Académique Documents
Professionnel Documents
Culture Documents
760, 2008
each of the methods we will look at will account for the additional
value of the PV(ITS) to the project in a different way
WACC will do it by creating an artificially lower discount rate than the
true cost of capital to discount the unlevered FCF
APV will do it by calculating the PV(ITS) separately and adding it to
unlevered firm value estimated from unlevered FCF and rU
Flows to Equity will calculated the levered FCF to Equity and discount it
at rE and then add the PV of Debt to get enterprise value
SAIS 380.760 Lecture 9 Slide # 3
f
f
f
f
f
Project Forecasts
110
(60)
50
(10)
(20)
20
(6)
14
110
(60)
50
(10)
(20)
20
(6)
14
110
(60)
50
(10)
(20)
20
(6)
14
20
0
20
0
34
34
20
5
0
39
SAIS 380.760 Lecture 9 Slide # 5
Liabilities ($MM)
Debt
200
Equity
240
Total Liabs+Eq
440
return information
WACC
with project of value $89.7M, the firms assets rise by this amount
to keep the leverage of the firm at desired level, D/V = 0.40, the
firm will have to add adjust right hand side of balance sheet
adjust mix of D and E to keep D/E = 2/3 or D/V = 0.40 along with
constraint that MV Assets = D + E
SAIS 380.760 Lecture 9 Slide # 8
Maintaining D/E
to maintain D/V ratio of 0.40, firm must add $89.7 x 0.40 = $35.9
in debt to its B/S today
Assets
Liabilities
Surplus cash
Other Assets
Heart Watch
Total Assets
40
400
89.7
529.7
Debt
New Debt
Equity
Total D+E
200
35.9
293.8
529.7
Assets
Surplus cash
Other Assets
Heart Watch
Total Assets
4.1
400
89.7
493.8
Debt
Liabilities
200
Equity
Total D+E
293.8
493.8
Debt Capacity
VtL =
FCF t +1 + VtL+1
where Vt+1L = value of FCF in years
(1 + rWACC )
t+2 onward
for this project the debt capacity each period (with d = 40%) is
Project Debt Capacity
Free cash flow
Levered value, VL
Debt capacity (@ d = 40%)
0
-68
89.7
35.9
1
34
63.9
25.6
2
34
35.7
14.3
3
39
SAIS 380.760 Lecture 9 Slide # 10
2 ways to estimate rU
1. WACCNOTAX = [E/(D+E)] rE + [D/(D+E)] rD = rU = rA
rU = [240/400] 12% + [160/400] 7% = 10%
2. U = [E/(D+E)] E + [D/(D+E)] D
U = [240/400] 1.2 + [160/400] 0.2 = 0.8 = A
rU = rF + U (E[RM] rf) => 6% + 0.8 (5%) = 10% = rA
Determining PV(ITS)
this will be a function of the interest rate, the tax rate and
the debt outstanding at the end of the previous year
interest tax shield in year t = Dt-1 x rD x C
f
the debt levels are determined from the debt capacity calculation
Interest Tax Shields
Debt capacity, Dt
1
25.6
2
14.3
3
-
Interest paid, at rD = 7%
2.51
1.79
1.00
0.75
0.54
0.30
0
35.9
when the firm maintains a target leverage ratio (D/V) , its future
interest tax shields are as risky as its asset value, so the ITS should
be discounted at the assets cost of capital, rU
these flows take account of all the payments to and from the
debtholders
this is how the interest tax shields are taken into account
-4.3
-4.3
-4.3
1.3
-3
-5
-60
35.9
-32.1
1
110
-60
50
-10
-20
20
-2.5
17.5
-5.2
12
2
110
-60
50
-10
-20
20
-1.8
18.2
-5.5
13
3
110
-60
50
-10
-20
20
-1.0
19.0
-5.7
13
20
0
20
0
-10.3
21.9
-11.3
21.5
20
5
0
-14.3
24.0
rD = 7%
FCFE also equal: FCF - after tax interest expense + net borrowings
SAIS 380.760 Lecture 9 Slide # 14
Valuation of Equity
same as the equity value of the project from the other methods
with D0 = $35.9M
V0L = D + E = $35.9M + $53.8M = $89.7M
same enterprise value as other methods
SAIS 380.760 Lecture 9 Slide # 15
this is a new line of business and not like their existing assets
Historic RE
11.55%
14.10%
12.65%
12.77%
RU
10.9%
11.0%
11.2%
11.1%
again we can do this for each firm or for a portfolio of the three
firms (arbitrarily weighted usually equal or MV weights)
Company 1
Company 2
Company 3
Average
E
1.05
1.54
1.23
1.27
D
0
0.17
0.09
0.08
D/V
0.11
0.42
0.25
0.26
U
0.93
0.96
0.95
0.96
Projects rU and rE
Projects rE
z
if the firm will have a post project D/V = 0.35 (D/E = 0.54) and
this is expected to entail a rD = 6.6% (D = .12) , then
rE = rU + D/E (rU - rD)
rE = 10.8% + (0.54)(10.8 - 6.6) = 13.1%
or E = U + (D/E)(U - D) = 0.96 + (0.54(0.96 0.12) = 1.41
rE = rf + E x (E[RM] rf) = 6% + 1.41 x 5% = 13.1%
SAIS 380.760 Lecture 9 Slide # 19
Project WACC
we just use the projects rE, and the firms post project
rD and D/V and the firms tax rate C
alternatively
rWACC = rU d x C x rD
plugging in
rWACC = 10.8% 0.35 x 0.30 x 6.6% = 10.1%
rWACC will fall with increasing D, but keep in mind that distress
costs and agency costs will be rising
SAIS 380.760 Lecture 9 Slide # 20
10
ignoring the other issues for the moment as we have been doing
VL = VU + C x k x VU = (1+ C x k) VU
z
11
thus D levels are known in advance but not the D/V ratio
0
36.0
1
24.0
12.0
2.52
2
12.0
12.0
1.68
3
0.0
12.0
0.84
0.76
0.50
0.25
SAIS 380.760 Lecture 9 Slide # 23
rather than use rU, since the interest payments are set
as a function of the known debt schedule, the ITS are
only as risky as the debt
f
the risk of the debt is captured by rD, the cost of the debt
12
use of debt or adding debt to the firm has costs that we need
to consider
13
but they must be taken into account once debt is large enough that
they are tangible
when the debt level gets high enough, and the probability of
distress becomes meaningful to investors, expected free cash
flows will be reduced by expected costs of financial distress
E[CFD]
this means its beta and therefore required return may be higher
than other firms with standard leverage even when unlevered
Example
firm with perpetual FCFs has VU = $250M has E(FCF) and rU as
function of level of D as given
Level of Debt ($MM)
FCF ($MM)
rU
0
20
8.0%
$50
20
8.0%
$100
19.8
8.2%
$140
19.4
8.5%
$180
18.6
8.8%
$220
17
9.5%
14
0
250.0
$50
250.0
$100
241.5
$140
228.2
$180
211.4
$220
178.9
PV(ITS) = C x D
$0.0
$15.0
$30.0
$42.0
$54.0
$66.0
VL = VU + PV(ITS)
$250.0
$265.0
$271.5
$270.2
$265.4
$244.9
Summary
WACC
f
APV
f
VL = E + D
other influences
f
Flows to Equity
15