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# CHAPT VALUATION AND FINANCING

LEARNING
OBJECTIVES
2

## Understand the relationship between leverage, beta and the cost of

capital.
Explain the unlevering and levering of beta for calculating the cost
of capital.
Discuss the utility and limitations of WACC in evaluating an
investment project.
Compare the free cash flow (FCF) approach and the capital cash
flow (CCF) approach of investment evaluation.
approach in project evaluation.
Explain the methodology for determining the value of the firm and
the value of equity.
BETA, COST OF CAPITAL
3 AND
CAPITAL STRUCTURE
The opportunity cost of capital of a firm depends on its
business risk. Hence, the opportunity cost of capital of a
levered firm and an unlevered firm, belonging to the same
homogeneous (business) risk class, will be the same.

## Beta of a levered firms equity will increase as debt is

introduced in the firms capital structure.
4
Asset Beta
The unlevered beta is a measure of the business risk of the firm.
A firm has a portfolio of assets, and therefore, the asset beta of a
firm, a is the weighted average of betas of individual assets.
Average asset beta = beta of asset 1 weight of asset 1 + beta of asset
2 weight of asset 2 ++ beta of asset n weight of asset n.
A firms assets are generally financed by debt and equity.
Therefore, a firms asset beta is also equal to the weighted average
of the firms equity beta and debt beta. Assuming no corporate tax,
the beta of assets will be as follows:

E D
a e d
V V
Asset Cost of Capital
5

## The asset or opportunity cost of capital is the same

as the pre-tax WACC. Hence,
Equity Beta and Cost of
EquityEquity
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beta of a levered firm:
D
e a (a d )
E
Cost of equity of a levered firm with risky debt as follows:
D
ke rf rp a a d
E
We can rewrite Equation as follows to decompose risk premium into
D
ke rf rp a rp a d
E
You may notice that shareholders of the levered firm demand premium
to rp(a d)D/E for assuming the financial risk.
Risk-free Debt, Equity Beta
and Cost of Equity
7

## Forcalculating the cost of equity of a levered firm

with risk-less debt:
Unlevering and
8 Relevering Beta
The equity beta of the firm will change when its financial
risk has changed. Two steps are involved in estimating the
new equity beta of the firm:
You should unlever the firms equity beta. This means that you
should estimate the firms asset beta:
E D
a e d
V V
E
a e (If d 0)
V
You should now relever the equity beta to reflect the new debt-
equity ratio:
Unlevering and
9 Relevering Beta
You should now relever the equity beta to reflect
the new debt-equity ratio:
E
e a (a d )
S
a D
e a 1
E /V E
Example
10
Corporate Taxes, Interest
Tax Shields and Beta
11

## Fixed debt-to-value ratio

The beta of the interest tax shields will be equal to
the asset beta. This implies that interest tax shield
will not reduce the risk of the firm.
The asset beta of the levered firm ( 1) will be
equal to the asset beta of the unlevered firm (u).
Example: Cost of Equity
12
Corporate Taxes, Interest
13
Tax Shields and Beta
Fixed amount of debt
The interest tax shields are as safe or risky as
debt is. Hence the beta of the interest tax shields
will be equal to the beta of debt. We discount the
interest tax shields by the cost of debt.
The equality of the betas of the interest tax
shields and debt under the fixed debt assumption
means that a levered firm (or project) will
have lower systematic risk. Therefore, the asset
beta should be adjusted for the tax effects of
debt.
Example: Effect of Interest
Tax Shield on Asset Beta
14
Summary of Methods of
Calculating Asset Beta and
15

Equity Beta
Free Cash Flow and
16 WACC
FCF is calculated as follows:
FCF = EBIT (1 T) + DEP NWC CAPEX

## FCFs are unlevered cash flows, which are

available for serving both equity shareholders
and debt holders.
WACC is the levered cost of capital. How can
you determine the unlevered cost of capital?
The opportunity or the asset cost of capital of a pure-
equity firm is the unlevered cost of capital. Under
CAPM, the opportunity cost of capital, ka, can be
calculated. Shown earlier that the opportunity cost of
capital, ka, is also equal to the pre-tax WACC.
Constant Capital Structure
and Debt Rebalancing
17

## The concept of WACC is based on the assumption

that debt is a constant proportion of value.
This means that as the firms or projects value
changes, the amount of debt is adjusted to maintain
the proportionality of debt.
WACC assumes that debt is rebalanced to maintain
the constant capital structure.
for the Projects Risk and
18
Debt Capacity
The following steps are involved in calculating the
projects cost of capital:
First, calculate the firms opportunity cost of capital
(assuming that MM Proposition I works).
Second, calculate the new cost of debt.
Third, calculate the projects cost of equity.
Fourth, calculate the projects cost of capital as the after-
tax weighted average cost of debt and the cost of equity.
Limitations of the WACC
19

## This approach has the following limitations:

Cash flow patterns
Debt capacity
Issue costs
Financing effects
We need alternative methodologies than the WACC approach to
evaluate projects that do not have constant debt ratio, have
different cash flow patterns and have several financing effects.
We discuss two alternative approaches the capital cash flows
(CCF) and the adjusted present value (APV).
EQUITY CASH FLOWS OR
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FLOW-TO-EQUITY
APPROACH
In the equity cash flow (ECF) approach, ECFs are calculated
net of debt flows (i.e., interest, interest tax shield and
repayments). Since these residual cash flows include the
effect of debt, they are also called levered cash flows. This
approach discounts ECFs the cash flows available to
shareholders at the levered cost of equity, ke.
Capital Cash Flows and
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the Opportunity Cost of
Capital
In this approach capital cash flows are
discounted at the projects opportunity cost of
capital. Capital cash flows are the free-cash
flows plus the interest tax shields:
Capital cash flows (CCF) Free cash flows Interest tax shield
( EBIT kd D)(1 T ) k d D DEP NWC Capex
EBIT (1 T ) DEP NWC Capex Tk d D
1 4 4 4 4 4 44 2 4 4 4 4 4 4 43 {
Free Cash Flows Interest
Tax Shield
(APV)
22

The APV approach can handle any patterns of cash flows (perpetuity or
uneven cash flows) and it can be extended to calculate the adjusted present
value of an investment project incorporating several financing effects. It
divides the net present value of a project into two main parts: the first part
consists of the all-equity NPV or the base-case NPV assuming that the
project is entirely equity financed and the second part consists of the value
of the interest tax shields and other financing effects:
APV = All-equity NPV + Value of financing effects

The application of the APV approach involves the following three steps:
First, find the all-equity NPV, or the base-case NPV.
Second, find the present value of cash flows resulting from the financing of the project.
Each cash flows are discounted by the discount rate appropriate to the risk of each cash
flow.
Third, sum the all-equity NPV and the present value of financing effects to arrive at the
projects NPV.
(APV)
23

Issue Costs:
APV = All-equity NPV + PV of interest tax shields Issue
costs
Fixed Debt Ratio:
Under the assumption of the constant capital structure (fixed debt
ratio), the CCF approach, the modified (compressed) APV approach
and the FCF will give the same value for the project.
Fixed Debt:
APV approach considers them less risky and discounts at the cost
of debt (the market interest rate).
APV and Subsidized
24 Financing
The interest tax shields are discounted at the pre-tax
cost of debt, and the after-tax interest subsidies are
discounted at the after-tax cost of debt. The projects
APV will be as shown below:
APV = Investment + All-equity PV + PV of interest
tax shields + PV of interest subsidies.

## Value of the Subsidised Financing

Amount is equal to the present value of the interest
subsidy.
25 CAPITAL:
CASE OF PERPETUAL
The projects NPV will be zero at this rate. The
adjusted cost of capital is equal to the opportunity
CASH FLOWS
cost of capital less the value created by the project
by adding to the firms debt capacity. This
minimum rate is the adjusted cost of capital, k*.
Instead of using APV approach, we can discount a
projects free cash flows at the adjusted cost of
capital.
The adjusted cost of capital is the MM formula for
the cost of capital of a levered firm (project).
Miles and Ezzells Formula
26

## We can use the MilesEzzell formula when debt

ratio is fixed and the amount of debt rebalances.

D 1 ka
k ka Tkd
*

V 1 kd
CHOICE OF THE
APPROPRIATE VALUATION
27

APPROACH

## Comparison of FCF, CCF and APV Valuation Approaches

Valuation of a Firm
28

## The value of a firm depends on the expected cash flows and

the discount rate.
Value of the firm is given as follows:
n
FCFt
V
t 1 (1 k0 )
t

where FCF is the free cash flow and k0 is the weighted average
cost of capital (WACC).
If we assume constant relations of earnings, working capital
and capital expenditure to sales, we can write the equation for
the free cash flows as follows:
NCF FCF SALES p (1 T ) DEP ( w f ) SALES
Estimating Free Cash
29 Flows
1. Sales projections
2. Estimate of expenses
3. Estimate of depreciation
4. Capital expenditure
5. Estimates of increase in net working capital
6. Treatment of interest expenses
7. Tax rate
8. Inflation
Horizon Period and
30 Terminal Value
In the case of a firm, it continuously makes investments that
generate revenues and cash flows, theoretically, forever.
Therefore, the financial analyst assumes a horizon period
because detailed calculations for a long period become quite
intricate. The financial analysis of such projects incorporate
an estimate of the value of cash flows after the horizon period
without involving detailed calculations. Thus, the value of the
firm is given as follows:
H
FCFt TVH
V
t 1 (1 k0 ) (1 k0 ) H
t
Methods of Valuing
31
Terminal Value
1. Constant perpetual cash flows
2. Growing perpetual cash flows
3. Price-earnings (P/E) ratio
4. Market-to-book value (M/B) ratio
5. Replacement cost of assets
Value of the Firms
32 Equity
Following steps are involved in the valuation of a firm:
Identify sales growth and profitability assumptions.
Consider depreciation, change in net working capital, capital expenditure and
taxes in estimating the free cash flows.
Estimate the amounts of free cash flows for the horizon period.
Estimate the cash flow patterns beyond the horizon period and determine the
terminal value.
Estimate the firms weighted average cost of capital.
Be consistent in treating inflation in the estimation of free cash flows and WACC.
Compute present value cash flows using WACC as the discount rate.
Subtract the value of the outstanding debt from the value of the firm to find out
the value of its equity.
Growth Patterns and the
Firm Value
33

## The DCF valuation of a firm makes assumptions

about the growth patterns of the firm during the
horizon period and beyond. Generally, there are
the following four possibilities:
No growth
Constant growth
Two-stage growth
Three-stage growth
Comparative Firms
Valuation Approach
34

## Identify the comparable firms based on the criteria of

similar products, size, age, growth and profitability trends.
For the comparable firms, calculate the firm value as a
ratio of sales, EBIT, free cash flows and market value-to-
book value of assets. Sales, EBIT, free cash flow and book
value of assets are assumed as value drivers. Notice that
firm value to EBIT ratio is equivalent of price-earnings
(P/E) ratio.
Average the ratios of the comparable firms, and apply them
to the sales, EBIT and free cash flow data of the firm.
Balance Sheet Approach
to Firm Valuation
35

## Balance sheet or adjusted book value uses assets

and liabilities information to determine the value of
the firm.
One approach to estimate the adjusted book values
of assets is to determine their current or replacement
costs.