CAPITAL BUDGETING WITH LEVERAGE. Introduction  Discuss three approaches to valuing a risky project that uses debt and equity financing.  Initial Assumptions.

Slides:



Advertisements
Similar presentations
NPV.
Advertisements

Capital Budgeting & Leverage
Capital Structure.
Valuing an Acquisition
Debt and Taxes Chapter 15.
Capital Structure Theory Under Three Special Cases
Models and methods to estimate the appropriate r
Capital Structure Decisions: Part I
Capital budgeting and valuation with leverage
Cash Flows in Capital Budgeting Three approaches:  Free Cash Flow and WACC  Adjusted Present Value  Cash Flows to Equity.
1 Risk, Return, and Capital Budgeting Chapter 12.
Capital budgeting considering risk and leverage
CHAPTER 18: CAPITAL BUDGETING WITH LEVERAGE
Interactions of investment and financing decisions
Valuation and Capital Budgeting for the Levered Firm
The Cost of Capital (Chapter 15) OVU-ADVANCE Managerial Finance D.B. Hamm, rev. Jan 2006.
Capital Budgeting and Valuation with Leverage
The Borrowing Mix 02/21/08 Ch What is the Borrowing Mix? The Borrowing Mix The funds used to finance the operations and the sources of the funds.
QDai for FEUNL Finanças Nov 30. QDai for FEUNL Topics covered  Capital budgeting with debt Adjusted Present Value Approach Flows to Equity Approach Weighted.
Risk, Return and Capital Budgeting For 9.220, Term 1, 2002/03 02_Lecture15.ppt Student Version.
QDai for FEUNL Finanças December 5. QDai for FEUNL Topics covered  An example of APV  Beta and leverage.
Valuing an Acquisition
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Cost of Capital Chapter Fourteen.
Teton Valley Case Solution Process.
Motivation What is capital budgeting?
1 Business Finance - DK 1 Cost of Capital - Definitions Capital structure - the mix of long-term financing sources such as debt, preferred shares, and.
VALUATION OF A FIRM.
Capital Budgeting Under Uncertainty
Valuation and levered Betas
Using DCF to Value Companies
Lecture No. 36 Review of Capital Structure, Leverage, WACC, & Betas
VALUATION OF A FIRM.
Sampa Video, Inc. A small video chain is deciding whether to engage in a new line of delivery business and is conducting an economic analysis of the valuation.
McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Corporate Finance Ross  Westerfield  Jaffe Seventh Edition.
Chapter 14 Berk and DeMarzo
Risk, Cost of Capital, and Capital Budgeting. Valuing a Project When valuing a project you need two things: Initially you were given both (Unit.
CAPITAL BUDGETING (REVIEW)
Capital Structure Decisions
Chapter 7 Fundamentals of Capital Budgeting. 7-2 Chapter Outline 7.1 Forecasting Earnings 7.2 Determining Free Cash Flow and NPV 7.3 Analyzing the Project.
Cost of Capital MF 807 Corporate Finance Professor Thomas Chemmanur.
Capital budgeting and valuation with leverage Chapter 18.
Key Concepts and Skills
Advanced Project Evaluation
Asymmetric information and Capital Structure In contrast to the agency costs problem, here the way of financing does not affect managerial actions. However,
© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 8: The Cost of Capital.
1 Prentice Hall, 1998 Chapter 11 Cost of Capital.
Financing and Valuation
VALUATION AND FINANCING
McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved CHAPTER 17 Capital Budgeting for the Levered.
Chapter 20 Principles PrinciplesofCorporateFinance Ninth Edition Financing and Valuation Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies,
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Corporate Finance Ross  Westerfield  Jaffe Sixth Edition.
© Prentice Hall, Corporate Financial Management 3e Emery Finnerty Stowe Cost of Capital.
Capital Structure with Taxes
Capital Structure. Effect of Corporate Taxes So far capital structure was irrelevant. What if we introduces corporate taxes? Corporate taxes are paid after.
Chapter 6 Frameworks for Valuation: Adjusted Present Value (APV) Instructors: Please do not post raw PowerPoint files on public website. Thank you! 1.
Chapter 18 Capital Budgeting and Valuation with Leverage
VALUATION AND CAPITAL BUDGETING FOR THE LEVERED FIRM
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cost of Capital Cost of Capital - The return the firm’s.
Investment Analysis Lecture: 13 Course Code: MBF702.
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
F9 Financial Management. 2 Designed to give you the knowledge and application of: Section F: Estimating the cost of equity F1. Sources of finance and.
1 Managing for Value Creation (Summer 2006). Class #1b Outline Review—Class #1a Lecture—Overview of business valuation Class discussion—Eskimo Pie Corp.
CAPITAL STRUCTURE & COST OF EQUITY MODIGLIANI AND MILLER MODEL CAPITAL STRUCTURE & COST OF EQUITY MODIGLIANI AND MILLER MODEL
Chapter 13 Learning Objectives
Financing and Valuation
FINA 4330 The Capital Asset Pricing Model (CAPM) Lecture 12 Fall, 2010
Teton Valley Case Solution Process.
CALPITAL BUDGETING and VALUATION MODELS
CALPITAL BUDGETING and VALUATION MODELS
Weighted Average Cost of Capital (Ch )
Presentation transcript:

CAPITAL BUDGETING WITH LEVERAGE

Introduction  Discuss three approaches to valuing a risky project that uses debt and equity financing.  Initial Assumptions  The project has average risk. For convenience the betas or costs of capital used will be for the existing firm rather than being project specific.  The firm’s debt-equity ratio is constant. This simplifies the application in that we don’t need to worry about changing costs of capital and fixes the adjustment of our risk measure for leverage.  Corporate taxes are the only imperfection. No agency, bankruptcy or issuance costs to quantify.

The Weighted Average Cost of Capital Method  Because the WACC incorporates the tax savings from debt, we can compute the levered value (V for enterprise value, L for leverage) of an investment, by discounting its future expected free cash flow using the WACC.

Valuing a Project with WACC  Ralph Inc. is considering introducing a new type of chew toy for dogs.  Ralph expects the toys to become obsolete after five years when it will be discovered that chew toys only encourage dogs to eat shoes. However, the marketing group expects annual sales of $40 million for the first year, increasing by $10 million per year for the following four years.  Manufacturing costs and operating expenses (excluding depreciation) are expected to be 40% of sales and $7 million, respectively, each year.

Valuing a Project with WACC  Developing the product will require upfront R&D and marketing expenses of $8 million. The fixed assets necessary to produce the product will require an additional investment of $20 million. The equipment will be obsolete once production ceases and (for simplicity) will be depreciated via the straight-line method over the five year period.  Ralph expects no incremental net working capital requirements for the project.  Ralph has a target of 60% Equity financing.  Ralph pays a corporate tax rate of 35%.

Expected Future Free Cash Flow

“Market Value” Balance Sheet  The firm is currently at its target leverage:  Equity to Net Debt plus Equity ratio is: $510.00/($ $ $50.00) = 60.0%

Valuing a Project with WACC  Ralph intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the project. Thus, Ralph’s WACC is:

Valuing a Project with WACC  The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows discounted at the WACC. The NPV (value added) of the project is $52.10 million $77.30 million – $25.20 million = $52.10 million It is important to remember the difference between value and value added.

Summary of the WACC Method 1. Determine the free cash flow of the investment. 2. Compute the weighted average cost of capital. 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC. 4. The WACC can be used throughout the firm as the companywide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.

Implementing a Constant Debt-Equity Ratio  By undertaking the project, Ralph adds new assets to the firm with an initial market value $77.30 million.  Therefore, to maintain the target debt-to-value ratio, Ralph must add $30.92 million in new debt. 40% × $77.30 = $ % × $77.30 = $46.38 (compare to $52.10)

Implementing a Constant Debt-Equity Ratio  Ralph can add (net) debt in this amount either by reducing cash and/or by borrowing and increasing actual debt.  Suppose Ralph decides to spend $25.20 million (cover the negative FCF in year 0) in cash to initiate the project. This increases net debt by $25.20 million

New Market Value Balance Sheet  We need an increase in net debt of $  Spend $25.20 million on the project and pay a $5.72 million dividend so $30.92 million in cash goes out (this further increases net debt and reduces equity by the required amount).

Implementing a Constant Debt-Equity Ratio  The market value of Ralph’s equity increases by $46.38 million.  $ − $ = $46.38 (60% of $77.30)  Adding the dividend of $5.72 million into the mix, the shareholders’ total gain is $52.10 million.  $ = $52.10  Which is exactly the NPV calculated for the project  Alternatively: without the dividend the equity increased by the project’s NPV of $52.10 = $ $ This is too large an increase in equity, given the increase in debt of $25.20, if Ralph is to maintain 60% equity.

Implementing a Constant Debt-Equity Ratio  Debt Capacity  The amount of debt at a particular date that is required to maintain the firm’s target debt-to-value ratio  The debt capacity at date t is calculated as: Where d is the firm’s target debt-to-value ratio and V L t is the project’s levered continuation value on date t.

Implementing a Constant Debt-Equity Ratio  Debt Capacity  V L t calculated as:

Debt Capacity  In order to maintain the target financing, the amount of new debt must fall over the life of the project.  This is true because the value of the project depends upon the future cash flow at each point in time. Since the project ends, value decreases. Since value decreases, debt must also decrease.

The Adjusted Present Value Method  Adjusted Present Value (APV)  A valuation method to determine the levered value of an investment by first calculating its unlevered value and then adding the value of the interest tax shield and deducting any costs that arise from other market imperfections

The Unlevered Value of the Project  The first step in the APV method is to calculate the value of the free cash flows using the project’s cost of capital if it were financed without leverage.

The Unlevered Value of the Project  Unlevered Cost of Capital  The cost of capital of a firm, were it unlevered: for a firm that maintains a target leverage ratio, it can be estimated (recall the picture) as the weighted average cost of capital computed without taking into account taxes (pre-tax WACC). This is, strictly speaking, only true for firms that adjust their debt to maintain a target leverage ratio.

The Unlevered Value of the Project  Target Leverage Ratio  When a firm adjusts its debt proportionally to a project’s value or its cash flows (where the proportion need not remain constant)  A constant market debt-equity ratio is a special case.

The Unlevered Value of the Project  For Ralph, the unlevered cost of capital is calculated as:  The project’s value without leverage is then calculated as:

Valuing the Interest Tax Shield  The value of $75.71 million is the value of the unlevered project and does not include the value of the tax shield provided by the interest payments on debt. The interest tax shield is equal to the interest paid multiplied by the corporate tax rate.

Interest Tax Shield  From the debt capacity calculation we can find the interest associated with the project if the financing is kept at the target.

Valuing the Interest Tax Shield  The next step is to find the present value of the interest tax shield.  When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at the project’s unlevered cost of capital.

Valuing the Project with Leverage  The total value of the project with leverage is the sum of the value of the interest tax shield and the value of the unlevered project.  The NPV of the project is $52.10 million $77.30 million – $25.20 million = $52.10 million This is exactly the same value found using the WACC approach.

Summary of the APV Method 1. Determine the investment’s value without leverage. 2. Determine the present value of the interest tax shield. a. Determine the expected interest tax shield. b. Discount the interest tax shield. 3. Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage.

Summary of the APV Method  The APV method has some advantages.  It can be easier to apply than the WACC method when the firm does not maintain a constant debt-equity ratio.  The APV approach also explicitly values market imperfections and therefore allows managers to measure their contribution to value.

The Flow-to-Equity Method  Flow-to-Equity  A valuation method that calculates the free cash flow available to equity holders taking into account all payments to and from debt holders. Free Cash Flow to Equity (FCFE), the free cash flow that remains after adjusting for interest payments, debt issuance and debt repayments  The cash flows to equity holders are then discounted using the equity cost of capital.

Free Cash Flow to Equity

Valuing the Equity Cash Flows  Because the FCFE represent payments to equity holders, they should be discounted at the project’s equity cost of capital.  Given that the risk and leverage of the project are the same as for Ralph Inc. overall, we can use Ralph’s equity cost of capital of 12.0% to discount the project’s FCFE.  The value of the project’s FCFE represents the gain to shareholders from the project and it is identical to the NPV computed using the WACC and APV methods. (The debt is sold at a fair price.)

Project-Based Costs of Capital  In the real world, a specific project may have different market risk than the average project for the firm.  In addition, different projects will may also vary in the amount of leverage they will support.

Estimating the Unlevered Cost of Capital  Suppose the project Ralph launches faces different market risks than its main business.  The unlevered cost of capital for the new project can be estimated by looking at publicly traded, pure play firms that have similar business risks.

Estimating the Unlevered Cost of Capital  Assume two firms are comparable to the chew toy project in terms of basic business risk and have the following observable characteristics: FirmEquity BetaDebt BetaDebt-to-Value Ratio Firm A % Firm B %

Estimating the Unlevered Cost of Capital using Betas  We now find their unlevered or asset betas:  An average of these unlevered betas is  Note, an unlevered beta of 1.02 gives an unlevered cost of equity capital of:

Project Leverage and the Equity Cost of Capital  Now assume that Ralph plans to maintain a 20% debt to value ratio for its chew toy project, and it expects its borrowing cost to be 4%.  We now “relever” the unlevered beta estimate of 1.02 and using the SML we find the cost of levered equity:  A cost of debt capital of 4% is consistent with the low leverage chosen and a debt beta of 0.

Project Leverage and the Weighted Average Cost of Capital  With a 20% debt to value ratio, a cost of equity capital of 11.65%, and a cost of debt capital of 4% we can now estimate the WACC for the project.

An Alternate Approach  From the observable (or measurable) data we can get estimates of the cost of equity capital and the cost of debt capital:  Firm A:  Firm B:

An Alternate Approach  Recall the relation between the levered cost of equity capital and the unlevered cost of equity capital:  Rearranging this we find:  In other words, the unlevered cost of equity capital equals the pre-tax WACC

Estimating the Unlevered Cost of Capital  Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital for each competitor can be estimated by calculating their pretax WACC.  Based on these comparable firms, we estimate an unlevered cost of capital for the project that is approximately 10.12%.

Project Leverage and the Equity Cost of Capital  Ralph plans to maintain a 20% debt to value ratio for its chew toy project, and it expects its borrowing cost to be 4%.  Given the unlevered cost of capital estimate of 10.12%, the chew toy division’s equity cost of capital is estimated to be:

Project Leverage and the Weighted Average Cost of Capital  The division’s WACC can now be estimated to be:  An alternative method for calculating the chew toy division’s WACC is: