a


|
  

  
   

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Key Concepts and Skills
º Understand the effects of leverage on the
value created by a project
º 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 Capital Budgeting When the Discount Rate Must
Be Estimated
18.6 APV Example
18.7 Beta and Leverage
18-2
18.1 Adjusted Present Value Approach




º The value of a project to the firm can be
thought of as the value of the project to an
unlevered firm (
) plus the present value
of the financing side effects (
).
º There are four side effects of financing:
The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing 18-3
APV Example
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 0 = 10 :
$125 $250 $375 $500

10% U$1,000

2

3


1 10 1 10 1 10 1 10 4

10% U$5 50
The project would be rejected by an all-equity firm: 
< 0. 18-4
APV Example
º Now, imagine that the firm finances the project with
$600 of debt at  = 8 .
º Pearson¶s tax rate is 40 , so they have an interest
tax shield worth r  = .40×$600×.08 = $19.20
each year.
À The net present value of the project under leverage is:





 
Î
 

 
 
ö V
V   


l

 
  l 
À So, Pearson should accept the project x

. 18-5
18.2 Flow to Equity Approach
º Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, 
.
º There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows (LCFs)
Step Two: Calculate 
.
Step Three: Value the levered cash flows at 
.

18-6
Step One: Levered Cash Flows
º Since the firm is using $600 of debt, the equity
holders only have to provide $400 of the initial
$1,000 investment.
º Thus, 0 = ±$400
º Each period, the equity holders must pay interest
expense. The after-tax cost of the interest is:
× ×(1 ± r ) = $600×.08×(1 ± .40) = $28.80

18-7
Step One: Levered Cash Flows

3 $375 ± 28.80 4 $500 ± 28.80 ± 600

2 $250 ± 28.80
1 $125 ± 28.80
ù 400 $96.20 $221.20 $346.20 ±$128.80

0 1 2 3 4

18-8
Step Two: Calculate 



 1 U   U 


To calculate the debt to equity ratio, , start with



Î


 


 



         
   Î

V
  V

= $943.50 + $63.59 = $1,007.09

= $600 when
= $1,007.09 so
= $407.09.

$600
u l .10
1 .40 .10 .0 l 11.77
$407.09 18-9
Step Three: Valuation
º Discount the cash flows to equity holders at 
=
11.77
±$400 $96.20 $221.20 $346.20 ±$128.80

0 1 2 3 4

. 1. . 1 .

U


U
1.1177 1.1177 1.1177 1.1177

.

18-10
18.3 WACC Method


aa

 1 U a



º To find the value of the project, discount the
unlevered cash flows at the weighted average cost of
capital.
º Suppose Pearson¶s target debt to equity ratio is 1.50

18-11
WACC Method


å l
å lÔ

å

å
l l l   l 
l Î





å
 å
Ô

aa
 11  8  1U
aa
8

18-12
WACC Method
º To find the value of the project, discount the
unlevered cash flows at the weighted average
cost of capital

1
 
3



U 1,
1 8 1 8  1 83 1 8 Î


7.58 = $6.68

18-13
18.4 A Comparison of the APV, FTE,
and WACC Approaches
º All three approaches attempt the same task:
valuation in the presence of debt financing.
º Guidelines:
Use ‰ or r
if the firm¶s target debt-to-value
ratio applies to the project over the life of the project.
Use the 
if the project¶s level of debt is known
over the life of the project.
º In the real world, the ‰ is, by far, the most
widely used.
18-14
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion

Cash Flows Ñ  Ñ   

Discount Rates 0 ‰ 

PV of financing
effects Yes No No
18-15
Summary: APV, FTE, and WACC
Which approach is best?
º Use 
when the  of debt is constant

º Use ‰ and r
when the debt 

 is
constant
‰ is by far the most common
r
is a reasonable choice for a highly levered
firm

18-16
18.5 Capital Budgeting When the
Discount Rate Must Be Estimated
º A project is one where the project is
similar to those of the existing firm.
º In the real world, executives would make the
assumption that the business risk of the non-scale-
enhancing project would be about equal to the
business risk of firms already in the business.
º No exact formula exists for this. Some executives
might select a discount rate slightly higher on the
assumption that the new project is somewhat riskier
since it is a new entrant.
18-17
18.7 Beta and Leverage
º Recall that an asset beta would be of the
form:

    3

sset l
ı ar et

18-18
Beta and Leverage: No Corporate Taxes
º In a world without corporate taxes, and with 2



corporate debt (RDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm
and the beta of levered equity is:
quity
sset l quity
sset
À In a world without corporate taxes, and with 2

corporate debt, it can be shown that the relationship
between the beta of the unlevered firm and the beta of
levered equity is:
ebt quity
ȕ sset l áȕ ebt
áȕ quity
sset sset
18-19
Beta and Leverage: With Corporate
Taxes
º 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:
 ebt

quity l 
1  quity 1 a ww nlevered firm

 ebt

À Since 1  1U a ww must be more than 1 for a
 Equity
levered firm, it follows that REquity > RUnlevered firm

18-20
BaaLag:WhCopoa
Taxs
º If the beta of the debt is non-zero, then:
Ô
 l 
      á
@

18-21
Summary
1. The APV formula can be written as:

A itional
V nitial

 V
effects of U
V
1 1  in estment
ebt
2. The FTE formula can be written as:

 V  

  

 
 V
U  U ww
V
  u  
  



3. The WACC formula can be written as

 



V

 l V
V l 

 
  18-22
Summary
4 Use the WACC or FTE if the firm's target debt to
value ratio applies to the project over its life.
À WACC is the most commonly used by far.
À 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.
À 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.
18-23
Quick Quiz
º Explain how leverage impacts the value
created by a potential project.
º Identify when it is appropriate to use the APV
method? The FTE approach? The WACC
approach?

18-24