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This is a simplification of the ubiquitous constant growth formula shown below, but with zero growth. In the
constant growth formula, V0 is the value now (time zero), CF1 is the cash flow one period in the future (time one), k
is the discount rate per period, and g is the growth rate of cash flows from time one onward.
CF1
V0
kg
With zero growth, the formula reduces to V0 = CF k, where there is no longer a need to subscript CF since all cash
flows are the same. To understand this formulas logic, consider the case where you put $100,000 in a bank account
that pays 5% forever. You will receive 0.05 $100,000 = $5,000 a year, every year. Now turn this around: If your
discount rate were 5%, and you were promised $5,000 a year forever, that would be the same as having $100,000 in
the bank today. In other words, at a 5% discount rate, $5,000 a year is worth $5,000 0.05 = $100,000.
This technical note was prepared by Associate Professor Marc Lipson. Copyright 2009 by the University of
Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.
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principles. Finally, the note considers explicitly how a financing change would affect stock
prices. This last analysis demonstrates quite clearly how the benefits associated with debt
financing (the tax deductibility of interest payments) benefit shareholders.
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Financial Risk
Our simple firm generates an expected EBIT of $104,000 a year, every year; however,
this cash flow is not certain. The calculation below explores the effects of a 20% decrease in
EBIT on the cash flow to equity holders. Consider this effect when the firm has zero debt and
when the firm has debt equal to $380,000 on which it pays 6.0%. Assume furthermore that the
firm pays taxes of 30%. Fill out the table below. Note that given the simple structure of the firm,
net income will be paid each year to equity holders.
No Debt
Base Case
20% Decrease
EBIT
Interest
Earnings Before Tax
Tax
Net Income
104,000
0
104,000
31,200
72,800
83,200
0
83,200
104,000
83,200
(1)
where L is the leveraged beta (beta given debt financing), U is the unleveraged beta (beta of
firm without debt, also called an asset beta), t is the marginal corporate tax rate, D is the market
value of debt, and E is the market value of equity.
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EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow
Unleveraged Beta
Proportion of Debt
Debt to Equity
Leveraged Beta
Cost of Equity (use CAPM)
No Debt
Debt = $380,000
104,000
0
104,000
0
0
104,000
104,000
0
104,000
0
0
104,000
0.80
0.00
0.00
0.80
0.80
0.38
WACC
Enterprise Value
Difference in Enterprise Values
Calculate Ratio of Debt to Enterprise Value
Provide an intuitive explanation for your results regarding the difference in enterprise values.
2
The analysis can be adjusted to accommodate risky debt, but assuming riskless debt is another simplification
that allows a focus on underlying principals.
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EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow
Unleveraged Beta
Proportion of Debt
Debt to Equity
Leveraged Beta
Cost of Equity (use CAPM)
No Debt
Debt = $380,000
104,000
31,200
72,800
0
0
72,800
104,000
31,200
72,800
0
0
72,800
0.80
0.00
0.00
0.80
0.80
0.46683
WACC
Enterprise Value
Difference in Enterprise Values
Calculate Ratio of Debt to Enterprise Value
The results above regarding the enterprise values are quite different from those in a world with
no taxes. Provide an intuitive explanation for the results.
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No Debt
EBIT
Interest Payments
Income Before Taxes
Tax
Net Income (Cash to Equity)
Cost of Equity
Value of Equity
Cash to Debt (Interest)
Cost of Debt
Value of Debt
Enterprise Value
104,000
0
104,000
Debt = $380,000
104,000
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No Debt
EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow
104,000
31,200
72,800
0
0
72,800
Debt = $380,000
104,000
31,200
72,800
0
0
72,800
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No Debt
Free Cash Flow
Discount rate for Operations
Value of Operations
72,800
Recapitalized
72,800