Chapter 18

Valuation and Capital Budgeting for the

Levered Firm

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

18-1
Chapter Outline
18.1 Adjusted Present Value Approach
18.2 Flows to Equity Approach
18.3 Weighted Average Cost of Capital Method
18.4 A Comparison of the APV, FTE, and WACC
Approaches
18.5 Valuation When the Discount Rate Must Be
Estimated
18.6 APV Example
18.7 Beta and Leverage
18-2
18.1 Adjusted Present Value 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 present value of the financing side
effects (NPVF).
 There are four side effects of financing:
 The Tax Subsidy to Debt (Tax effects)
 The Costs of Issuing New Securities (flotation costs)
 The Costs of Financial Distress (Bankruptcy costs)
 Subsidies to Debt Financing (interest subsidies)
18-3
APV Example
Consider a project of the Pearson Company.
 Cash inflows: $500,000 per year for the indefinite future
 Cash costs: 72% of sales
 Initial investment: $475,000
 Tc = 34%
 The unlevered cost of equity is R0 = 10%, the cost of
capital for a project of an all-equity firm.

18-4
APV Example
If both the project and the firm are financed with only equity, the
project’s cash flow:

18-5
APV Example
The project’s cash flow:

–$475 $ 92.4 $92.4 $92.4 $92.4

0 1 2 3 …
The unlevered cost of equity is R0 = 20%:
NPV20%  C0  PV
$92.4
NPV20%  $475   $13
(1.2)

NPV <0, the project would be rejected by an all-equity firm.

18-6
APV Example 1
 Now, imagine that the firm finances the project with
$126.229,5 debt.

 The net present value of the project under leverage is:

APV = NPV + NPVF(debt tax-shield)

0.34  $126,229.5  0.1
NPV (tax  shield )   t
t 1 (1 .1)
APV  $13  $42,918  $29,918
 So, Pearson should accept the project with debt.
18-7
APV Example 1
 Note 2: Debt ratio of the project is Debt to the
Present value of the project under leverage is .25
Debt Ratio
Debt

PV  of  project
Debt

( APV  initial investment)
126,229.5
  0.25
(29,918  475,000)
18-8
APV Example 2
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%:

 Now, imagine that the firm finances the project with

$600 of debt at RB = 8%.
 Should the firm accept the project without/with debt?
18-9
18.2 Flow to Equity Approach
 Simply discounting 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.

18-10
 Step One: Levered Cash Flows
 The perpetual cash flow to equity holders of levered firm
(LCF).

 CF to Equity holders (in Unlevered firm) – CF to

Equity holders (in Levered firm ) = is the aftertax
interest payment.
18-11
Step One: Levered Cash Flows
 Since the firm is using $126,229.5 of debt
 The remaining investment of $348,770.50
(=$475,000 - $126,229.50) is financed with equity.
The project’s cash flow to the equity holders of levered firm is:

–$348,770.5 $ 84,068.85 $ 84,068.85 $ 84,068.85 …

0 1 2 3 …

18-12
Step Two: Calculate RS
B
RS  R0  (1  TC )( R0  RB )
S

18-13
Step Three: Valuation
 Discount the cash flows to equity holders (FTE) at RS
= 22.2%

–$348,770.5 $ 84,068.85 $ 84,068.85 $ 84,068.85 …

0 1 2 3 …

$84,068.85
NPV  $348,770.5   $29,918
0.222

18-14
18.3 WACC Method
S B
RW ACC  RS  RB (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.
 Pearson’s target debt to equity ratio is 1/3
B/S = 1/3  B/(B+S) = 0.25
RWACC  (0.75)  (22.22%)  (0.25)  (10%)  (1  .34)
RWACC  18.31%
18-15
WACC Method
 To find the value of the project, discount the
unlevered cash flows (UCF) at the weighted
average cost of capital
$92,400
NPV  $475,000 
0.1831
NPV  29,918

18-16
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.
[B/(B+S) is unchanged]
 Use the APV if the project’s level of debt is known
over the life of the project (B is known).
 In the real world, the WACC is, by far, the most
widely used.
18-17
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
18-18
Summary: APV, FTE, and WACC
Which approach is best?
 Use APV when:
 The level of debt is constant
 The tax shield can be easy to forecast (e.g, in LBO,
lease-versus-buy decision with known a schedule
of debt reduction)
 Interest subsidies and flotation costs included.

18-19
Summary: APV, FTE, and WACC
Which approach is best?
 Use WACC and FTE when the target debt-to-
equity ratio is constant over project’s life
 WACC is by far the most widely used method
 FTE is a reasonable choice for a highly levered
firm

18-20
18.5 Valuation When the Discount
Rate Must Be Estimated (Without tax)
 Recall from chapter 16.
 In a world without tax:
 Cost of equity: R  R  b R  R 
S F M F

MM Proposition II: B
 RS  R0  R0  RB 
S

 Once we have R0 You can apply Propotion II for

any other B/S ratio.
B S
 Average cost of capital: RWACC  RB B  S  RS S  B
18-21
18.5 Valuation When the Discount
Rate Must Be Estimated (With tax)
 In a world with tax:
 Cost of equity:
RS  RF  b RM  RF 

 MM Proposition II: R  R  B R  R 1  t 

S 0 0 B C
S

 Once we have R0 You can apply Propotion II for

any other B/S ratio.
B S
 Average cost of capital: RWACC  RB 1  tC   RS
BS SB

18-22
 18.5 Valuation When the Discount
Rate Must Be Estimated (With tax)
EX
 Cost of Capital World-Wide Enterprises (WWE) is a large
conglomerate thinking of entering the widget business, where it
plans to finance projects with a debt-to-value ratio of 25 percent (or a
debt-to-equity ratio of 1/3).
 There is currently one firm in the widget industry, American Widgets
(AW). This firm is financed with 40 percent debt and 60 percent
equity. The beta of AW’s equity is 1.5. AW, has a borrowing rate of
12 percent, and WWE expects to borrow for its widget venture at 10
percent. The corporate tax rate for both firms is .40, the market risk
premium is 8.5 percent, and the riskless interest rate is 8 percent.
 What is the appropriate discount rate for WWE to use for its widget
venture (for the three evaluation approaches)
18-23
 18.7 Beta and Leverage:
(without tax)
 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 without corporate taxes, and with riskless
corporate debt (bDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm
and the beta of levered equity is:
Equity Debt
β Asset   β Equity β Equity  (1  )  β Asset
Asset Equity
18-24
Beta and Leverage (With Tax)
 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 Unleveredfirm
 Equity 

 Debt 

 Since 1   (1  TC )  must be more than 1 for a
 Equity 
levered firm, it follows that bEquity > bUnlevered firm
18-25
Beta and Leverage: With Corporate
Taxes
 If the beta of the debt is non-zero, then:
B
β Equity  β Unlevered firm  (β Unlevered firm  β Debt )  (1  TC )
SL

18-26
Summary
1. The APV formula can be written as:
Additional

UCFt Initial
APV   t
 effects of 
t 1 (1  R0 ) investment
debt
2. The FTE formula can be written as:

LCFt  Initial Amount 
FTE   t
   
t 1 (1  RS )  investment borrowed 

3. The WACC formula can be written as


UCFt Initial
NPVW ACC   t

t 1 (1  RW ACC ) investment 18-27
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 by far.
 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.
18-28
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?

18-29
 Quiz
Click the Quiz button to edit this object

18-30