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Corporate Finance

Term III, Sections E & F

Class Notes 9

Indian Institute of Management Calcutta

Prof Purusottam Sen


December 2017-March 2018
Cost of Equity Capital

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

APV = NPV + NPVF


• The value of a project to the firm can be thought of as the
value of the project to an unlevered firm (NPV) plus the
present value of the financing side effects (NPVF).

• 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
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 R0 = 10%:

125 250 375 500


NPV10%  1,000    
2 3
(1.10) (1.10) (1.10) (1.10) 4
NPV10%  56.50
The project would be rejected by an all-equity firm: NPV < 0.
APV Example

• 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.

 The net present value of the project under leverage is:


APV = NPV + NPV debt tax shield
4
19.20
APV  56.50   t
t 1 (1.08)
APV  56.50  63.59  7.09
 So, Pearson should accept the project with debt.
Flow to Equity (FTE) Approach

• Discount the cash flow from the project to the equity holders of the levered
firm at the cost of levered equity capital, RS.

• There are three steps in the FTE Approach:


– Step One: Calculate the levered cash flows (LCFs)
– Step Two: Calculate RS.
– Step Three: Value the levered cash flows at RS.
Step One: Levered Cash Flows

• Since the firm is using 600 of debt, the equity holders only have to
provide 400 of the initial 1,000 investment.

• Thus, CF0 = –400

• 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

CF3 = 375 – 28.80 CF4 = 500 – 28.80 – 600


CF2 = 250 – 28.80
CF1 = 125 – 28.80
–400 96.20 221.20 346.20 –128.80

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

PV = 943.50 + 63.59 = 1,007.09


B = 600 when PV = 1,007.09 so S = 407.09.
600
RS  .10  (1  .40)(.10  .08)  11.77%
407.09
Step Three: Valuation

Discount the cash flows to equity holders at RS = 11.77%

–400 96.20 221.20 346.20 –128.80

0 1 2 3 4

96.20 221.20 346.20 128.80


NPV  400   2
 
(1.1177) (1.1177) 3
(1.1177) (1.1177) 4
NPV  28.56
WACC Method

S B
RWACC  RS  RB (1  tC )
SB SB

• To find the value of the project, discount the unlevered cash


flows at the weighted average cost of capital.

• Suppose Pearson’s target debt to equity ratio is 1.50


WACC Method

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 SB

RWACC  (0.40)  (11.77%)  (0.60)  (8%)  (1  .40)


RWACC  7.58%
WACC Method

To find the value of the project, discount the unlevered cash


flows at the weighted average cost of capital

125 250 375 500


NPV  1,000    
(1.0758) (1.0758) 2 (1.0758) 3 (1.0758) 4

NPV7.58% = 6.68
Comparison of the APV, FTE, and WACC Approaches

• All three approaches attempt the same task: valuation in the


presence of debt financing.
.
• In the real world, the WACC is, by far, the most widely
used.
Comparison of the APV, FTE, and WACC Approaches

Which approach is best?

• Use APV when the level of debt is constant


– The APV method is frequently used for special situations like
interest subsidies, LBOs, and leases.

• Use WACC and FTE when the debt ratio is constant


– WACC is by far the most common
– FTE is a reasonable choice for a highly levered firm
Summary: APV, FTE, and WACC

APV WACC FTE

Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing effects Yes No No


Capital Budgeting When the Discount Rate
Must Be Estimated
• A scale-enhancing project is one where the project is similar to
those of the existing firm.

• 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.

• No exact formula exists for this. For example, 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.

• We however know how to apply proxy betas and the issues


involved in assessing divisional cost of capital.
Beta and Leverage
an asset beta would be of the form:
Cov(UCF , Market )
β Asset 
σ 2Market

• In a world without corporate taxes, and with riskless corporate


debt (bDebt = 0), it can be shown that the relationship between
the beta of the unlevered firm and the beta of levered equity is:
Equity
β Asset   β Equity
Asset
 In a world without corporate taxes, and with risky corporate
debt, it can be shown that the relationship between the beta of
the unlevered firm and the beta of levered equity is:

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 

firm, it follows that bEquity > bUnlevered firm


Financial Leverage and Beta (contd)

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

1. The APV formula can be written as:



Additional
UCFt Initial
APV    effects of 
t 1 (1  R0 ) t investment
debt

2. The FTE formula can be written as:



LCFt  Initial Amount 
FTE      
t 1 (1  RS )
t
 investment borrowed 

3. The WACC formula can be written as


 Initial
UCFt
NPVWACC  
t 1 (1  RWACC )
t
investment

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