CHAPTER 18: FINANCING

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

 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
THREE METHODS TO VALUE A PROJECT (OR FIRM)

 (1) Adjusted-present-value (APV) method

   UCFt
APV     initial investment  benefits of debt
  t 1 (1 r )t
0
 
 (2) Flow-to-equity (FTE) method
 LCFt
NPV     initial investment  amount borrowed 
t
t 1 (1 rs )

 (3) WACC method

   UCFt
NPV    initial investment
t
t 1 (1 rWACC )

 
CASH FLOWS AND DISCOUNT RATES
 Numerators

Let UCF = unlevered cash flows

= cash flows that would accrue to shareholders if firm only uses equity

Let LCF = levered cash flows

= cash flows that accrue to shareholders under current capital structure
(with some debt)

 Denominators

Let r0 = cost of equity capital if a firm uses only equity financing

Let rS = cost of equity capital under current capital structure (with some
debt)
Let rWACC = weighted average cost of capital
18.1 A CLOSER LOOK AT THE APV APPROACH

 Basic formula for APV of a project: APV = NPV + NPVF

  
NPV is the net present value of a project calculated assuming no debt
 
NPVF is the net present value of the financing side effects

 Components of NPVF 

 Tax benefit from debt financing. This benefit is TC x rB x B each year

  Costs of issuing new securities: investment banking costs, legal fees, etc.

  Expected financial distress costs from taking on project

 Subsidies to debt financing

 
EXAMPLE: CALCULATING APV WITH TAX BENEFITS TO DEBT

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

If firm and project are

all equity financed then:
Annual corporate taxes -$47,600
Unlevered cash flow (UCF) $92,400

 NPV assuming no leverage is:

  -475,000 + (92,400/.20) = -$13,000
Project would be rejected by an all equity firm
  
EXAMPLE (CONTINUED)

Suppose firm finances the project as follows: 

$126,229.50 in bonds issued
$348,770.50 in stock issued
 
Since B= 126,229.50, the tax benefit of debt is:
  T x B = .34 x 126,229.50 = $42,918
C

 
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

Expected annual sales $500,000

Expected annual cash costs -$360,000
Interest (rB=10%) -$12,662.95
Cash flow after interest $127,377.05
Corporate income tax -43,308.20
Cash flow after interest and taxes- (LCF)$84,068.85
 
 Another way to calculate levered cash flows (LCF):

LCF = UCF – (1 – TC)rBB

LCF = $92,400 – (.66) x .10 x 126,229.5 = 84,068.85
Step 2- calculate rS
 
Recall: r0 = .20 and (B/V) = 1/4  (B/S) = 1/3
rs = r0 + (B/S) (1 – TC) (r0 – rB)
.20 + (1/3) (.66) (.20 - .10) = .222
rS =
 
  Step 3- calculate PV of LCF and NPV of project to equityholders

PV of LCF = (LCF / rS) = $84,068.85 / .222 = $378,688.50

 Cash from equityholders for project: $348,770.50
NPV to equityholders:
  $378,688.50 - $348,770.50 = $29, 918
 

Note: Same answer as in calculation of APV above!

18.3 A CLOSER LOOK AT THE WACC METHOD

Recall: rWACC = (B/V) rB (1 – TC) + (S/V) rS

 
 WACC valuation method:
Discount unlevered cash flow at rWACC and then subtract
initial investment by all investors (debt & equity)
 
 UCF
NPV    Initial Investment
(1  r ) t
t 1 WACC
For a perpetuity:
  NPV  UCF  Initial Investment
rWACC
ILLUSTRATION USING PREVIOUS EXAMPLE

rWACC = (3/4)x.222 + (1/4)x.10x.66 = .183

NPV = (92,400/.183) – 475,000 = $29,918

  
Same answer as in APV and FTE calculations above!
 
 Note: rwacc < .20  rwacc decreases with leverage
 project value increases with leverage
 
18.4 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.

 In the real world, the WACC is, by far, the most widely used.

 FTE is a reasonable choice for a highly levered firm

SUMMARY: APV, FTE, AND WACC

APV WACC FTE

Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

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

 A. If the company were financed entirely by equity, how much does it

worth?
 B. What is the required return on the firm’s equity

 C. Use the weighted-average cost of capital method to calculate value

of the company? What is the value of equity? What is the value of
debt?
 D. Use the flow-to-equity method to calculate the value of the firm’s
equity
 A. If the firm is all-equity financed:

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

UCF 4, 200, 000

PV    $32,307, 692.31
r0 0.13
 B. required return of equity

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%

UCF 4, 200, 000

Value of the Company    $36, 045, 772, 41
rWACC 0.1165

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

World-wide Enterprises (WWE) is a large conglomerate considering of

entering the widget business, where it plans to finance projects with a debt-to-
value ratio of 25%. There is a currently one firm in the widget industry,
Awesome Widgets (AW). This firm is financed with 40% debt and 60% equity.
The beta of AW’s equity is 1.5. AW, has a borrowing rate 12%, and WWE
expects to borrow for its widget venture at 10%. The corporate tax rate for
both firms is .40, the market risk premium is 8.5%, and the riskless interest
rate is 8%. What it the appropriate discount rate for WWE to use for its widget
venture?
 WWE  AW
 Planned B/V=0.25  Debt=40%; Equity=60%
 Beta=?  Beta=1.5
 RB=10%  RB =12%
 Tc=40%  Tc=40%

Rf=8%
Rm-Rf=8.5%
Step 1: determining AW’s cost of equity capital using CAPM

RS  R f   AW   Rm  R f   8%  1.5  8.5%  20.75%

Step2: determining AW’s hypothetical all-equity cost of capital using MM’s

proposition II
B
RSAW  R0  (1  TC )  ( R0  RBAW )
SL
0.4
20.75%  R0  (1  0.40)  ( R0  12%)
0.6
R0  18.25%

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

Step 4: Determining the WACC of WWE’s widget venture

B S
WWE
RWACC  RB (1  TC )  RS  16.425%
SB BS
18.6 APV EXAMPLE
 Bicksler Enterprise is considering a$10 million project
that will last five years, implying straight-line
depreciation per year of $2 million. The cash revenue
less cash expense per year are $3,500,000. The corporate
tax rate is 34%, and the cost of unlevered equity is 20%.
The cash flow projection each year are these:

CF0 CF1 CF2 CF3 CF4 CF5

Initial outlay -10,000,000

Depreciation 2000000*.34 680,000 680,000 680,000 680,000

Tax shield =680,000

After tax operation (1-.34)3500000 2,310,000 2,310,000 2,310,000 2,310,000

income =2,310,000
 Scenario 1: All-equity financing

680, 000  2,310, 000 1 5

APV  10, 000, 000   [1  ( ) ]
.20 1.20
 $1, 058, 070
 Scenario 2: Debt financing by bank loans
 A five-year, non-amortizing loan for $7,500,000 after
flotation costs at the rate of 10%. Flotation costs are 1% of
the gross proceeds.
 Gross proceeds *(1-1%)=$7,500,000
 Hence: Gross proceeds=7,575,758
 Flotation costs = 75,758

 Cash flows from the flotation costs are :

CF0 CF1 CF2 CF3 CF4 CF5
Flotation cost -75,758

Deduction per year 75758/5 15,152 15,152 15,152 15,152

=15,152
Tax shield from =.34*15,152 5,152 5,152 5,152 5,152
flotation costs =5,152

5,152   1  
5

75, 758  1      56, 228

 NPV(flotation cost)= .10   1.10  
 Tax subsidy from debt borrowing

CF0 CF1 CF2 CF3 CF4 CF5

loan 7,575,758

Interest paid 10%*7,575,758 757,576 757,576 757,576 757,576

=757,576
After tax interest =(1-.34)*757,576 500,000 500,000 500,000 500,000
cost =500,000

Debt repayment -7,575,758

 NPV(loan)=+amount borrow- PV(after tax interest payments)-

PV(loan repayment) 5
500, 000  1  7,575, 758
 7,575, 758   [1    ] 
 1.10 
5
0.10  1.10 
 7,575, 758  1,895,393  4, 703,950
 976, 415
 APV=all-equity value +NPV(flotation cost)+NPV(loan)
= -1,058,070-56,228+976,415
=-$137,883
 Scenario 3: non-market-rate financing
Suppose that the project of Bicksler Enterprise is deemed
socially beneficial and the government grant the firm a
$7,500,000 loan at 8% interest, all flotation costs are
absorbed by the state.
CF0 CF1 CF2 CF3 CF4 CF5
loan 7,500,000

Interest paid 8%*7,500,000 600,000 600,000 600,000 600,000

=600,000
After tax interest =(1-.34)*600,000 396,000 396,000 396,000 396,000
cost =396,000

Debt repayment -7,500,000

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

 Recall that an asset beta would be of the form:

Cov(UCF , Market )
β Asset 
σ 2Market
18.7 BETA AND LEVERAGE
 In a world without corporate taxes, and with riskless corporate debt (b Debt = 0), it
can be shown that the relationship between the beta of the unlevered firm and the
beta of levered equity is:
Equity
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
 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 Asset
 Equity 
 Debt 
Since 1  Equity  (1 must
T )  be more than 1 for a levered firm, it follows that
C

bEquity > bAsset
We call bEquity levered beta, bAsset unlevered beta.
 MM proposition II
 (1)

 CAPM:
 (2)

 (3)

 Plug equations (2) and (3) into equation (1), we get:

 Debt 
β Equity  1   (1  TC )  β Asset
 Equity 

 Note is also called ; is also called

BETA AND LEVERAGE
Example 1
Lee Inc. is considering a scale-enhancing project. The market value of the
firm’s debt is $100 million, and the market value of the firm’s equity is $200
million. The debt is considered riskless. The corporate tax rate is 34%.
Regression analysis indicates that the beta of the firm’s equity is 2. The risk-
free rate is 10%, and the expected market premium is 8.5%. What would be
the project’s discount rate in the hypothetical case that Lee Inc. is all 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

 The J. Lowes corporation, which currently manufactures staples, is considering a $1

million investment in a project in the aircraft adhesives industry. The corporation
estimates unlevered after tax cash flows (UCF) of $300,000 per year into perpetuity
from the project. The firm will finance the project with a debt-to-value ratio of .5 (or,
equivalently, a debt-to-equity ratio of 1.0). The three competitors in this new industry
are currently unlevered, with betas of 1.2, 1.3, and 1.4. Assuming risk-free rate of 5%, a
market risk premium of 9%, and a corporate tax rate of 34%, what is the NPV of the
project ?
 Step1: average beta of the industry: (1.2+1.3+1.4)/3=1.3
 Step2 : levered beta for J. Lowes:

 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

 Step 4: Calculate weighted-average-cost of capital

B S 1 1
rWACC  (1  Tc )  rf  rs   .66  .05   .244  .139
V V 2 2

 Step 5: UCF  initial Investment= 300, 000  1, 000, 000  $1.6million

NPV 
rWACC .139
18.7 SUMMARY

(1) Adjusted-present-value (APV) method

   UCF
APV   t
- initial investment t
t  1 (1+r0 )benefits of debt
 
 
(2) Flow-to-equity (FTE) method
   LCFt
NPV   
(initial investment t
t 1 (1 r –) amount borrowed)
s

(3) WACC method

 UCFt
  NPV  
t

t  1 (1  rWACC )
initial investment
 
SUMMARY

 Explain how leverage impacts the value created by a

potential project.

 What the difference between APV, FTE and WACC

approaches?

 Identify when it is appropriate to use the APV method? The

FTE approach? The WACC approach?

 Levered-beta (equity beta) vs. unlevered beta (asset beta)