CHAPTER 16

VALUATION AND FINANCING

Q-1 What is an asset beta? How is it calculated? Assume no taxes.

A firm’s assets are generally financed by debt and equity. Therefore, a firm’s
asset beta is also equal to the weighted average of the firm’s equity beta and debt
beta. Assuming no corporate tax, the beta of assets will be as follows:
Asset beta = equity beta × equity weight + debt beta × debt weight
E D
βa = βe + βd
V V

Q-2 Do the interest tax shields reduce the systematic risk? If yes how is the asset’s
beta affected by the interest tax shield?
A-2 When a firm (or project) employs fixed amount of debt, it will not fluctuate with
the value. The interest flows and tax savings are known, and they will remain tied
to debt. They remain insulated from fluctuations in the value. The interest tax
shields are as safe or risky as debt is. If debt is risk free, the interest tax shields
will also be risk free. The interest tax shields will be risky only if debt is risky.
Hence the beta of the interest tax shields will be equal to the beta of debt. When
debt is a fixed amount, and interest tax shields have same risk as debt, it is quite
plausible to discount the interest tax shields by the cost of debt.
The equality of the betas of the interest tax shields and debt under the fixed debt
assumption will affect a levered firm’s (or project’s) systematic risk. The asset
beta should be adjusted for the tax effects of debt. Hamada showed that the
adjustment factors would include the corporate tax rate and the firm’s leverage
(debt ratio). The adjusted asset beta of the levered firm will be as follows:
E D
βa = βe + βd
V − TD V − TD

Q-3 How is the equity beta determined? How is it affected by the capital structure?
A-3 We need estimate of the discount rate to determine the net present value of a
project. The discount rate depends on the project’s business risk and financial
risk. Under CAPM, the equity beta captures both the business risk and the
financial risk. Financial risk arises when the firm uses debt.
We can rewrite equation in Q-1 to obtain the following equation for the equity
beta of a levered firm:
D
β e = β a + (β a − β d )
E
You can see from the above that the equity beta increases linearly with leverage
(debt-to-equity, D/E, ratio) since it adds financial risk to shareholders
The equity beta may, thus, be referred to as the levered equity beta or simply
levered beta. Financial leverage causes variability in the return of shareholder.
This adds financial risk. As a consequence, beta of a levered firm’s equity will
increase as debt is introduced in the firm’s capital structure

Q-4 What is the asset cost of capital? How is it calculated? Is the asset cost of capital
same as the opportunity cost of capital?
A-4 Under the CAPM, the asset or opportunity cost of capital of a pure-equity
(unlevered) firm is given as follows:
Opportunity cost of capital = risk-free rate + risk premium × asset beta
k a = rf + rp β a
The cost of debt and the cost of equity of a levered firm are given as follows:
Pre - tax cost of debt = k d = rf + rp β d
Cost of equity = k e = rf + rp β e
We can calculate the pre-tax weighted average cost of capital (WACC) as
follows:
E D
Pre - tax WACC = k e + k d
V V
Substituting the values for kd and ke, respectively, we obtain:
E D
Pre - tax WACC = (rf + rpβe ) + (rf + rpβd )
V V
 E D  E D
= rf  +  + rp  βe + βd 
V V  V V
 S D
= rf + rp  β e + β d 
 V V
We may notice that the term within parentheses on the right hand side of the
above equation represents the asset beta. Hence, we can conclude that the asset or
opportunity cost of capital is the same as the pre-tax WACC. Hence,
E D  E D
Pre - tax WACC = k e + k d = k a = rf + rp  β e + β d  = rf + rp β a
V V  V V
Q-5 Using CAPM, how would you calculate the cost of equity? Show that the levered
firm’s cost of equity requires compensation for both the business risk and the
financial risk?
A-5 The cost of equity of a levered firm is as follows:

k e = rf + rp β e
D
We know that: β e = β a + (β a − β d ) . Hence:
E
 D
k e = rf + rp β a + (β a − β d ) 
 E
The shareholders of a levered firm require compensation for both business risk
and financial risk. Hence,
Cost of equity = risk-free rate + business risk premium + financial risk premium
We can rewrite the above equation as follows to decompose risk premium into
business risk and financial risk:
D
k e = rf + rp β a + rp (β a − β d )
E
We may notice that shareholders of the levered firm demand premium equal to
rpβa for assuming the business risk and additional premium equal to rp(βa – βd)D/E
for assuming the financial risk. In the case of an unlevered firm, financial risk
premium is zero and shareholders are compensated only for the business risk.

Q-6 How is the levered firm’s cost of equity determined according to the MM
Proposition II? Is it equivalent to the cost of equity under CAPM?
A-6 According to CAPM, the cost of equity is given below:

k e = rf + rp β e
D
where β e = [β a + (β a − β d ) ]
E

under MM’s proposition II, the levered firm’s cost of equity is:

D
k e = k a + (k a − k d )
E
D D
ke = ka + ka − kd
E E
D D
= k a (1 + ) − k d
E E
D D
= (rf + rpβ a )(1 + ) − (rf + rpβ d )
E E
D D D D
= rf + rpβ a + rf + rpβa − rf + rpβ d
E E E E
 D
= rf + rp [β a + (β a − β d ) ]
E
= rf + rp β e
Q-7 What is the logic of the MM adjusted cost of capital? Can you use it as a discount
rate for evaluating an investment project?
A-7 The concept of the adjusted cost of capital is based on the MM tax-corrected
hypothesis. As the firm employs debt, it saves tax on cost of debt (interest) which
causes the overall cost of capital to decline. Two critical assumptions are that the
cash flows are perpetual and the amount of debt is fixed. The MM adjusted cost of
capital is given as follows:
D
k* = k a − Tk d
V
The MM adjusted cost of capital can be used as a discount rate for investment
project’s employing fixed debt and generating perpetual cash flows.
In case of the fixed debt ratio, which implies rebalancing of debt, the adjusted cost
of capital can be estimated using the Miles-Ezzell formula as given below:
1 + k a 
ACC = k ∗ = k a − Tk d D V  
1 + k d 
This formula is same as WACC except for the last term, (1 + ka)/(1+kd). Both
WACC and the Miles-Ezzell formula assume the fixed debt ratio and debt
rebalancing.

Q-8 How do you calculate WACC? What are its assumptions? Can you use it to
evaluate an investment proposal? Is it same as the MM adjusted cost of capital?
A-8 WACC is calculated as the average of the cost of equity multiplied by the weight
of shareholders’ equity plus the after-tax cost of debt multiplied by the weight of
debt. Remember that WACC assumes a target capital structure based on the
market values of equity and debt. WACC is given as follows:
E D
WACC = k e + k d (1 − T )
V V
The traditional approach of investment evaluation is to use free cash flows (FCF)
and WACC. FCFs are unlevered cash flows; this is accounted for through WACC
as the discount rate. WACC is the ‘levered’ cost of capital.
If the project’s risk is higher or lower than the ‘average’ risk, and/or its debt
capacity is different than the firm’s debt capacity, one cannot use the firm’s
WACC for discounting the project’s FCFs. You will have to calculate the
project’s cost of capital commensurate with its operating risk and capital
structure.
Concept of pre-tax WACC as the opportunity (or unlevered) cost of capital is
based on the MM proposition I. It assumes that financing (capital structure) does
not affect the firm’s opportunity cost of capital, ka (pre-tax WACC). When the
firm employs debt, pre-tax WACC will decline because of interest tax shield.
MM’s adjusted cost of capital accounts for this. Thus, (after-tax) WACC and
MM’s adjusted cost of capital are same.
Example: cost of equity: 20%; after-cost of debt: 8%; D/V ratio: 50%, Tax rate:
 30%.
Pre-tax WACC = 20% × (1-0.50) + 8%/(1-.3) × 0.50 = 15.7%
WACC = 20% × (1-0.50) + 8% × 0.50 = 10% + 4% = 14%
Adjusted cost of capital: 15.7% - 0.3×.1143×0.50 = 15.7% - 1.7%= 14%

Q-9 How will you calculate a project’s WACC with its unique capital structure, given
the firm’s cost of capital and capital structure data?
A-9 We could use the firm’s WACC as discount rate only for those projects that are
carbon copies of the firm. We should calculate the project’s cost of capital if its
risk and/or debt capacity is different
The following steps are involved in calculating the project’s cost of capital:
First, calculate the firm’s opportunity cost of capital (assuming that MM
Proposition I works).
Second, calculate the new cost of debt. The cost of debt may change if the capital
structure of the project changes.
Third, calculate the project’s cost of equity, as given by MM’s Proposition II,
using the opportunity cost of capital and the project’s debt-equity ratio.
Fourth, calculate the project’s cost of capital as the after-tax weighted average
cost of debt and the cost of equity:

Q-10 How does the free cash flow and WACC approach work in the project evaluation?
What are the limitations of this approach?
A-10 The free cash flow approach adjusts the effect of the interest tax shields in the
discount rate (WACC) rather than the project’s cash follows. This approach is
based on the assumption that the capital structure (debt ratio) is constant over
time. It also assumes that the project’s and the firm’s risk and capital structures
are the same. Hence, this approach will not work if the project’s and the firm’s
risk and capital structure are different, and where the project’s capital structure is
not constant.

Q-11 Does the equity cash flow approach give the same results as the free cash flow
approach in evaluating a project? Why?
A-11 The equity cash flow (ECF) approach is similar to the FCF approach and it is
based on the same assumptions. In the ECF approach the equity cash flows, which
are residual cash flows available to the equity shareholders, are discounted by the
levered cost of equity.

Q-12 What are the capital cash flows? How does the capital cash flow approach work?
How does it differ from the FCF approach?
A-12 The capital cash flow (CCF) approach is much easier to use when the project’s
debt amount is fixed and the capital structure does not remain constant. CCFs are
calculated as the free cash flows plus the interest tax shields, and they are
discounted by the project’s all-equity or opportunity cost of capital. The project’s
opportunity cost of capital depends on its business risk and is not affected by the
capital structure. In the CCF approach the effect of the interest tax shields are
adjusted in the cash flows rather than the discount rate as is done under the FCF
 approach.

Q-13 What is the adjusted present value (APV) of a project? How is it calculated? What
is the difference between the CCF approach and the APV approach?
A-13 The adjusted present value (APV) approach is an alternative approach for the
project’s evaluation. It is a flexible approach that unbundles the project’s value
into several parts. It separates the operational part from the financing effects. The
base-case NPV is calculated by discounting the free cash flows at the project’s
opportunity cost of capital. The present values of the financing effects are
calculated separately using the discount rates appropriate to the risk of these
effects. For example, the interest tax shields are treated as risky as debt. Hence,
the interest tax shields are discounted at the cost of debt. APV is the sum of the
base-case NPV (assuming no financing effect) and the value of financing effects:
APV = Base-NPV + value of interest tax shields + value of other financing effects
APV is a useful approach in the project financing where the debt is fixed and
there are several other financing effects like issue costs, investment incentives and
special tax benefits.
The APV formula under the assumption of the perpetual cash flows and the
perpetual fixed amount of debt and without other financing effects is as follows:
FCF Tk d D
APV = +
ka kd

Q-14 What principles govern the valuation of a firm? How will you calculate the value
of the firm’s equity?
A-14 The use of the DCF techniques can be extended to value a business firm. In the
valuation of a firm a financial analyst usually assumes a constant debt ratio.
The firm can be valued using FCFs and WACC. Further, the analyst assumes a
horizon period for analysis and calculates the horizon value at the end of the
horizon period. Horizon value depends on the growth prospects of the firm after
the horizon period. Thus, the value of he firm is given as follows:
H
FCFt TVH
V=∑ t
+
t =1 (1 + WACC) (1 + WACC) H
The value of equity is obtained by subtracting the outstanding amount of debt
from the value of the firm. The value of equity divided by the number of
outstanding shares gives the equity value per share.

Q-15 Why is the calculation of the terminal value critical in determining the value of
the firm? How is the terminal value calculated?
A-15 In the case of a firm, it continuously makes investments that generate revenues
and cash flows, theoretically, forever. Therefore, the financial analyst assumes a
horizon period (H) for detailed calculations of cash flows. Financial analysts or
managers make assumption of horizon period because detailed calculations for a
long period become quite intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after the horizon period without
involving detailed calculations. This value is also called as terminal value (TV).
 Thus, the value of the firm is given as follows;
H
FCFt TVH
V=∑ t
+
t =1 (1 + k 0 ) (1 + k 0 ) H
To calculate TV at the end of horizon period, we should make a reasonable
assumption regarding the growth in cash flows after the horizon period.
Generally, it is expected that after the horizon period, growth will slow down. So
a lower rate of growth is assumed. Thus, TV at period H will be as follows:
FCFH (1 + g )
TVH =
k0 − g
A common approach is to assume that growth will be zero. Then TV will be:
FCFH
TVH =
k0

There are many ad hoc methods used in practice to determine terminal value.
1. Price-earnings (P/E) ratio
2. Market-to-book value (M/B) ratio
3. Replacement cost of assets

Q-16 What is the comparative firm valuation approach? How does it work?
A-16 In the comparable companies or comparable transactions approach, key
relationships are calculated for a group of similar companies or similar
transactions as a basis for the valuation of a firm. This approach is based on the
premise that similar companies should sell for similar prices. This is a straight-
forward approach that appeals to managers and financial analysts in practice.
The following steps are involved in applying the comparative firms approach:
• Identify the comparable firms based on the criteria of similar products, size,
age, growth and profitability trends.
• For the comparable firms, calculate the firm value as a ratio of sales, EBIT,
free cash flows and market value-to-book value of assets. Sales, EBIT, free
cash flow and book value of assets are assumed as value drivers. Notice that
firm value-to-EBIT ratio is equivalent of price-earnings (P/E) ratio.
• Average the ratios of the comparable firms, and apply them to the sales, EBIT
and free cash flow data of the firm.
• Use prudent judgement in arriving at the final conclusion.

Q-17 What is the balance sheet approach to the valuation of a firm? What are its merits
and limitations?
A-17 Balance sheet (or adjusted book value) approach uses assets and liabilities
information to determine the value of the firm. Without any adjustment, the book
value of equity funds and debt funds represent the claims of investors over the
firm’s assets. Hence, the value of the firm is at least equal to the book value of its
assets. However, assets are not worth the amounts shown in the balance sheet.
They are worth more or less than the book values. Therefore, assets should be
revalued to determine the value of the firm. One approach to estimate the adjusted
book values of assets is to determine their current or replacement costs. It is
relatively easy to find out the current costs of current assets. It is quite difficult to
determine the current or replacement costs of fixed assets.
A firm is not worth the current or replacement costs of its assets only. The value
of the intangible assets like brand equity, customer loyalty, or human capital
drives the value of the firm. In practice, both tangible and intangible assets should
be valued to determine the value of the firm.
Balance sheet approach forces an analyst to estimate the true value of a business.
Book value of a firm is based on historical costs which have no relevance. The
problem with this approach is that it is quite difficult to estimate current or
replacement costs. Also, this approach does not consider the future earnings
potential of assets.