ADVANCED VALUATION

THREE MAIN METHODS FOR CAPITAL BUDGETING WITH LEVERAGE AND MARKET IMPERFECTION:
1) WACC,
2) APV
3) FLOW-TO-EQUITY (FTE)

We address how the financing decision of the firm can affect both the cost of capital and the set of
cash flows that we ultimately discount.

While their details differ, when appropriately applied each method pro- duces the same estimate of an
investment’s (or firm’s) value

We can include the value of this tax shield in the capital budgeting decision in several ways.

1)First, we can use the WACC method, in which we discount the unlevered free cash flows using the
weighted-average cost of capital, or WACC. Because we calculate the WACC using the effective after-
tax interest rate as the cost of debt, this method incorporates the tax benefit of debt implicitly
through the cost of capital.

2) Alternatively, we can first value a project’s free cash flows without leverage by discount- ing them
using the unlevered cost of capital. We can then separately estimate and add the present value of the
interest tax shields from debt. This method, in which we explicitly add the value of the interest tax
shields to the project’s unlevered value, is called the adjusted present value (APV ) method

3) Rather than value the firm based on its free cash flows, we can also value its equity based on the
total payouts to shareholders. The flow-to-equity (FTE) method, introduced in Section 18.4, applies
this idea to value the incremental payouts to equity associated with a project.

SIMPLIFYING ASSUMPTION:

1) The project has average risk. We assume initially that the market risk of the project is
equivalent to the average market risk of the firm’s investments. In that case, the project’s cost
of capital can be assessed based on the risk of the firm. is likely to fit typical projects of firms
with investments concentrated in a single industry.

2) The firm’s debt-equity ratio is constant. Initially, we consider a firm that adjusts its lever- age to
maintain a constant debt-equity ratio in terms of market values. This policy determines the amount of
debt the firm will take on when it accepts a new project. It also implies that the risk of the firm’s equity
and debt, and therefore its weighted average cost of capital, will not fluctuate due to leverage changes.
This assumption reflects the fact that firms tend to increase their levels of debt as they grow larger; some may
even have an explicit target for their debt-equity ratio
 3) Corporate taxes are the only imperfection. We assume initially that the main effect of leverage on
valuation is due to the corporate tax shield. We ignore personal taxes and issuance costs, and we assume
that other imperfections (such as financial distress or agency costs) are not significantly affected by the
investment decision. For firms without high level of debt the interest rate tax shield is likely to be the
most important market imperfection affecting capital budgeting decision.

THE WACC METHOD

FREE-CASH-FLOW (FCF) : measures the after-tax cash flow of a project be- fore considering how it is financed

Because interest is tax deductible, leverage reduces the firm’s total tax liability, enhancing its value.

The WACC method takes the interest tax shield into account by using the after-tax cost of capital as the discount rate.

When the market risk of the project is similar to the average market risk of the firm’s investments, then its cost of
capital is equal to the firm’s weighted average cost of capital (WACC).

For now we assume that the D/E is costant so the WACC too.

Because WACC include the tax savings from debt we can compute the LEVERED value of an investment, which is the
value including benefit of interest tax shield, given the firm leverage policy by discounting FCF by WACC.

To summarize, the key steps in the WACC valuation method are as follows:
 1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital using Eq. 18.1.
3. Compute the value of the investment, including the tax benefit of leverage, by dis- counting the free cash flow of
the investment using the WACC.

The WACC can be used as cost of capital for new investments valuation if they have comparable risk to the rest of the
firm and if they not alter the firm D/E.

Thus far, we have simply assumed the firm adopted a policy of keeping its debt-equity ratio constant.
In fact, an important advantage of the WACC method is that you do not need to know how this leverage policy is
implemented in order to make the capital budgeting decision.

Keeping the debt-equity ratio constant has implications for how the firm’s total debt will change with new
investment.

For example, Company X currently has a debt(net debt)-equity ratio of 300/300 = 1 or, equivalently, a debt-to-value
ratio [D/(E + D )] of 50%. To maintain this ratio, the firm’s new investments must be financed with debt equal to 50%
of their market value. By undertaking the Project X, Company X adds new assets to the firm with initial market value
V L0 = $70.73 million. Therefore, to maintain its debt-to-value ratio, Company X must add 50% * 70.73 = $35.365
million in new net debt. By reducing cash or by borrow increasing net debt. For ex, spend its cash= $20 million
borrowing an additional $15,365. If net debt was 300 = Debt-20 Debt=300+20=320
The cost of the project(capex) is only $29 so Company X pay $35,365-$29 as dividend to shareholders.
The market value of Firm X equity increases by 335.365 - 300 = $35.365 million. (670,73 asset -335,365 debt
=335,365 equity )
Adding the dividend of $6.365 million, the shareholders’ total gain is 35.365 + 6.365 = $41.73 million, which is exactly
the NPV we calculated for the RFX project.

Balance Sheet with project

ASSET. LIABILITIES

Cash 0 Debt 335,365 (320+15,365)

Existing Assets 600. Equity 335,365
Project X 70,73
------------------------------- --------------------------------
670,73 670,73
DEBT CAPACITY : An investment debt capacity is the amount of debt at each time that is required to maintain the
firm’s D/E or D/D+E .
We compute the value levered at each time t and apply the target D/D+E (d).

Dt = d * V Lt
Where VL t = (FCF t+1 + VL t+1) / (1+wacc)

VL t+1 is the value of the FCF in t+2 and beyond

THE APV METHOD

Determine the levered value by first calculating the unlevered value and then adding the npv of interest tax shield.

The FCF is discounted by the Pre-Tax WACC (unlevered cost of capital) , the required return for hold the entire firm (both
debt and equity). Consider that the WACC pre-tax depend only on the firm overall risk so as long as the leverage does not
affect the overall risk the WACC does not change whether is leverage or not.

Assumption: The overall risk of the firm is independent of the choice of leverage.  holds in perfect market or when the
risk of tax shield is the same of the overall firm  the tax shield does not change the risk of the firm.

The tax shield of the firm have the same risk as the firm if the firm maintains a target leverage D/E ratio the target
means that the firm adjust its debt proportionally to the project value or its cash-flow.  so if the value increase the debt
increase  tax shield increase  same risk of the overall firm means same cost of capital

WACC ( include the tax benefit) < Sometimes the pre-tax WACC (unlevered cost of capital) < Cost of equity (includes the
financial risk of leverage)

The unlevered value of the firm does not include tax shield representing a 100% Equity financed firm.

Given the debt capacity of the project/firm, we can estimate the interest payments and the tax shield

Interest paid in year t = rD * Dt - 1

Tax Shield = Interest paid in year t * Corporate tax rate tc .

When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s
cash flows, so they should be discounted at the project’s unlevered cost of capital

The tax shield at each year is discounted by the cost of capital unlevered (pre-tax wacc) as the unlevered cash flow

At the end we sum the NPV of the Tax shield to the Unlevered Value

V L = V U + PV (interest tax shield)

rU =0.50*10.0%+0.50*6.0%=8.0%

21/1,08 21/1,08^2 21/1,08^3 21/1,08^4

VU = + + + =$69.55million

0.53/1,08 0.41/1,08^2 0.28/1,08^3 0.15/1,08^4

PV (interest tax shield) = + + + = $1.18 million

V L = V U + PV (interest tax shield) = 69.55 + 1.18 = $70.73 million

Given a Capex of $29

The NPV levered of the project is $70.73 - $29 = $41,73

Summary:

1. Determine the investment’s value without leverage, V U, by discounting its free cash flows at the
unlevered cost of capital, rU. With a constant debt-equity ratio, rU may be estimated using Eq. 18.6.
2. Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield: Given expected debt Dt on date t, the

interest tax shield on date t + 1 is tc rD Dt .7

b. Discount the interest tax shield. If a constant debt-equity ratio is maintained,
 using rU is appropriate.

3. Add the unlevered value, V U, to the present value of the interest tax shield to de-

termine the value of the investment with leverage, V L.

Thus, we need to know the debt level to compute the APV, but with a constant debt-equity ratio we need to
know the project’s value to compute the debt level.

It can be easier to apply than the WACC method when the firm does not maintain a constant debt-equity ratio.

Byt the leverage value we compute the debt capacity each year. We should know the debt capacity each year to
compute the interest payment each year and so the interest tax shield which is discounted by the unlevered cost
of capital

DEBT CAPACITY : An investment debt capacity is the amount of debt at each time that is required to maintain the
firm’s D/E or D/D+E .
We compute the value levered at each time t and apply the target D/D+E (d).

Dt = d * V Lt
Where VL t = (FCF t+1 + VL t+1) / (1+wacc)

VL t+1 is the value of the FCF in t+2 and beyond

Two alternative leverage policy than the constant D/E:

- Constant interest coverage

- Predetermined debt levels.

THE FLOW-TO-EQUITY METHOD

In WACC and APV methods we value a project based on its FCF (FCFO)
which ignored interest and debt payments.

In FTE method we compute the free-cash-flow available to shareholders

after taking into account all payments to and from debtholders (interests,
debt repayment, debt issuance).

The FTE is discounted using the equity cost of capital.

The interests expenses are deducted before taxes. Hence, we compute the
Levered Net Income not the unlevered one that we compute in FCF.
We add also computing the cash flow , the proceeds/outflows from firm’s
borrowing activity.  > 0 if the firm increase the net debt ; < 0 if decrease
repaying the debt.

For a given Debt Capacity = Dt

Net Borrowing t = Dt – Dt-1

STARTTING FROM THE FCF:

FCF
(We adjust the FCF for the After-tax interest expenses)

- After-tax interest expenses = Interest Expenses * (1-t)

(Then we add Net Borrowing:)

+ Net Borrowing

= FCFE

The FCFE shows the expected amount of additional cash that the firm will
have available to pay as dividends or share repurchase, each year.
The FCFE is lower than FCF due to interest and debt payments on debt.

However, in at the beginning t=0  the proceeds from borrowing more than
offset the negative FCF so the FCFE > 0

The NPV computed using the FTE method is not lower than the WACC and
APV because of the initial cash received as borrowing/debt issued, even if
this considers also the interest and debt repayment that the other two do not,
considering the FCF in the NPV computation.

If a company has the same risk and leverage of another one, we can use the
cost of capital of the comparable and its cost of equity to discount the FCFE.

In WACC method the interest and debt repayment are computed in the
calculation of the WACC because the FCF does not consider them.

In the FTE method the FCFE considers them so the discounted rate excludes
their values and it is simply the cost of equity.

Assumption: Cost of Equity is constant because the D/E remains constant.

If D/E changes, the risk of equity changes and so its cost (required return)

The FTE as the same problems of the APV  we need to compute the debt
capacity to determine the interest and net borrowing before being able to take
a capital budgeting decision.
FTE is useful if want compute the value of the equity of the firm when the
financial structure is unknown/complex to compute as well as the market
values of securities ( ex. bond=debt, share=equity). If you don’t know the the
leverage D/E ratio because you don’t know their values .

RE-LEVERING THE WACC :

D/E start  D/V start , E/V start and Re start (because Re depends on the
financial structure ), Rd target

METHOD 1)

WALL LEV = Re start * E/V + Rd start * D/V (1-t)

D/E target  E/V target, D/V target, Re target, Rd target

1) WACC unlev = Re start * D/E start + Rd start * D/V start

2) Re target = WACC unlev + D/E target * (WACC unlev – Rd target )
3) WACC lev = Re target * E/V target +Rd target * D/V target * (1-t)
METHOD 2)

1) BETA unlevered (beta asset) =BETA levered start / ((1+D/E start*(1-t))

2) BETA levered (beta equity) = BETA unlevered * (1+D/Etarget*(1-t))
3) Re target = Rf + Beta levered * ERP
4) Rd target i(f change the ratings for example)
5) WACC levered with new Rd,Re and D/E all target ones.

PROJECT COST OF CAPITAL

In the real world, specific projects often differ from the average investment
made by the firm.

Projects may also vary in the amount of leverage they will support.

We want compute how calculate the cost of capital for the project’s cash flow
when a project’s risk and leverage differ from those of the overall firm

Unlevered cost of capital :

Supposing that the project has the same risk and is comparable with the
business of comparable firms

WACC unlev= Re * E/V + Rd * D/V

We take an Average WACC unlev of Comparable firms.

With this we can apply the APV.

[ Using the CAPM is the same of compute Beta unlev = Beta equiy*E/V+B
debt* D/V
 Bu = Be / (V/E) = Be * E/V

Be = Bu * V/E = Bu / (E/V)

If we want know the levered value using the WACC or the FTE methods, we
have to know the Re

Re  depend on the incremental debt the firm will take on as a result of the
project implementation.

Assuming that the firm will fund the project according to a target D/E. This
D/E may differs from the overall D/E  D/E project ≠ D/E firm

Re = WACC unlev + D/E project * ( WACC unlev – Rd )

Oppure

Beta Lev = Beta Un * (1+D/E project *(1-t))

Re = Rf+ Beta Lev * ERP

Once we have the Re, we can compute the WACC levered

1) WACC unlev= Re * E/V + Rd * D/V of each comparable firms/project

2) Average WACC unlev of Comparable firms/projects
3) Re = WACC unlev + D/E project * ( WACC unlev – Rd )
4) WACC levered with the Re computed in 3) .
Otherwise, we can compute the WACC levered when there is a target D/E as:

WACC levered = Average WACC unlev – Rd *D/(D+E)* t

INCREMENTAL LEVERAGE OF THE PROJECT

Amount of debt associated with the project is the incremental financing that
results if the firm takes on the project

Incremental Debt = ∆ Net Debt firm with project - ∆ Net Debt fir without
project

CHANGING LEVERAGE
When a firm does not maintain a constant debt-equity ratio for a project, the
APV method is generally the most straightforward method to apply because
use the WACC unlev.

The WACC and the FTE methods become more difficult to use because
when the proportion of debt financing changes, the project’s equity cost of
capital and WACC will not remain constant over time.
Predetermined Debt
When a firm adjust debt according to a fixed schedule  is not the D/E but only D the
target

We compute the Tax shield by knowing the interest payments  when the target was
D/E we use the cost of capital to discount because the debt in that case follow the value
and so they have same risk  but in this case the debt does not fluctuate, so is less risky
and equal to the risk of debt payments  then we use the cost of debt

• D/E target  Debt fluctuates to follow the project/firm value  Tax shield discounted
at cost of capital

• D target (pre-scheduled)  Debt is scheduled so doesn’t fluctuate  less risky  Tax

shield is predetermined as well discounted cost of debt
VALUING DISTRESS COSTS