Vous êtes sur la page 1sur 42

17-0

McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
17
Chapter Seventeen
Capital Budgeting for the
Levered Firm
Prepared by

Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
17-1
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Prospectus
Recall that there are three questions in corporate
finance.
The first regards what long-term investments the
firm should make (the capital budgeting question).
The second regards the use of debt (the capital
structure question).
This chapter is the nexus of these questions.
17-2
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Chapter Outline
17.1 Adjusted Present Value Approach
17.2 Flows to Equity Approach
17.3 Weighted Average Cost of Capital Method
17.4 A Comparison of the APV, FTE, and WACC
Approaches
17.5 Capital Budgeting for Projects that are Not Scale-
Enhancing
17.6 APV Example
17.7 Beta and Leverage
17.8 Summary and Conclusions
17-3
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.1 Adjusted Present Value Approach
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
NPVF NPV APV + =
17-4
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
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:
0 1 2 3 4
-$1,000 $125 $250 $375 $500
50 . 56 $
) 10 . 1 (
500 $
) 10 . 1 (
375 $
) 10 . 1 (
250 $
) 10 . 1 (
125 $
000 , 1 $
% 10
4 3 2
% 10
=
+ + + + =
NPV
NPV
The unlevered cost of equity is r
0
= 10%:
The project would be rejected by an all-equity firm: NPV < 0.
17-5
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
APV Example (continued)
Now, imagine that the firm finances the project with
$600 of debt at r
B
= 8%.
Pearsons tax rate is 40%, so they have an interest
tax shield worth T
C
Br
B
= .40$600.08 = $19.20
each year.
NPVF NPV APV + =
- The net present value of the project under leverage is:

=
+ =
4
1
) 08 . 1 (
20 . 19 $
50 . 56 $
t
t
APV
09 . 7 $ 59 . 63 50 . 56 $ = + = APV
- So, Pearson should accept the project with debt.
17-6
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
APV Example (continued)
Note that there are two ways to calculate the NPV
of the loan. Previously, we calculated the PV of the
interest tax shields. Now, lets calculate the actual
NPV of the loan:
NPVF NPV APV + =
09 . 7 $ 59 . 63 50 . 56 $ = + = APV
- Which is the same answer as before.
59 . 63 $
) 08 . 1 (
600 $
) 08 . 1 (
) 4 . 1 ( 08 . 600 $
600 $
4
4
1
=


=

=
loan
t
t
loan
NPV
NPV
17-7
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.2 Flows to Equity Approach
Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, r
S
.

There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows
Step Two: Calculate r
S
.
Step Three: Valuation of the levered cash flows at r
S
.
17-8
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Step One: Levered Cash Flows for Pearson
Since the firm is using $600 of debt, the equity holders only have to
come up with $400 of the initial $1,000.
Thus, CF
0
= -$400
Each period, the equity holders must pay interest expense. The after-tax
cost of the interest is Br
B
(1-T
C
) = $600.08(1-.40) = $28.80
0 1 2 3 4
-$400 $221.20
CF
2
= $250 -28.80
$346.20
CF
3
= $375 -28.80
-$128.80
CF
4
= $500 -28.80 -600
CF
1
= $125-28.80
$96.20
17-9
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Step Two: Calculate r
S
for Pearson
To calculate the debt-to-equity ratio, B/S, start with the debt
to value ratio. Note that the value of the project is
) )( 1 (
0 0 B C S
r r T
S
B
r r + =

=
+ + + + =
4
1
4 3 2
) 08 . 1 (
20 . 19
) 10 . 1 (
500 $
) 10 . 1 (
375 $
) 10 . 1 (
250 $
) 10 . 1 (
125 $
t
t
PV
- B = $600 when V = $1,007.09 so S = $407.09.
% 77 . 11 ) 08 . 10 )(. 40 . 1 (
09 . 407 $
600 $
10 . = + =
S
r
09 . 007 , 1 $ 59 . 63 50 . 943 $ = + = PV
17-10
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Step Three: Valuation for Pearson
Discount the cash flows to equity holders at r
S
= 11.77%
0 1 2 3 4
-$400 $96.20 $221.20 $346.20 -$128.80
56 . 28 $
) 1177 . 1 (
80 . 128 $
) 1177 . 1 (
20 . 346 $
) 1177 . 1 (
20 . 221 $
) 1177 . 1 (
20 . 96 $
400 $
4 3 2
=
+ + + =
PV
PV
17-11
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.3 WACC Method for Pearson
To find the value of the project, discount the unlevered cash
flows at the weighted average cost of capital.
Suppose Pearson Inc. target debt to equity ratio is 1.50.
) 1 (
C B S WACC
T r
B S
B
r
B S
S
r
+
+
+
=
% 58 . 7
) 40 . 1 ( %) 8 ( ) 60 . 0 ( %) 77 . 11 ( ) 40 . 0 (
=
+ =
WACC
WACC
r
r
S
B
= 50 . 1
B S = 5 . 1
60 . 0
5 . 2
5 . 1
5 . 1
5 . 1
= =
+
=
+ S S
S
B S
B
40 . 0 60 . 0 1 = =
+ B S
S
17-12
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Valuation for Pearson using WACC
To find the value of the project, discount the
unlevered cash flows at the weighted average cost
of capital
4 3 2
) 0758 . 1 (
500 $
) 0758 . 1 (
375 $
) 0758 . 1 (
250 $
) 0758 . 1 (
125 $
000 , 1 $ + + + + = NPV
68 . 6 $
% 88 . 6
= NPV
17-13
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.4 A Comparison of the APV, FTE, and
WACC Approaches
All three approaches attempt the same task:
valuation in the presence of debt financing.
Guidelines:
Use WACC or FTE if the firms target debt-to-value ratio
applies to the project over the life of the project.
Use the APV if the projects level of debt is known over
the life of the project.
In the real world, the WACC is the most widely used
approach by far.

17-14
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion
Cash Flows UCF UCF LCF
Discount Rates r
0
r
WACC
r
S

PV of financing effects Yes No No

Which approach is best?
Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is constant
17-15
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
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. 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.
17.5 Capital Budgeting for Projects that
are Not Scale-Enhancing
17-16
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.5 Capital Budgeting for Projects that are
Not Scale-Enhancing: An example
World-Wide Enterprises (WWE) is planning to enter into a
new line of business (widget industry)
American Widgets (AW) is a firm in the widget industry.
WWE has a D/E of 1/3, AW has a D/E of 2/3.
Borrowing rate for WWE is10 %
Borrowing rate for AW is 8 %
Given: Market risk premium = 8.5 %, R
f
= 8%, T
c
= 40%
What is the appropriate discount rate for WWE to use for its
widget venture?
17-17
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.5 Capital Budgeting for Projects that are
Not Scale-Enhancing: An example
A four step procedure to calculate discount rates:

1. Determining AWs cost of Equity Capital (r
s
)
2. Determining AWs Hypothetical All-Equity Cost of
Capital. (r
0
)
3. Determining r
s
for WWEs Widget Venture
4. Determining r
WACC
for WWEs Widget Venture.
17-18
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
STEP 1:Determining AWs cost of Equity
Capital (r
s
)

) (
F
M
F s
R R R r + =
% 8.5 1.5 8% + =
s
r
% 20.75 =
s
r
17-19
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
STEP 2 :Determining AWs Hypothetical All-
Equity Cost of Capital. (r
0
)

) )( 1 (
0 0 B C S
r r T
S
B
r r + =
) 12 . 0 )( 6 . 0 (
3
2
2075 . 0
0 0
+ = r r
1825 . 0
0
= r
17-20
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
STEP 3 :Determining r
s
for WWEs Widget
Venture

) )( 1 (
0 0 B C S
r r T
S
B
r r + =
) 10 . 0 1825 . 0 )( 6 . 0 (
3
1
1825 . 0 + =
s
r
199 . 0 =
s
r
Assuming that the business risk of WWE and AW
are the same,
NOTE : r
s (WWE)
< r
s (AW)
because D/E
(WWE)
< D/E
(AW)
17-21
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
STEP 4: Determining r
WACC
for WWEs Widget
Venture.

) 1 (
C B S WACC
T r
B S
B
r
B S
S
r
+
+
+
=
) 6 . 0 ( 10 . 0
4
1
199 . 0
4
3
+ =
WACC
r
% 425 . 16 16425 . 0 = =
WACC
r
17-22
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example:
Worldwide Trousers, Inc. is considering a $5 million expansion
of their existing business.
The initial expense will be depreciated straight-line over five
years to zero salvage value
The pretax salvage value in year 5 will be $500,000.
The project will generate pretax earnings of $1,500,000 per year,
and not change the risk level of the firm.
The firm can obtain a five-year $3,000,000 loan at 12.5% to
partially finance the project.
If the project were financed with all equity, the cost of capital
would be 18%. The corporate tax rate is 34%, and the risk-free
rate is 4%.
The project will require a $100,000 investment in net working
capital.
Calculate the APV.
17-23
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example: Cost
shield tax
interest
shield tax
on depreciati
PV PV PV Cost APV
project
unlevered
+ + + =
25 . 561 . 873 , 4 $
) 1 (
) 34 . 1 ( 000 , 500
) 1 (
000 , 100
1 . 5 $
5
0
5
=
+

+
+
+ =
r r
m Cost
f
The cost of the project is not $5,000,000.
We must include the round trip in and out of net working
capital and the after-tax salvage value.
Lets work our way through the four terms in this equation:
NWC is riskless, so
we discount it at r
f
.
Salvage value should
have the same risk as
the rest of the firms
assets, so we use r
0
.
17-24
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example: PV
unlevered project
shield tax
interest
shield tax
on depreciati
25 . 561 . 873 , 4 $ PV PV PV APV
project
unlevered
+ + + =
The PV
unlevered project
is the present value of the unlevered cash
flows discounted at the unlevered cost of capital, 18%.

Turning our attention to the second term,
899 , 095 , 3 $
) 18 . 1 (
) 34 . 1 ( 5 . 1 $
) 1 (
5
1
5
1
=

=
+
=

= =
project
unlevered
t
t
t
t
o
t
project
unlevered
PV
m
r
UCF
PV
17-25
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example: PV
depreciation tax shield
shield tax
interest
shield tax
on depreciati
899 , 095 , 3 $ 25 . 561 . 873 , 4 $ PV PV APV + + + =
The PV
depreciation tax shield
is the present value of the tax
savings due to depreciation discounted at the risk free rate,
at r
f
= 4%
Turning our attention to the third term,
619 , 513 , 1 $
) 04 . 1 (
34 . 1 $
) 1 (
5
1
5
1
shield tax
on depreciati

=
=
=

=
+

=
t
t
t
t
f
C
m
r
T D
PV
17-26
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example: PV
interest tax shield
shield tax
interest
619 , 513 , 1 $ 899 , 095 , 3 $ 25 . 561 . 873 , 4 $ PV APV + + + =
The PV
interest tax shield
is the present value of the tax savings
due to interest expense discounted at the firms debt rate, at
r
D
= 12.5%
Turning our attention to the last term,
46 . 972 , 453
) 125 . 1 (
500 , 127
) 125 . 1 (
3 $ 125 . 0 34 . 0
) 1 (
3 $
5
1
shield tax
interest
5
1
5
1
shield tax
interest
= =

=
+

=


=
= =
t
t
t
t
t
t
D
D C
PV
m
r
m r T
PV
17-27
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.6 APV Example: Adding it all up
Since the project has a positive APV, it looks like a go.
Lets add the four terms in this equation:
930 , 189 $
46 . 972 , 453 619 , 513 , 1 899 , 095 , 3 25 . 561 . 873 , 4 $
=
+ + + =
APV
APV
17-28
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.7 Beta and Leverage
Recall that an asset beta would be of the form:
2
Market
Asset

) , (

Market UCF Cov


=
17-29
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.7 Beta and Leverage: No Corp.Taxes
In a world without corporate taxes, and with
riskless corporate debt, it can be shown that the
relationship between the beta of the unlevered firm
and the beta of levered equity is:
Equity Asset

Asset
Equity
=
- 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:
Equity Debt Asset

Asset
Equity

Asset
Debt
+ =
17-30
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.7 Beta and Leverage: with Corp. 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:

firm Unlevered Equity
) 1 (
Equity
Debt
1
|
|
.
|

\
|
+ =
C
T



- Since must be more than 1 for a

levered firm, it follows that

firm Unlevered Equity
>
|
|
.
|

\
|
+ ) 1 (
Equity
Debt
1
C
T
17-31
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.7 Beta and Leverage: with Corp. Taxes
If the beta of the debt is non-zero, then:

L
C
S
B
T + = ) )( 1 (
Debt firm Unlevered firm Unlevered Equity
17-32
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.8 Summary and Conclusions
1. The APV formula can be written as:



2. The FTE formula can be written as:


3. The WACC formula can be written as

investment
Initial
debt
of effects
Additional
) 1 (
1
0
+
+
=

= t
t
t
r
UCF
APV
|
|
.
|

\
|

+
=

=
borrowed
Amount
investment
Initial
) 1 (
1 t
t
S
t
r
LCF
APV
investment
Initial
) 1 (
1

+

= t
t
WACC
t
r
UCF
17-33
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17.8 Summary and Conclusions (cont.)

4 Use the WACC or FTE if the firm's target debt to
value ratio applies to the project over its life.

5 The APV method is used if the level of debt is
known over the projects life.

6 The beta of the equity of the firm is positively
related to the leverage of the firm.

17-34
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Appendix 17-A:The APV approach to
Valuing Leveraged Buyouts (LBOs)
An LBO is the acquisition by a small group of investors of a
public or private company financed primarily with debt.
In an LBO, the equity investors are expected to pay off
outstanding principal according to a specific timetable.
The owners know that the firms debt-to-equity ratio will fall
and can forecast the dollar amount of debt needed to finance
future operations.
Under these circumstances, the APV approach is more
practical than the WACC approach because the capital
structure is changing.
17-35
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The APV Approach to Valuing LBOs:
The RJR Nabisco Buyout
In 1988, the CEO of the firm announced a bid of $75 per
share to take the firm private in a management buyout.
Another bid of $90 per share by Kohlberg Kravis and
Roberts (KKR) was followed.
At the end, KKR emerged from the bidding process with an
offer of $109 a share, totalling $25 billion.
We use the APV technique to analyze KKRs winning
strategy.
17-36
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
KKR planned a significant increase in leverage with
accompanying tax benefits.
The firm issued almost $24 billion of new debt to complete
the buyout with annual interest costs of $3 billion.
4 Steps for RJR LBO valuation
Step1: Calculating the PV of UCF for 1989-93:

5 4 3 2
1988
) 14 . 1 (
536 . 2 $
) 14 . 1 (
336 . 2 $
) 14 . 1 (
173 . 2 $
) 14 . 1 (
311 . 4 $
) 14 . 1 (
404 . 5 $
+ + + + = PV
billion 224 . 12 $
1988
= PV
17-37
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
Step1: Calculating the PV of UCF beyond 1993:
Assume :UCF grow at 3 % after 1993
billion $23.746
03 . 0 14 . 0
) 03 . 1 ( 536 . 2 $
1993
=

= PV
billion 333 . 12 $
) 14 . 1 (
billion $23.746
5
1988
= = PV
TOTAL UNLEVERED VALUE = 12.224 +12.333 = $24.557 b
17-38
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
Step3: Calculating the PV of interest tax shields 1989-93:
Given: average cost of debt (pretax) = 13.5 %



b $3.877
) 135 . 1 (
184 . 1 $
) 135 . 1 (
120 . 1 $
) 135 . 1 (
058 . 1 $
) 135 . 1 (
021 . 1 $
) 135 . 1 (
151 . 1 $
5 4 3 2
1988
= + + + + = PV
Step4: Calculating the PV of interest tax shields beyond 1993:
Assume: debt/assets ratio will be maintained at 25 %.
The WACC method will be appropriate to find terminal value.

17-39
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
% 8 . 12 128 . 0 ) 34 . 0 1 ( 135 . 0
4
1
) 141 . 0 (
4
3
= = + =
WACC
r
141 . 0 ) 135 . 0 14 . 0 )( 34 . 0 1 (
3
1
14 . 0 = + =
s
r
billion $26.654
03 . 0 128 . 0
) 03 . 1 ( 536 . 2 $
1993
=

= PV
17-40
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
We know that: V
L
= V
U
+ PVTS
PVTS = V
L (1993)
-V
U(1993)

V
L (1993)
(from Step4) and V
u (1993)
(from Step1)

PVTS = $26.654 23.746 = $2.908 billion



billion 544 . 1 $
) 135 . 1 (
billion $2.908
5
1988
= = PV
Total value of interest tax shields = 1.544 + 3.877 (from Step3)
= $5.421
17-41
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
The RJR Nabisco Buyout (cont.)
Total value of RJR = Total unlevered value +
Total value of interest tax shields

= $24.557 (Step1) + 5.421 (Step 4)
= $29.978 billion