Scribd Logo
Upload

Welcome to Scribd!

  • 77 views

    Valuation Lecture I: WACC vs. APV and Capital Structure Decisions

    Uploaded by

    Juan Manuel Veron
    1. This document discusses two methods for valuing a firm - the weighted average cost of capital (WACC) method and the adjusted present value (APV) method. The key difference is that WACC incorporates the value of tax shields from debt financing into the discount rate, while APV discounts cash flows at the unlevered cost of equity and adds the present value of tax shields separately. 2. It also discusses how a firm's value is affected by its capital structure under the tradeoff theory. As debt increases, value initially rises due to tax shields but eventually falls due to costs of financial distress as bankruptcy risk grows. The optimal capital structure balances these effects.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd

    Valuation Lecture I: WACC vs. APV and Capital Structure Decisions

    Uploaded by

    Juan Manuel Veron
    77 views14 pages
    1. This document discusses two methods for valuing a firm - the weighted average cost of capital (WACC) method and the adjusted present value (APV) method. The key difference is that WACC incorporates the value of tax shields from debt financing into the discount rate, while APV discounts cash flows at the unlevered cost of equity and adds the present value of tax shields separately. 2. It also discusses how a firm's value is affected by its capital structure under the tradeoff theory. As debt increases, value initially rises due to tax shields but eventually falls due to costs of financial distress as bankruptcy risk grows. The optimal capital structure balances these effects.

    Original Title

    Valuation Lecture I

    Copyright

    © © All Rights Reserved

    Available Formats

    PPT, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    1. This document discusses two methods for valuing a firm - the weighted average cost of capital (WACC) method and the adjusted present value (APV) method. The key difference is that WACC incorporates the value of tax shields from debt financing into the discount rate, while APV discounts cash flows at the unlevered cost of equity and adds the present value of tax shields separately. 2. It also discusses how a firm's value is affected by its capital structure under the tradeoff theory. As debt increases, value initially rises due to tax shields but eventually falls due to costs of financial distress as bankruptcy risk grows. The optimal capital structure balances these effects.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    77 views14 pages

    Valuation Lecture I: WACC vs. APV and Capital Structure Decisions

    Uploaded by

    Juan Manuel Veron
    1. This document discusses two methods for valuing a firm - the weighted average cost of capital (WACC) method and the adjusted present value (APV) method. The key difference is that WACC incorporates the value of tax shields from debt financing into the discount rate, while APV discounts cash flows at the unlevered cost of equity and adds the present value of tax shields separately. 2. It also discusses how a firm's value is affected by its capital structure under the tradeoff theory. As debt increases, value initially rises due to tax shields but eventually falls due to costs of financial distress as bankruptcy risk grows. The optimal capital structure balances these effects.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 14

    Valuation Lecture I: WACC vs.

    APV and Capital Structure


    Decisions
    Financial Decisions
    Timothy A. Thompson
    Market value balance sheet

    Market value assets Market value claims

    Total enterprise value Market value claims


    Notation

    Asset or claim Required return, beta


    C = excess cash rc, βc
    A = value of projects ra, βa,reu,βeu
    (unlevered)
    D = mkt value debt rd,βd
    E = mkt value equity reL,βeL
    TS = debt tax shields rTS,βTS
    Net debt = D’ = D – C
    TEV = D – C + E
    Balance sheet mathematics
     Logic:
     LHS and RHS of B/S must be equal
     Assume that TS refers to the present value of tax sheilds net
    of costs of financial distress

    V  C  A  TS  D  E

    TEV  ( A  TS )  ( D  C )  E
    E  ( A  TS )  C  D
    Calculating the equity value of the
    firm
     Equity method
     Present value of all future cash flows to equity
     Discounted at the required return on the levered equity
    of the firm, reL, (based on levered equity beta, βeL)
     reL is greatly affected by differences in leverage
     Method buries future net debt payments into the equity
    cash flow
     Valuation by components
     E = TEV + C – D
    Valuation by components method
     Value the total enterprise value of the firm by
    discounting all the operating asset cash flows
     Discounted at either
     WACC (using the WACC method)
     Or at
     The unlevered cost of equity reU (APV method)
     What is the difference between WACC and reU?
     TAX SHIELDS
     Equity = Total enterprise value + Excess Cash –
    Market Value of Financing Obligations
    Value of investment is the present value
    of the investment’s cash flows (DCF)
     Cash flows are measured as free cash flows from
    operations
     From operations means no financing-related cash
    flows are included
     Free cash flows means after expected new investments
     When financial structure matters either
     Discount operating free cash flow at WACC
     WACC incorporates tax benefits of debt into the valuation by
    reducing the discount rate relative to reU , WACC method
     Discount operating free cash flow at r eU (gives VU)
     Then add the present value of tax benefits of debt financing
    explicitly (VL = VU + PVTS), APV method
    What about costs of financial
    distress?
     Theoretically, whatever costs of financial
    distress (COFD) have not been subtracted off
    in the operating cash flows should be
    subtracted from either method (WACC or
    APV)
     Often difficult to estimate COFD
     Good to develop intuition about what COFD are
     Understand what business likely to suffer from
    large/small COFD
    Capital Structure

     Tradeoff theory of the capital structure


     Value of the firm is a function of capital structure
    (in particular, the debt/value ratio)
     As firm levers up (from zero leverage, holding
    investments fixed) value increases due to PVTS
    (and perhaps for other reasons)
     As firm levers up, the value decreases due to
    COFD
     Want to find the happy medium!
    Tradeoff Theory of the Capital Structure
    Maximum value of firm

    Costs of
    Market Value of The Firm

    financial distress

    PV of interest
    tax shields
    Value of levered firm

    Value of
    unlevered
    firm

    Optimal amount
    of debt
    Debt
    How do you calculate PVTS?

    Simple model, Fin II


     For example in the 40% debt scenario
     Assume that the level of debt in the scenario is
    perpetual debt
    How do you calculate COFD?
     Difficult
     COFD is the present value of all future
    expected costs associated with financial
    distress
     If you did a method in Fin II, you can go ahead
    and attempt it
     You would need inputs that are not in the case, and you
    would have to look them up
     If you didn’t learn a method in Fin II
     You can try to figure out a good guess from Chapter
    17/18 of BM
    Structure of COFD

     COFD is a function of
     The probability of financial distress
     The cost of financial distress conditional on the
    firm becoming financially
     COFD could be small even if distress is likely, if the firm
    would not likely incur large costs in distress
     However, if we are pretty certain that the probability of
    distress is very small, then the above “product” is likely
    to be very small and PVTS is likely to exceed COFD
    Bond Ratings

     Investment Grade Ratings


     AAA, AA, A, BBB (S&P)
     Junk Bond Ratings
     BB, B, CCC, etc.
     If proforma bond rating (based on a certain
    capital structure) is high investment grade
     AAA or AA, maybe even high A
     Then probability of subsequent bankruptcy is very low
    (see BM) – these would very likely be safe capital
    structures

    You might also like