• If we assume perpetual unlevered Free Cash Flows, NPV is equal to

• WACC ∞
𝐹𝐶𝐹𝑈,𝑡
෍ −𝐼
(1 + 𝑊𝐴𝐶𝐶)𝑡
𝑡=1

• APV ∞
𝐹𝐶𝐹𝑈,𝑡
෍ + 𝑁𝑃𝑉(financing effects) − 𝐼
(1 + 𝑟𝑎 )𝑡
𝑡=1

∞
• FTE 𝐹𝐶𝐹𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦
෍ +𝐷 −𝐼
(1 + 𝑟𝑒 )𝑡
𝑡=1

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 The Adjusted Present Value

• The most straightforward and permits the user to see the sources of value
in the project (if the project is accepted)
• Procedure:
– (1) Compute the (unlevered) base-case NPV using a discount rate that
employs all-equity financing (rA), applied to the project’s unlevered
free cash flows
– (2) Then, adjust for the effects of financing which arise from:
• Transaction/flotation costs
• Tax Shields on Debt Issued
• Effects of Financing Subsidies
• Other financing impacts

APV = base-case NPV + NPV(financing decisions)

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 The Adjusted Present Value: MM (1963) with taxes

• Tax shield = Interest payment × Marginal Corporate Tax Rate

𝑟𝑑 × 𝐷 × 𝑇𝑐
– rd : cost of new debt
– D : market value of debt

• PV(Tax Shield) - Assume permanent borrowing

𝑇𝑐 × 𝐷 × 𝑟𝑑
𝑃𝑉(𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) = = 𝑇𝑐 × 𝐷
𝑟𝑑

• Other assumptions?
• Value of the firm: VL = VU +TcD

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 APV Example

• Data
– Cost of investment 10,000
– Incremental FCFs (unlevered) 1,800/year
– Duration (constant FCF) 10 years
– Discount rate rA 12%

• Base-case NPV = -10,000 + 1,800 x AF10 (=constant annuity) = 170

(1) Stock issue:

• Issue cost : 5% from gross proceed
• Size of issue : 10,526 (= 10,000 / (1-5%))
• Issue cost = 526
• APV = + 170 – 526 = - 356

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 APV Example

(2) Borrowing
Suppose now that 5,000 are borrowed to finance partly the project
• Cost of borrowing : 8%
• Constant annuity: 1,252/year for 5 years
• Corporate tax rate = 40%
Year Balance Interest Amortization Tax Shield
1 5,000 400 852 160
2 4,148 332 920 133
3 3,227 258 994 103
4 2,223 179 1,074 72
5 1,160 93 1,160 37

• PV(Tax Shield) = 422

• APV = 170 + 422 = 592
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 Adjusted Present Value

• Has some strong defenders => see Luerhman (1997) for an easy-to-read
discussion
• Strong points
 Allows easily to determine and analyze the precise impact of very different
actions linked to capital structure (tax shields but also costs of financial
distress, subsidies, hedges, cost of issue etc..)
 Unbundling of each factor (in this respect rwacc is much more opaque)
 Probably easier to communicate
 Easy when amount of debt to issue is known
• Minus points
 Need to determine the proper rate to discount the Tax shield (not so simple,
so far assumption that rd is the proper rate)
 When we have a target leverage ratio: necessity to solve for both the debt
level AND the project value (but less of an issue with a spreadsheet allowing
iterative calculation)
 Not easy to implement when we have a variable debt/equity ratio
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 WACC method

• Alternative approaches rely on a discount rate adjusted for the financial

decisions
• One of the most commonly used measure: the weighted average cost of
capital (wacc)
• After-tax WACC for a levered company:

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝐸 × + 𝑟𝐷 × (1 − 𝑇𝐶 ) ×
𝑉 𝑉

• !NB!: E, D and V are MARKET VALUES not book values

• NB: With this formula, only the tax shield is taken into account

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 WACC: Sangria Corporation

Balance Sheet (Book Value, millions) Balance Sheet (Market Value, millions)
Assets 100 Debt 50 Assets 125 Debt 50
Equity 50 Equity 75
Total 100 Total 100 Total 125 Total 125

Cost of equity 14.6%

Cost of debt (pretax) 8% Equity ratio = E/V = 75/125 = 60%
Tax rate 35% Debt ratio = D/V = 50/125 = 40%

75 50
𝑊𝐴𝐶𝐶 = 0.146 × + 0.08 × (1 − 0.35) × = 0.1084
125 125

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 WACC: Sangria Corporation

• WACC is used to discount free cash flows (unlevered)

• Example: Sangria Corp. considers investing $12.5m in a machine.
• Expected pre-tax unlevered free cash flow = $ 2.085m (a perpetuity)
• After-tax free cash flow = 2.085 (1 - 0.35) = 1.355

1.355
𝑁𝑃𝑉 = −12.5 + =0
10.84%

• Beware of two traps:

(1) Risk of project might be different from average risk of company
(2) Financing of project might be different from average financing of company

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 WACC method: 3 Models

• New project may have an influence on the capital structure itself!

• WACC may change over time! A future change in the capital structure will
automatically lead to a change in WACC value

• Need to determine the WACC value under several scenarios

1. Modigliani-Miller (1963) => assumptions: FCFu is a perpetuity, debt is
constant over time
2. Miles-Ezzell (1980, 1985) => assumptions: any FCFu, target leverage
ratio (L = Dt/Vt) is a constant with a rebalancing of the debt at a
given time interval
3. Harris and Pringle (1985) assumptions: any FCFu, target leverage
ratio (L = Dt/Vt) is a constant with a continuous rebalancing of the
debt

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 WACC - Modigliani-Miller formula

• Remember that 𝑉𝑢 𝑇𝑐 𝐷 𝐸 𝐷
𝑟𝑎 × + 𝑟𝑑 × = 𝑟𝑒 × + 𝑟𝑑 ×
𝑉𝐿 𝑉𝐿 𝑉𝐿 𝑉𝐿

𝑉𝐿 − 𝑇𝑐 𝐷 𝐸 𝐷
• And VL = VU + TcD, thus 𝑟𝑎 ×
𝑉𝐿
= 𝑟𝑒 × + 𝑟𝑑 × (1 − 𝑇𝑐 ) ×
𝑉𝐿 𝑉𝐿

𝐸 𝐷
• Since 𝑊𝐴𝐶𝐶 = 𝑟𝐸 × + 𝑟𝐷 × (1 − 𝑇𝐶 ) ×
𝑉𝐿 𝑉𝐿

• Then 𝑊𝐴𝐶𝐶 = 𝑟𝐴 (1 − 𝑇𝐶 𝐿) with L = D/ 𝑉𝐿

𝐹𝐶𝐹𝑢 𝐹𝐶𝐹𝑢
• As FCFu is perpetual => 𝑉𝐿 = = , assuming constant FCFu
𝑟𝐴 (1 − 𝑇𝐶 𝐿) 𝑊𝐴𝐶𝐶

𝐹𝐶𝐹𝑢
• Or as VL = VU + TcD = + Tc* L* VL and solve for VL
𝑟𝐴

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 MM formula: example

Data Base-case NPV: -100 + 22.5(1-0.40)/.09 = 50

Investment 100
Pre-tax unlevered FCF
(perpetuity) 22.50 Financing:
rA 9% Borrow 50% of PV of future cash flows after taxes
rD 5% D = 0.50 VL
TC 40%

Using MM formula: WACC = 9%(1-0.40 × 0.50) = 7.2%

NPV = -100 + 22.5(1-0.40)/.072 = 87.50

Same as APV introduced previously? To see this, first calculate D.

As: VL = VU + TC D = 150 + 0.40 D
and: D = 0.50 VL
VL = 150 + 0.40 ×0.50× VL → VL = 187.5 → D = 93.75
→ APV = base-case NPV + TC D = 50 + 0.40 × 93.750 = 87.50

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 Using standard WACC formula

𝐷
Step 1: calculate rE using (MM) 𝑟𝐸 = 𝑟𝐴 + (𝑟𝐴 − 𝑟𝐷 )(1 − 𝑇𝐶 )
𝐸
As D/V = 0.50, D/E = 1
rE = 9% + (9% - 5%)(1-0.40)(0.50/(1-0.50)) = 11.4%

Step 2: use standard WACC formula 𝐸 𝐷

𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 (1 − 𝑇𝐶 )
𝑉 𝑉

WACC = 11.4% x 0.50 + 5% x (1– 0.40) x 0.50 = 7.2%

Same value as with MM formula

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 Miles-Ezzell: WACC formula with target leverage ratio

• Assumptions:
• Any set of free cash flows
• Debt ratio L = Dt / VL,t constant

• where VL,t = PV of remaining after-tax free cash flows

• Demonstration see Miles-Ezzell (1980) => main point to understand, since

debt is adjusted annually, tax shield will change, the value of the tax shield
will be known only one year in advance, for the rest of the time the tax
shield is risky as the total company and should be discounted at ra
1 + 𝑟𝐴
𝑊𝐴𝐶𝐶 = 𝑟𝐴 − 𝐿 ∗ 𝑇𝐶 ∗ 𝑟𝐷 ( )
1 + 𝑟𝐷

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 Miles-Ezzell: Example

Data Base case NPV = -300 + 340.14 = +40.14

Investment 300
FCFu Using Miles-Ezzell formula (WACC method)
Year 1 50 WACC = 10% - 0.25 x 0.40 x 5% x 1.10/1.05 = 9.48%
Year 2 100 VL = PV(future FCFu) @9.48% = 344.85
Year 3 150 NPV = 344.85 – 300 = 44.85
Year 4 100 Using APV formula
Year 5 50 VU = PV(future FCFu) @10% = 340.14
rA 10% PV(Tax shield) = 344.85 – 340.14 = 4.70
rD 5% OR
TC 40% Initial debt: D0 = 0.25 VL,0 = (0.25)(344.85) = 86.21
L 25% Debt rebalanced each year:
Year Vt Dt PV(Tax Shield)
0 344.85 86.21 4.70
1 327.52 81.88 3.37
2 258.56 64.64 1.99
3 133.06 33.27 0.83
4 45.67 11.42 0.22

APV = -300 + 340.14 + PV(Tax shield) @rD and @rA (see

Excel file)
= 40.14 + 4.70 = 44.85
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 Harris and Pringle (1985)

• Assumption:
– any free cash flows
– Debt ratio L = Dt / VL,t constant
– debt rebalanced continuously

• Demonstration see Harris and Pringle (1985). Idea very close to Miles-
Ezzell, main difference here continuous rebalancing => uncertainty related
to next year’s tax shield => need to discount it at ra

𝑊𝐴𝐶𝐶 = 𝑟𝐴 − 𝑟𝑑 𝑇𝐶 𝐿

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 Harris and Pringle: Example

Data Base case NPV = -300 + 340.14 = +40.14

Investment 300
FCFu Using Harris Pringle formula (WACC method)
Year 1 50 WACC = 10% - 0.25 x 0.40 x 5% = 9.50%
Year 2 100 VL = PV(future FCFu) @9.5% = 344.63
Year 3 150 NPV = 344.63 – 300 = 44.63
Year 4 100 Using APV formula
Year 5 50 VU = PV(future FCFu) @10% = 340.14
rA 10% PV(Tax shield) = 344.63 – 340.14 = 4.49
rD 5% OR
TC 40% Initial debt: D0 = 0.25 VL,0 = (0.25)(344.63) = 86.16
L 25%
Year Vt Dt PV(Tax Shield)
0 344.63 86.16 4.49
1 327.37 81.84 3.21
2 258.47 64.62 1.90
3 133.02 33.26 0.79
4 45.66 11.42 0.21

APV = -300 + 340.14 + PV(Taxshield) @rA (see Excel file)

= 40.14 + 4.49 = 44.63
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 Discount relevant cash flows with the relevant discount rate

If you discount the … using as a discount rate … … (associated with its … you obtain as a
following cash flows… Beta), … present value
Cost of assets (cost of equity of the all-
Unlevered FCF βA = βU VU
equity firm): rA
Weighted Average Cost of Capital:
Unlevered FCF βWACC VL
WACC = rE * E/V + rD* (1–TC) * D/V

Interest Tax Shield (TS) Discount rate of the tax shield: rTS* βTS PV(TS)

FTE Cost of equity: rE βE E

Cash Flows to debtholders

Cost of debt: rD βD D
(CFD)

• There are several ways to perform company valuation

• If you make consistent hypotheses, all methods should all lead to the same value
(principle of the sum of the parts)
• The choice of the method depends on the valuation situation faced
* Modiglianni Miller: rTS = rD or Harris Pringle: rTS = ra or Miles-Ezzell rTS = rD and ra
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 Company value, relevant CF and discount rates with taxes
2 1 3
VL = VU + PV(TS) = E+D
2 WACC method: discount FCFu with the WACC

Value of equity:
FCFu Value of all-equity FTE
firm: E
FCFu rA; βA rE; βE
VU
WACC;
βwacc
Value of tax Value of debt: CFD
TS
shield: D rD; βD
rTS; βTS
PV(TS)

3
1 APV method

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 « In short »
Source: Taggart – Consistent Valuation and Cost of Capital Expressions With Corporate and Personal Taxes Financial
Management Autumn 1991

Modigliani Miller Miles-Ezzell Harris-Pringle

FCF (unlevered) Perpetuity Finite or Perpetual Finite of Perpetual

Debt level Certain Uncertain Uncertain

First tax shield Certain Certain Uncertain
rE(E/V) + rD(1-TC)(D/V)
WACC
rA (1 – TC L) 1 + 𝑟𝐴 r A – r D TC L
L = D/V 𝑟𝐴 − 𝐿𝑇𝐶 𝑟𝐷
1 + 𝑟𝐷

Cost of equity rA+(rA –rD)(1-TC)(D/E) 𝑟𝑎 − 𝑟𝑑 𝐿 rA+(rA –rD) (D/E)

𝑟𝑎 + (𝑟𝑎 − 𝑟𝑑 × (1 + 𝑇𝑐 × ( ))) ×
1 + 𝑟𝑑 1−𝐿

Beta equity βA+(βA – βD) (1-TC) (D/E) 𝐷

𝛽𝑎 × (1 + ) × (
1 + 𝑟𝑑 (1 − 𝑇𝑐 ∗ 𝐿)
) βA +( βA – βD) (D/E)
𝐸 1 + 𝑟𝑑

Beta asset (Assuming 𝛽𝐸 𝛽𝐸

𝛽𝐴 =
risk-free debt) 𝐷 𝛽𝐴 =
1 + (1 − 𝑇𝐶 ) 𝐸 𝐷
1+
𝐸
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 In practice: how to estimate a company / project’s
opportunity cost of capital
Use the CAPM relationship:
𝐸(𝑅𝑖 ) = 𝑟𝑓 + (𝐸(𝑅𝑀 ) − 𝑟𝑓 ) × 𝛽𝑖
– rf = expected return on the risk-free asset (e.g., yield-to-maturity on a
US government bond: T-bills)

– E(RM) – rf = expected market risk premium (generally between 4 and

6%)

– βi = measure of the systematic risk of activity i

• Identify a group of listed companies with similar business risk (i.e.,
similar activity)
• Plot the total returns on the stock price over a recent period*
(e.g., weekly returns over a 2–5 year period)
• Compute the Beta for each stock (levered or equity beta)
* The time period chosen for the computation of the Beta should be a long enough period over which the company (activity) stayed relatively stable
(sound judgment is necessary)
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 How to estimate Beta equity?

30

20, 27.5

25 15, 25

20

15 15, 15

10
Return on asset

Slope = Beta = 1.5

5

0
-15 -10 -5 0 5 10 15 20 25

-5, -5 -5

-10

-5, -15 -15

-10, -17.5

-20
Return on market

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 How to estimate Beta asset?
• Betas equity are often estimated using stock price, yielding beta equity (βE)
• (βE) depends on both:
– Activity (βA) = beta assets
– Leverage (D/E)

• In order to get rid of the leverage effect, we need to compute beta assets (which only
depends on company activity)
• An unlevering formula can be used to estimate beta assets: e.g. (HP if 𝛽𝐷 = 0):
𝛽𝐸
𝛽𝐴 =
𝐷
1+
𝐸

• You can also estimate 𝛽𝐴 based on competitors (i.e., calculate an average of comparable
companies)

• Once a reliable estimate of beta assets is obtained, if relevant, the beta assets can be
relevered to a beta equity based on the same formula (HP if 𝛽𝐷 = 0 )
𝐷
𝛽𝐸 = 𝛽𝐴 ∗ (1 + )
𝐸
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 Unlevering and relevering beta – Example
• You need to estimate the cost of capital for the following project
– Project sector: transportation
– Target debt-to-equity ratio (D/E) of the project is 1
– Marginal corporate tax rate of the project is 22%
– Risk-free debt (rf = 2%); market risk premium (MRP) = 5%

• You have identified 3 companies with a comparable activity (transportation) and gathered the
following data*:
Company βE D/E βA**
A 1.25 0 1.25
B 2.88 1.5 1.15
C 1.80 0.5 1.20

• These data allow you to:

1) Compute an estimated unlevered beta for each comparable company
2) Estimate an unlevered beta for your project (e.g., average of unlevered betas of comparable): 1.20
3) Estimate the levered beta for your project (taking into account your target debt-to-equity ratio): 2.40
4) Estimate the cost of equity for your project (using the CAPM): rE = rf + βE * MRP = 2 % + 2.40 * 5% = 14%
5) Estimate a WACC for your project: rE * E/V + rD * (1-TC) * D/V = 14% * 0.5 + 2% * 78% * 0.5 = 7.78%
[Link]

* Data consistent with Aswath Damodaran sector beta estimates (Jan 2016, [Link]
|30 ** Assuming Harris-Pringle and 𝛽𝐷 = 0
 Terminal value (1/3)

• In company valuations, Free Cash Flows generally do not stop

after a given period of time

• In practice, Free Cash Flow projections generally involves at

least two distinct projection periods

1. Detailed projection horizon: over a first period (e.g., 5-15 years),

detailed cash flow projections are made, in order to factor in detailed
information available about the firm/project (e.g., sales projections,
new projects, potential synergies)

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 Terminal value (2/3)

2. After the detailed projections horizon, the formula of a growing

perpetuity can be used to estimate a terminal value at the end of the
detailed projection horizon

3. Simplifying assumptions need to be made, commonly assuming that

FCF (unlevered) grow (for ever) at constant growth rate g

𝐹𝐶𝐹𝑡 (1 + 𝑔)
𝑇𝑉𝑡 =
𝑟−𝑔

where:
• g = long-term growth rate of the FCF
• you need to know the discount rate r!

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 Terminal value (3/3)

• The terminal value is very sensitive to the chosen value of the parameters,
in particular the perpetual growth rate → don’t be over-optimistic in your
estimate of the perpetual growth rate (for example, one could use as a
proxy the GDP growth rate in a mature economy)

• Don’t forget that the terminal value obtained is expressed at time t (still
needs to be discounted to time 0 to obtain a present value!)

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