Corporate Finance

Questions and Practice problems_Chapter 18

Chapter 18:
Concept questions (page 574 textbook): 2, 3, 4

2. WACC and APV What is the main difference between the WACC and APV
methods?

The difference between APV and WACC is in the details of their execution,
and how they account for the value created or destroyed by financial
decisions, as opposed to operations. APV incorporates the value of the
interest tax shield generated from debt financing directly, rather than by
adjusting the discount rate, as in the WACC method.

3. FTE What is the main difference between the FTE approach and the other
two approaches?

The main difference between the Flow to Equity (FTE) approach and the
other two approaches, Adjusted Present Value (APV) and Weighted Average
Cost of Capital (WACC), lies in how they handle the valuation of a project or
firm, particularly in relation to debt and taxes.

1. Flow to Equity (FTE):

o Focus: Calculates the cash flows available to equity holders after
accounting for debt payments.
o Discount Rate: Uses the cost of equity to discount these cash
flows.
o Application: Best used when the firm’s leverage is expected to
change over time.
2. Adjusted Present Value (APV):
o Focus: Separates the value of the project into the value if it were
all-equity financed (unlevered value) and the value of the tax
shield from debt.
o Discount Rate: Uses the unlevered cost of capital for the
project’s cash flows and the cost of debt for the tax shield.
o Application: Useful when the project’s debt level is expected to
change significantly over time1.
3. Weighted Average Cost of Capital (WACC):
o Focus: Calculates the overall cost of capital, weighting the cost
of equity and the cost of debt by their respective proportions in
the firm’s capital structure.
o Discount Rate: Uses this weighted average to discount the
project’s cash flows.
 o Application: Suitable when the firm’s debt-to-equity ratio is
expected to remain constant12.

In summary, while FTE focuses on equity holders and uses the cost of equity,
APV separates the project’s value into unlevered value and tax shield, and
WACC combines the costs of equity and debt into a single discount rate.
Each method has its own advantages depending on the specific financial
structure and expectations of the project or firm.

4. Capital Budgeting
You are determining whether your company should undertake a new project
and have calculated the NPV of the project using the WACC method when
the CFO, a former accountant, notices that you did not use the interest
payments in calculating the cash flows of the project. What should you tell
him? If he insists that you include the interest payments in calculating the
cash flows, what method can you use?

When using the WACC method to calculate the Net Present Value (NPV) of a
project, interest payments are not included in the project's cash flows. This is
because the WACC already accounts for the cost of debt, including the tax
shield from interest payments, in the discount rate. Therefore, including
interest payments in the cash flows would result in double-counting the cost
of debt.
 Explanation:
The WACC method incorporates the cost of debt and the tax shield
benefits directly into the discount rate. This means that the cash flows
used in the NPV calculation should be unlevered, i.e., they should not
include interest payments. The WACC reflects the blended cost of
capital from both equity and debt, making it unnecessary to adjust the
cash flows for interest expenses
 If the CFO insists on including the interest payments in the cash flows
 can use the Adjusted Present Value (APV) method instead.
- Definition: The APV method separates the value of the project into its base
value (assuming it is financed entirely by equity) and the value of financing
effects (such as tax shields from debt).
- Usage: First, calculate the NPV of the project's unlevered cash flows
(excluding interest payments). Then, add the present value of the tax shields
from the interest payments to this unlevered NPV.

Questions and Problems (page 575 textbook): 3, 5, 8

3.FTE
Milano Pizza Club owns three identical restaurants popular for their specialty
pizzas. Each restaurant has a debt–equity ratio of 40 percent and makes
interest payments of $41,000 at the end of each year. The cost of the firm’s
levered equity is 19 percent. Each store estimates that annual sales will be
$1.3 million; annual cost of goods sold will be $670,000; and annual general
and administrative costs will be $405,000. These cash flows are expected to
remain the same forever. The corporate tax rate is 40 percent.
a. Use the flow to equity approach to determine the value of the company’s
equity.
b. What is the total value of the company?

a. Value of the Company’s Equity

Step 1: Calculate the annual net income:
 Sales: $1,300,000
 Cost of Goods Sold (COGS): $670,000
 General and Administrative Costs: $405,000
 Interest Payments: $41,000
 Tax Rate: 40%
Operating Income = EBIT = Sales – COGS – General and Administrative
Costs
 EBIT = 1,300,000 – 670,000 – 405,000 = 225,000
Net Income = (EBIT – Interest) x (1- Tax Rate) = (225,000 – 41,000) x (1 –
0.40) = 110,400

Step 2: Calculate the annual cash flow to equity:

Net Income: $110,400

Interest Payments: $41,000 (since interest is a cash outflow that equity
holders do not receive)
Cash Flow to Equity = Net Income + Interest Payments = 110,400 + 41,000
= 151,400

Step 3: Determine the value of the company’s equity using the cost
of levered equity (19%):

¿ 151,400
Value of Equity = CF ¿ Equity = =797,894.74
Cost of Levered Equity 0.19

b. Total Value of Company

Step 1: Calculate the value of the debt:
 Debt-Equity Ratio: 40%
 Value of Equity: $797,894.74
Value of Debt = Debt-Equity Ratio x Value of Equity = 0.40 x 797,894.74 =
319,157.89
Step 2: Calculate the total value of the company:
Total Value of company = Value of Equity + Value of Debt = 797,894.74
+319,157.89 = 1,117,053
5.Beta and Leverage
North Pole Fishing Equipment Corporation and South Pole Fishing Equipment
Corporation would have identical equity betas of 1.10 if both were all equity
financed. The market value information for each company is shown here:

The expected return on the market portfolio is 10.9 percent, and the risk-free
rate is 3.2 percent. Both companies are subject to a corporate tax rate of 35
percent. Assume the beta of debt is zero.
a. What is the equity beta of each of the two companies?
b. What is the required rate of return on each of the two companies’ equity?

a. The equity beta of each of the two companies

 Unlevered beta = β U = 1.10

 Corporate tax rate (T) = 35%
 Beta of debt = β D = 0
D
The levered beta = β L =β U ×[1+(1−T ) ×
]
E
North Pole Fishing Equipment Corporation:
 Debt (D) = $2,900,000
  Equity (E) = $3,800,000
 Debt-to-Equity ratio = D/E = 0.7632

β L , North=1.10 ×[1+(1−0.35)× 0.7632]=1.10 ×[1+ 0.4961]≈ 1.6457

South Pole Fishing Equipment Corporation:
 Debt (D) = $3,800,000
 Equity (E) = $2,900,000
 Debt-to-Equity ratio = 1.3103

β L , South=1.10 ×[1+(1−0.35)×1.3103]=1.10×[1+0.8517 ]≈ 2.0369

b. Required Rate of Return on Each Company’s Equity

The required rate of return can be calculated using the Capital Asset Pricing
Model (CAPM):

R E=R F + β L ×(RM −RF )

Risk-free rate = RF = 3.2%

Expected return on the market portfolio = RM = 10.9%
Market risk premium = RM - RF = 10.9% - 3.2% = 7.7%

North Pole Fishing Equipment Corporation:

R E , North =3.2 %+1.6457 ×7.7 %=3.2 %+12.67 % ≈15.87 %

South Pole Fishing Equipment Corporation:

R E , South=3.2 %+ 2.0369× 7.7 %=3.2 %+15.68 % ≈ 18.88 %

8. WACC
National Electric Company (NEC) is considering a $45 million project in its
power systems division. Tom Edison, the company’s chief financial officer,
has evaluated the project and determined that the project’s unlevered cash
flows will be $3.1 million per year in perpetuity. Mr. Edison has devised two
possibilities for raising the initial investment: Issuing 10-year bonds or
issuing common stock. NEC’s pretax cost of debt is 6.9 percent, and its cost
of equity is 10.8 percent. The company’s target debt-to-value ratio is 80
percent. The project has the same risk as NEC’s existing businesses, and it
will support the same amount of debt. NEC is in the 34 percent tax bracket.
Should NEC accept the project?

Calculate the Weighted Average Cost of Capital (WACC):

Given:
 Cost of debt (pretax) = 6.9%
 Cost of equity = 10.8%
 Debt-to-value ratio = 80%
  Tax rate = 34%
The after-tax cost of debt is:

Calculate the Present Value of Perpetual Cash Flows:

Given:
 Unlevered cash flows = $3.1 million per year
 WACC = 5.8032%
The present value of perpetual cash flows is:

Calculate the NPV:

Given:
 Initial investment = $45 million
The NPV is: