Dr Charlene Lee ()

I. Review of the Modigliani & Miller theorems

II. Valuation methods commonly used in
practice
III. Relation between R0 and RWACC
IV. Exercises

Proposition I:
VL = VU + TCB,
where VL/VU denotes for the value of the
levered/unlevered firm, TC is the corporate
tax rate, and B denotes for the book value
of debt.

The value of a firm is a linearly increasing

function of its outstanding debt.
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Refer to MMI;

Why is TCB the value of tax shield?

Proposition II:
RS = R0 + (B / SL) (1-TC) (R0 - RB),
where RS /R0 denotes for the cost of equity
for the levered/unlevered firm, SL is the
value of levered equity, and RB is the (before
tax) cost of debt.

The cost of equity capital is a linear

function of the debt to equity ratio, the netof-tax rate, and the costs of capital
premium of unlevered equity over debt.
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Refer to MMII;

Can you sort RS, R0, and RB in a descending

order?

1. Adjusted Present Value Approach:

APV = NPV + NPVF

Net Present Value of Financing Side Effects

APV

N
t 1

UCFt
(1 R0 )t

Initial
investment

Additional
effects of ,
debt

where UCF denotes for the unlevered CFs.

1. Adjusted Present Value Approach

APV = NPV + NPVF

APV

N
t 1

UCFt
(1 R0 )t

Initial
investment

Additional
effects of ,
debt

where UCF denotes for the unlevered CFs.

How do you compare APV with MMI?

APV

N
t 1

UCFt
(1 R0 )t

Initial
investment

Additional
effects of
debt

MMI (with taxes): VL = VU + TCB

2. WACC Approach

NPVWACC

N
t 1

UCFt
(1 RWACC )t

Initial
investment

Its the most popular method in practice.

Q: Then why do we need to learn other

valuation methods, such as APV?
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3. Flow to equity approach

FTE

N
t 1

LCFt
(1 RS )t

Initial
Amount
,
investment borrowed

where LCF denotes for the levered CFs.

Note: I will require you to calculate UCF and

LCF by using I/S if we have spare time.

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3. Flow to equity approach

FTE

N
t 1

LCFt
(1 RS )t

Initial
Amount
investment borrowed

Its more suitable for highly-levered

firms/projects.

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RWACC

RWACC

R 0 (1-TC

B
S

Its useful when you have the info for R0

at hand.

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An existing perpetual project under which the

evaluations are the same by using three methods.
Check: Which three methods?
Structure 1: zero debt

Structure 2: 25% debt

Structure 3: 50% debt
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What are the features of an existing perpetual

project? In terms of:

Cash flows?

Depreciation expenses?
Capital investments?

NWC investments?
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Which structure has the highest corporate

value?

Possible to compare rates used in these

methods with accounting ratios?

Rates derived from CAPM?

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Is WACC method the simplest one to use in

evaluation?

How about MMI method (with taxes)?

Then why is WACC method most popular in

practice?
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On March 3, 1988, Beazer Plc., a British

construction company, and Shearson Lehman
Hutton, Inc. (an investment banking firm),
commenced a hostile tender offer to
purchase all the outstanding stock of Koppers
Company, Inc., a producer of construction
materials, chemicals, and building products.

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Originally the raiders offered $45 per share;

subsequently the offer was raised to $56, and
then finally $61 per share.
The Koppers board generally asserted that
the offers were inadequate and its
management was reviewing the possibility of
a major recapitalization.
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Assume that Koppers could borrow a maximum of

$1,738,095,000 at a pretax cost of debt of 10.5%
and that the aggregate amount of debt will remain
constant in perpetuity.
Also assume that the proceeds of the loan would be
paid as an extraordinary dividend to shareholders.

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Fill out Exhibit 1 to present the changes in Koppers'

book- and market-value balance sheets after the
recapitalization.
Tax rate?

Why do these items differ in book- and marketvalue balance sheets?

Fixed assets; PV tax shield; Common equity

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Q1: What is the fair price for Koppers stock before

and after the re-capitalization?
Q2: If you were in the management, will you use
this strategy to defend the hostile tender offer
attempt?

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