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Corporate Finance Equations Notes 5

Week 7 focuses on investment decision rules like NPV, IRR, and payback period. The objective is to evaluate assets using capital budgeting techniques. NPV is the difference between the present value of cash inflows and outflows. Projects are accepted if their NPV is positive. IRR is the discount rate that sets NPV to zero. Projects are accepted if their IRR exceeds the cost of capital. Payback period is how long it takes to recover the initial investment but it ignores the time value of money.

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0% found this document useful (0 votes)
22 views13 pages

Corporate Finance Equations Notes 5

Week 7 focuses on investment decision rules like NPV, IRR, and payback period. The objective is to evaluate assets using capital budgeting techniques. NPV is the difference between the present value of cash inflows and outflows. Projects are accepted if their NPV is positive. IRR is the discount rate that sets NPV to zero. Projects are accepted if their IRR exceeds the cost of capital. Payback period is how long it takes to recover the initial investment but it ignores the time value of money.

Uploaded by

Sotiris Haris
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Week 7 – Investment Decisions Rules (Chapter 8)


Objective - Evaluate the value of productive assets using a range of capital budgeting techniques.
CFn= Cash flow that arrives at date n Concept - when corporations have surplus cash, they
NPV = Net present value invest in a variety of assets and that includes real asse
IRR = Internal Rate of Return like a productive assets such as developing new produ
PI = Profitability Index in the company.
R = discount rate =cost of capital And the cash flow arising from the operation of the re
assets, we will call it free cash flows and to discount f
cash flow, so we have to employ specific discount rat

The discount rate is the cost of capital:


 Cost of capital is the average of the cost of de
and cost of equity, this will be learnt in lectur
Week 10 where we learn to compute the cost
capital

Objective of investment decisions: Type of projects/investment opportunities that compa


 Investment decision is about selecting can undertake with their excess funds/capital/equity a
investment in real assets that will increase debt (loans):
the value of the firm.  1. Mutually exclusive projects:
Conventional cash flows: o Projects that compete with one anoth
 A cash flow pattern made up of an initial by accepting one, you exclude the
cash outflow that is followed by one or others.
more cash inflows o A set of projects where only one can
Unconventional cash flows: accepted
 When future cash flows include both  2. Independent projects
positive and negative cash flow o Projects whose cash flows are not
 Therefore when the sign (negative and affected by the acceptance or rejectio
positive cash flows) change more than other projects
once it is an unconventional cash flow o Therefore you look at the investment
isolation
Importance of Cost of capital (r):
 Is the discount rate that will be used to discou
cash flows arising from real assets.
 And the cost of capital it's an opportunity cos
concept, it's the minimum return that capital
budgeting projects must earn for it to be
accepted.
 And that minimum return is the opportunity c
of capital so it's reflecting the rate of return
investors can earn on financial assets of simil
risk.
 Cost of capital is the rate of return that your
investors can get elsewhere for the best
alternative asset that they have forgone.
 Method of calculating cost of capital is learnt
lecture 7
1st method of evaluating investment opportunities: Understanding NPV:
Net Present Value:  If your net present value is plus 1 million that
 Definition: The difference between the PV indicates your company's value will increase
of an investment’s benefits and the PV of 1 million by adopting that project.
its costs.  If your net present value can also be negative
 NPV = PV (Benefits) – PV (Costs) like -500,000 so that indicates that by employ
that project your firm value will decrease by
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 If you projects are: 500,000.


o If mutually exclusive, choose one
with highest + ve NPV Ads of NPV method:
o If independent, accept when  Corresponds directly to the impact of the proj
NPV > 0 on the firm’s value
 reject when NPV < 0  NPV represents the $ increase (if+) or $ decre
(if-) in the value of firm
Disadvantage of NPV method:
 Relies on an accurate estimate of the discount
rate (r)

2nd method Payback period (standard): Discounted payback period:


- Determining how long it would take to - Standard pay back period DOES NOT take in
pay back your initial outlay/the initial account the time value of money
investment - The discounted pay back period requires futu
- Rule – Select only projects that pay back cash flows to be discounted by the firm’s cost
their initial investment within a pre- capital
specified period (cut off period): - This method considers the time value of mon
o Mutually exclusive project:
Accept project with the shortest
payback period as long as it is ≤
cut-off points
o Independent project: Accept
when Payback period ≤ Payback
cut-off point
Advantages:
- Simple to compute & favours liquidity
Drawback:
- The payback rule is not as reliable as the
NPV rule because it (1) ignores the time
value of money, (2) ignores cash flows
after the payback period, and (3) lacks a
decision criterion grounded in economics.
- No guidance as to correct payback cutoff
- Lacks a decision criterion grounded in
economics
- What is the economic rationale behind the
determination of cut-off point of say 2
years?
- Ignores cash flows occurring after the
payback year
- Ignores time value of money
- Not necessarily consistent with
maximising shareholder wealth
3 method of evaluating investment opportunities:
rd
- IRR must be compared with cost of capital
Internal Rate of Return (IRR): - IRR = the average return of the project
- IRR is a unique discount rate which
makes net present value equal to zero so - Cost of capital = the rate of return that your
it's the interest rate that sets the net present investors can get elsewhere from the best
value (NPV) of the cash flows equal to alternative asset
zero, and IRR is a unique discount rate or - Rule:
rate of return which meets this condition o If independent - Choose all whose IR
- Essentially the average rate of return of cost of capital
the investment o If mutually exclusive - choose one wi
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highest IRR (>cost of capital)


Essential IRR is: -
- IRR investment rule is based on the
concept that if the return on the
investment opportunity you are
considering is greater than the return on
other alternatives (which is the cost of
capital (r)) in the market with equivalent
risk and maturity (i.e. the project’s cost of
capital), you should undertake the
investment opportunity.
- We state the IRR investment rule formally
as follows:
o Take any investment opportunity
whose IRR exceeds the
opportunity cost of capital. Turn
down any opportunity whose IRR
is less than the opportunity cost of
capital.
-
Relationship between NPV and IRR rule: Where are is an unconventional cash flows:
- For independent projects with - There would be two IRR cash flows
conventional cash flows: - You have as many IRR as the number of sign
- Both NPV and IRR lead to the same switches or reversal of signs, e.g. there are the
accept/reject decision negative outflows = 3 IRR
- If NPV > 0, then IRR must be greater than - You don’t use the result because it gives you
cost of capital different answers to accept one rate and reject
- If NPV < 0, then IRR must be smaller the other rate
than cost of capital - Therefore use the NPV method
- In such cases, it doesn’t matter whether
we use NPV or IRR Where there is no IRR:
- It is possible to have NO IRR and a positive
NPV
- But where the IRR method does not work wh
there are unconventional cashflows, therefore
just use NPV

Relationship between NPV and IRR rule:


- For mutually exclusive projects – The
NPV and IRR methods can provide
different rankings
- Cross over point – where two
- Summarise - If projects are mutually projects/investments have the same discount r
exclusive... (cost of capital) and NPV for the NPV profile
o If Cost of capital > crossover for two mutually exclusive projects
point, the two methods lead to the o At this point both investments are
same decision and there is no equally good
conflict. o Crossover point is where NPVA = NP
o If Cost of capital < crossover
point, the two methods lead to
different accept/reject decisions.
- Then which one is a better decision
criterion?
o The most weight should be given
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to NPV
o It selects the project that adds the
most to shareholder wealth
- Therefore when there is a conflict in
ranking between net present value and
IRR when cost of capital is less than
crossover point, you should use net
present value.
Downfall of IRR: - A lower IRR can be better if a cash INflow is
- IRR is a return measure therefore you followed by cash outflows.
cannot tell how much value has actually - Investment decision: Choose IRR _>__ cost o
been created without knowing the basis capital
for the return. - Loan decision: Choose IRR _<__ cost of capi
- The IRR rule is unaffected by the scale of o Here IRR will be the cost of borrowin
the investment opportunity because IRR
measures average return of the
investment.
- Another shortcoming of IRR rule? – The
IRR rule cannot be used to compare
projects with different scales.
o Therefore use the same scale (the
investment amount)
4th method of evaluating investment opportunities: Calculating PI:
Profitability Index and Summary: - NPV/Resource consumed
- When funds are limited, we must pick the - Measures NPV per $1 of investment
project that offer the highest NPV per - PI=NPV/Resource consumed ("PI > 0"
dollar of initial investment; the ratio equivalent to "NPV > 0")
known as the Profitability Index o Therefore – when you have one
- Why - when your resources are constraint, independent project the rule will be a
when you evaluate the project, you want long PI > 0
to make sure that you can maximize the - RULE for multiple independent projects: Ran
net present value per every single dollar projects according to their profitability index
that you invest based on the constrained resource and move
- Meaning of PI - every single dollar that down the list accepting value-creating project
you invest your net present value per until the resource is exhausted.
dollar is $2.10 - Steps : calculate PI
o Rearrange most beneficial projects ba
on highest PI and choose them all unt
you run out of your budget limit
(investment limit)
Where does PI fail:
- Where there is more than one constraint
(example of constrain – you can only
spend 10 M in year 0 and 10 M in year 1):
- Sometimes it is best to choose investments
that have the highest sum of the NPV
Week 8 – Fundamental of Capital Budgeting (Chapter 9)
Objective - Evaluate the value of productive assets using a range of capital budgeting techniques.
Notations: We are learning how to estimate the use of free cash
COGS = Cost of goods sold: flows which is a common feature of each investment
- COGS = Production related expenses and decision tool learnt in week 7 of:
it includes the items such as the cost of - NPV
raw materials and the cost of direct Labor. - IRR
- Revenue – COGS = Gross Profit - Payback
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CapEx – Capital Expenditure - PI


EBIT = Earnings before interest and taxes
FCFt = Free cash flow in year t
NWCt = Net working capital in year t
Tc = Corporate tax rate
r = cost of capital
Capital Budgeting Process: - Free Cash Flows = The incremental effect of
- the capital budgeting process capital is the project on a company's available cash is know
process of analysing investment as the free cash flows and we are very much
opportunities and deciding which ones to interested in computing free cash flows for ea
accept so it's the process of choosing project to assess the worthiness of that projec
value maximizing investment. - Note that accounting figures are not actual ca
- It begins with the forecast of each flows
project’s future cash flows - We learn how to convert earnings to free cash
- Incremental – means the additional cash flows:
flows produced from another asset. How o Earnings = the Accounting measure o
much the additional benefit gain from it. firms’ performance
- ONLY INCREMENTAL CASH FLOWS o We want to go from calculating the
is considered in the equation incremental earnings to obtain the
o Incremental = New minus old incremental FCF’s to use for the capi
budgeting tools such as NPV

This is the usual accounting table format to obtain


incremental earnings FCFs:
- After you obtain incremental earnings, you m
add back depreciation
- Then Minus Capex (Any investment amount
goes into long term assets that will be listed
under capex so if the company has any positiv
net present value project, and if the money
needed to be invested into it, the cost of long
term assets will go under capex.)
- Then minus the costs associated with Net
Working Capital (when you run a business, in
addition to the cost of a long term asset, you a
have to make an investment in working capita
for example, if the company runs e.g. printing
business, they will definitely need photocopie
but in addition to photocopier, which is a long
term asset, you also need papers and toners
that will be your investment in current asse
- Therefore - the cost of long term assets will g
under capex and the investment in current ass
will go under NWC networking capital.
- Final value = Incremental FCFs

OR:
 FCF = (Revenue – Costs – Depreciation) X (1- Tc) +
Depreciation – CapEx – Changes in NWC
 Note – the red highlighted does not include interest
expenses associated with debt (this is the unlevered net
profit)
o When you calculate the free cash flows you d
deduct interest expenses.
o By definition, free cash flow is supposed to b
funds available for distribution to both
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shareholders and debt holders.


o Why don’t we include interest expense?
 Short answer – we don’t use any debt for making a
capital decision, we use our own money which is not
based on any debt/financing.
 When evaluating a capital budgeting decision, however
generally do not include interest expenses. Any increme
interest expenses will be related to the firm’s decision
regarding how to finance the project, which is a separat
decision.
 Here, we wish to evaluate the earnings contributions fro
the project on its own, separate from the financing decis
Ultimately, managers may also look at the additional
earnings consequences associated with different method
financing the project. Thus, we evaluate a project as if t
company will not use any debt to finance it (whether or
that is actually the case), and we postpone the considera
of alternative financing

Or

 FCF = ( Revenue – Costs) X (1- Tc)


+ Tc x Depreciation – CapEx – Changes in NWC

Depreciation Expense - In free cash flow Net Working Capital (NWC):


computation in capital budgeting depreciation is to o It’s the amount of money that you ne
be calculated for tax purposes: to purchase/invest capital and obtain
 For the purposes of calculating FCF, you necessary current assets such as
don’t deduct the residual value from the inventory and cash for the project
asset when calculating the depreciation - The amount of money required that needs to b
expense through the straight line method invested for the project to be successful
- NWC = Current Assets – Current Liabilities =
Have to add back depreciation after Cash + Inventory + Receivables – Payables
incremental earning: - When current asset is greater than current
 Depreciation is not a cash expense that is liability it indicates the need of investment in
paid by the firm. Rather, it is a method current assets, because:
used for accounting and tax purposes to o To fund/finance current assets, you n
allocate the original purchase cost of the capital
asset over its life. Because depreciation is o When your current asset is greater tha
not a cash flow, we do not include it in the current liability it's an indication of th
cash flow forecast. need for capital that's why at the
 However, that does not mean we can beginning of the project life it has to
ignore depreciation. The depreciation entered as a negative value because it
expense reduces our taxable earnings an indication of investment in current
and in doing so reduces our taxes. assets
Taxes are cash flows, so because - Thus, whenever net working capital increases
depreciation affects our cash flows, it reflecting additional investment in working
still matters. Our approach for capital, it represents a reduction in cash flow
handling depreciation is to add it back year
to the incremental earnings to recognise -
the fact that we still have the cash flow - When firms invest in projects, firms may need
associated with it. maintain a minimum cash balance to meet
unexpected expenditures, because your future
cash flows can be quite uncertain depending o
Importance of NWC: the market condition and also the level of
Net working capital is important because it demand, so there is always uncertainty
NEED to fix up week 2

reflects a short-term investment that ties up cash associated with the future cash flows that's wh
flow that could be used elsewhere. For example, the company would like to keep some cash
when a firm holds a lot of unsold inventory or has balance as a safety cushion.
a lot of outstanding receivables, cash flow is tied - To get your project going it is necessary for th
up in the form of inventory or in the form of credit firms to make an investment in networking
extended to customers. It is costly for the firm to capital but,
tie up that cash flow because it delays the time - Those funds invested in networking capital
until the cash flow is available for reinvestment or they are recoverable so it will eventually be
distribution to shareholders. Since we know that recovered, because the money that you put
money has time value, we cannot ignore this delay into inventories, you will be able to recover
in our forecasts for the project. Thus, whenever you sell your inventories and accounts
net working capital increases, reflecting additional receivables will also be collected over time.
investment in working capital, it represents a - So to reflect that for our practical questions, w
reduction in cash flow that year. will assume that all networking capital will be
recovered in the terminal year (the last year),
we will just to make one-off adjustment in the
terminal year to recover any working capital
investment.

Having two entries:


- At the start of the year, it will be –(CA – CL)
this is the investment you have made at the st
because CA is greater than CL, therefore the
portion you investment in for more capital is
CA – CL, & then at the end of the year, you
recover it back when you sell goods and it is +
(CA – CL)

Therefore at the end of the project, you will receiv


the amount of NWC that you invested
NOTE – when you are calculating the values on
slide 19, they are the annual cash flows, & they
obviously compound like an annuity. Therefore
we need to use the annuity formula to bring the
values back to zero.
Purpose of ‘Other effects’ – When computing the incremental FCF, all changes between the firm’s free ca
flows with the project versus without the project should be considered. These include opportunities forgone
due to the project and effects of the project on other parts of the firm. In this section, we discuss these other
effects, some of the pitfalls and common mistakes to avoid, and the complications that can arise when
forecasting incremental free cash flows.
Other Effects on Incremental Free Cash Flow:
(these are things that affect your CapEx) - 3. Sunk costs:
These are factors that relate to incremental cost & o Any unrecoverable costs for which
whether they should be considered: firm is already liable:
- 1. Opportunity Cost o The cost to be incurred is newly arisi
o Define - The value a resource and you include it, if not you exclude
could have provided in its best o Remember we only care about
alternative use (what is the best INCREMENTAL?
value of the alternative use) o Sunk costs are NOT incremental with
o Value lost when the resource is respect to the current decision therefo
used by another project →An should be ignored!
Incremental Cost o Regardless of whether you go ahead
o Purpose – Opportunity Cost for a with the project or not, is the cost stil
project has to be included as an there? Then it’s the sunk cost!
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incremental cost of the project. - Examples:


o E.g. Selling the land instead of o 1# Fixed overhead expenses
building on it  Overhead expenses: Those
- 2. Project externalities expenses associated with
o Indirect effects of a project that activities that are not directly
may increase or decrease the attributable to a single busine
profits of other business activities activity but instead affect ma
of a firm different areas of corporation
o When one product displaces  They are sunk cost because,
another product = cannibalisation regardless of whether you
o The lost sales of the existing produce a new product or not
product is an incremental cost it's those costs will have been
a newly arising cost when the incurred anyway and it's not
project goes ahead, therefore, it newly arising with the
should be included as cash production of a new product
outflow. under consideration.
o Are there any ADDITIONAL overhe
expenses that arise? Then Include!
 If you are going to hire a new
supervisor for a new product
then that salary will be an
incremental cost
o The cost has to be newly arising to be
considered
o 2# Past research and development
expenditure:
 E.g. developing a new drug a
you invested a lot of money i
past research and developmen
expenditure and that's not goi
to influence, whether you are
going to develop this new dru
or not, because it's not newly
arising cost it's the sunk cost.
- 4. Cash flows from sales of assets
o As a result of liquidation or salvage
value of the assets e.g. Cash inflow
arising from sales of old asset
o We must include liquidation value of
any assets that are no longer needed o
disposed of.
o Capital gain = Sale price – Book valu
o (If Book value > Sale price, then
negative capital gain(= Capital loss))
o Book value = Purchase price –
Accumulated depreciation
 (where accumulated
depreciation = annual
depreciation*age of the asset
o After-tax cash flow from asset sale (y
have to pay tax when you sell with a
gain or when you make a loss, you ca
save on tax (& your sale price will go
up))
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o = Sale price – (Tax rate x capital gain


o = Sale price + (Tax rate x capital loss
- When do you do these type of calculations?
o Normally this type of calculation sho
take place twice at the year zero and i
the terminal year.
o So the sales of the assets will influenc
the account capex.
 CapEx is new - old
o At year zero and year n terminal year
please keep in mind incremental, so i
year zero when old asset is to be
replaced by new machine.
o You use the calculations at year 0 a
year 1 when you sell an old asset fo
new one,
 At year 0, you figure out th
value of selling the old
machine, and find the
incremental value of the ne
machine (the trade in
difference)
 At the terminal year (e.g. ye
1), you will assume that you
will be able to sell the new
machine.
 And also, you have to consi
that what value would you
have received if you had sol
old machine instead of new
machine yeah.
 So you have to do, new min
old so you will get after tax
cash flows from the sales fr
both the new and old, and y
will take the difference and
you are only interested in
incremental after tax cash
flows from the sales of the
assets.
Remember that the definition of Free Cash flows is: F
= Cash flows for distribution to both Shareholder and
Debtholders after a firm has made investments in long
term assets and working capital
NOTE ORDER OF CONVERTING EARNINGS Note the converting table only concerns incremental
TO Free cash flows is not in formula sheet, values
therefore you have to memorise it.
Once you have completed the table, you can use
the formulas such as NPV to calculate present
value
Week 9 – Cost of capital (Chapter 13):
Objective – Learning how to calculate weighted average cost of capital, which is the appropriate discount r
for free cash flows. In week 8 we only had an assumed or given rate
Purpose - Most firms draw on some combination of equity, debt and other securities to raise the funds they
NEED to fix up week 2

need for investment. In this section, we examine the role of financing sources in determining the firm’s
overall cost of capital. We begin by stepping back to assess these financing sources in the context of the
firm’s balance sheet. the firm’s capital structure. A firm’s sources of financing, which usually consist of de
and equity, represent its capital . The typical firm raises funds to invest by selling shares to shareholders (it
equity) and borrowing from lenders (its debt).

Capital = A firm’s sources of financing, which usually consist of debt and equity

Notations: - WACC We can also call it weighted average


 rWACC = Weighted average cost of capital of capital or weighted average of cost of equi
 rD = required return (cost of capital) for debt and cost of debt
 rE = required return (cost of capital) of levered equity - WACC should reflect the level of cost of deb
 rp = required return (cost of capital) for preference shares and cost of equity that's why it's got the term
 D%, E%, P% =Fraction of the firm financed with debt, weighted average in front, it is therefore a
ordinary shares and preference shares blended version of determining the rate of fre
 PE = price of ordinary shares cash flows for the cost of equity and cost of d
 Pp= price of preference shares
 Divp= dividend on preference shares
 FCFt =Incremental free cash flow in year t

 Tc = marginal corporate tax rate

Homemade notations
 DH = Debtholders
 SH = (Ordinary) Shareholders
 PSH = Preference Shareholders

Why WACC/cost of capital is important: Looking at definition of Free Cash Flows again:
- For IRR determination as: - They are distributable cash flows or ready to
o Accept if IRR > Cost of Capital distribute cash flows after a company has mad
o Reject if IRR < Cost of Capital an investment in new project via Capex and
- & for the calculation of profitability index NWC
you divide net present value by the - So after the company has made an investmen
resource consumed, which is $5 so your long term assets and networking capital and a
WACC is embedded in the calculation of leftover cash flow is now ready to be distribu
net present value so to all types of investors to either debtholders (
coupons), ordinary or preference shareholders
(as dividends)
- Therefore because of the different nature of c
flows involved to discount those cash flows, y
have to employ different types of discount rat
o For coupons you will need cost of de
and for ordinary shares you will need
cost of equity and for preference shar
you will need cost of preference share
- Therefore for Free Cash flows because they a
take into account the different cost of capital
rates we need to know how to calculate each o
these rD, rE & rP
Intuition behind rWACC: - The average of the company's equity and deb
- When investors buy the shares or bonds of cost of capital weighted by the fractions of th
a company they forgo the opportunity to company's market value that corresponds to
invest that money elsewhere, so there equity and debt respectively
exist opportunity costs and the expected o So your WACC will be the weighted
return from those alternative investment average of cost of equity and cost of d
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constitutes an opportunity cost to them. if the company has preference shares


- Therefore, to attract their investment as a
capital to the firm, the firm must offer rWACC for Unlevered firm:
potential investors as an expected return - Does not have debt outstanding
equal to what they could expect to earn - Capital = Equity
elsewhere for assuming the same level of - Therefore Cost of Capital for unlevered firm =
risk. Cost of equity
- So the opportunity cost constitutes the
rate of return that your investors could
have earned from the best alternative asset rWACC for levered firm:
they have forgone. - Has Debt outstanding (therefore debt emerges
- Therefore cost of capital is – an - Pre-tax rWACC = (Fraction of firm value finance
opportunity cost concept and to attract by equity) * rE + (Fraction of firm value finan
their investment as a capital to the firm the by debt)* rD
company must be able to offer the - Therefore for unlevered firm WACC will be
potential investors, the minimum rate of cost of equity and for levered firm, cost of
return that your investors would require capital will be the weighted average of rE and
by investing in your firm
- Providing this return is the cost the Impact of Tax on
company bears in exchange for obtaining - Consistency principle
capital from the investors, so if the o Before-tax CFs to be discounted by
company cannot provide this minimum Before-tax rWACC – After-tax CFs to be
return, it will be difficult for firms to discounted by After-tax rWACC
retain that capital. - After-tax CFs =Before-tax CFs * (1-Tc)
- Cost of debt (rD)
Cost of debt capital: o rD is the before-tax cost:
 A firm’s cost of debt is the interest rate it  Cost of debt remember when
would have to pay to refinance its existing interest is paid interest is paid
debt, such as through new bond issues. before tax is paid therefore
 Tax - The difference arises because interest expense is tax
interest paid on debt is a tax-deductible deductible.
expense. When a firm uses debt financing, o To make it after-tax, multiply it by 1-
the cost of the interest it must pay is offset hence rD * (1-Tc)
to some extent by the tax savings from the
tax deduction. - Cost of equity(rE)
 o rE is the after-tax cost:
 Cost of equity dividends are
out of taxed profits and there
rE by default is the after tax
cost.
o To make it before-tax, divide it by 1-
hence rE/(1-Tc)

How to compute rE , rD & rP to compute WACC: Computing rE:

Computing rD:  1st Method via CAPM:


 rD is a new term for y, yield to maturity so o E[Ri]=rf+ßi(E[Rmkt]-rf]) =rE
it's the yield to maturity or cost of debt  2nd Method via Constant div growth model:
that you learnt in bond valuation, but o P = Div1/rE - g
E
simply we use different notation for cost
o Rearrange constant div growth model to make
of capital topic the subject
 Note – cost of debt (rD) is before tax Div1/PE +
o rE = g
 In the bond valuation formula, y = rD , you
Computing rP:
will not be asked to calculate y, but it is  Dividends are fixed & can be perpetual:
NEED to fix up week 2

important to know that y is the  Pp Divp / rp


=
compounding yield to maturity (YTM)
o Rearrange perpetual formula model to make r
 You must then convert the rate to an subject. For Divp it is similar to calculating
annual pre-tax rD because interest rates are coupon rate
annual using the APR formula, note when  rp Div p / Pp
you are giving a compounding period rate, =
you don’t have to divide by m, because 
the rate could be semi-compounding
already, therefore you would square it by
2
 Then convert it to after tax rate

Calculating rWACC:
- WACC is what you need for the use of Prerequisite in calculating P% (must calculate the tota
investment decision making tools like net market value of the firms debt) = current share price x
present value IRR discounted payback shares outstanding
period and profitability index.
RWACC = rE E% + rp P% + rd (1− T)D% Prerequisite in calculating E% (must calculate the tota
 Part of it is calculating the weighted market value of the firms debt) = current share price x
average of the costs of e.g. debt from the shares outstanding
three sources. E.g D%
 Perquisite in calculating D% weighted Then input everything into RWACC formula (Reference
average of the costs of e.g. debt from the slides 24 -28 of week 9)
three sources. E.g D%:
 For this you need the total value of the
firms debt: Therefore plus the value of
each source of debt to get the ‘total
market value of the firm’s debt” for e.g. rD
and then get the fraction of each source of
debt over the total market value and add
them together to get the total weight for
each component e.g. rD
 Note for rD the weight, it is the pre-tax
cost of debt, therefore it will need to be
converted to after tax
There are three conditions that need to be met to 2. Assumption 2 - Constant debt-equity ratio
use a company’s WACC as a discount rate for a  The company will maintain a constant debt to
new project: equity ratio remember in addition to the cost
1. Assumption 1 – Average risk: itself the WACC contains the weightings D%
 The market risk or systematic risk of the % and P%, and you have to make sure that th
project, should be comparable to the debt to equity ratio will be maintained.
average market risk of the company's  When the new project is employed.
existing investments.  This policy determines the amount of debt
 So you have to make sure that systematic company will take on when it accepts a new
risk, beta, is comparable, otherwise the project, so it doesn't mean that you can't incre
higher risk, it should be followed by a the debt.
higher discount rate.  But for you to maintain debt to equity ratio w
 Therefore, to start with, you have to make debt is raised the equity will have to be raised
sure that the systematic risk of the new as well, so that you can maintain the debt to
project is comparable to the average equity ratio.
market risk of the company's the existing  It also implies that the risk of the company's
investment so that the level of WACC is equity and debt therefore its rWACC will not
appropriate to reflect the level of risk fluctuate as leverage changes, so having the
inherent in the new project. constant debt to equity ratio will make sure th
NEED to fix up week 2

 The WACC will not fluctuate as leverage


3. Assumption 3 - Limited leverage effects: changes because your D% and E% are
(leverage = the ratio of a company's loan capital maintained.
(debt) to the value of its ordinary shares (equity)) Other stuff to add?
 The side effect of leverage (financial
distress) is not significant at the level of
debt chosen.
 So you will have to make sure that your
rD can be maintained and if newly
employed debt will significantly increase
the financial distress of the firm, that
means your rD may not be no longer
appropriate
 So this will make sure that the new
leverage / new debt will not be significant
at the level of debt chosen so that your rD
can be maintained, therefore, so is your
WACC.

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