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Class Notes 9
Source : John R. Graham, Campbell R. Harvey, The theory and practice of corporate finance: evidence from the
field, Journal of Financial Economics, Volume 60, Issues 2-3, May 2001, Pages 187-243,
Adjusted Present Value Approach
Consider a project of the Pearson Company. The timing and size of the
incremental after-tax cash flows for an all-equity firm are:
0 1 2 3 4
The unlevered cost of equity is R0 = 10%:
• Now, imagine that the firm finances the project with 600 of
debt at RB = 8%.
• Pearson’s tax rate is 40%, so they have an interest tax shield
worth tCBRB = .40×600×.08 = 19.20 each year.
• Discount the cash flow from the project to the equity holders of the levered
firm at the cost of levered equity capital, RS.
• Since the firm is using 600 of debt, the equity holders only have to
provide 400 of the initial 1,000 investment.
• Each period, the equity holders must pay interest expense. The after-tax
cost of the interest is:
B×RB×(1 – tC) = 600×.08×(1 – .40) = 28.80
Step One: Levered Cash Flows
0 1 2 3 4
Step Two: Calculate RS
B
RS R0 (1 tC )( R0 RB )
S
To calculate the debt to equity ratio, B , start with V (in
this case PV) S
4
125 250 375 500 19.20
PV
(1.10) (1.10) 2 (1.10)3 (1.10) 4 t 1 (1.08)t
0 1 2 3 4
S B
RWACC RS RB (1 tC )
SB SB
B 1.5S B
1.50
S
B 1.5S 1.5 S
0.60 1 0.60 0.40
S B S 1.5S 2.5 SB
NPV7.58% = 6.68
Comparison of the APV, FTE, and WACC Approaches
• 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.
Debt Equity
β Asset β Debt β Equity
Asset Asset
Beta and Leverage: With Corporate Taxes
• 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:
Debt
β Equity 1 (1 tC ) β Unlevered firm
Equity
Debt
Since 1 (1 tC ) must be more than 1 for a levered
Equity
When we consider tax and that beta of debt is non zero, then it can be shown that,
B
b L bU (1 TC )( bU b D ) b L levered b
S bU Unlevered b
If we assume, b D 0 Tc Tax rate
B
b S bU (1 TC )( bU )
S
This leads us to the familiar adjustment :
B
b S (1 (1 TC ) )( bU )
S
Summary