Financing and Valuation 19 Financing and Valuation McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

19-1 after-tax weighted-average cost of capital Capital Project Adjustments Discount rate Modify to reflect capital structure, bankruptcy risk, other factors Present value Assume firm financed entirely by equity, make adjustments to value based on financing Adjusted discount rate modifies the discount rate by taking into account capital structure, bankruptcy risk, and other factors. Adjusted present value assumes all-equity-financed firm and then makes adjustments to the value by taking into account the method of financing and related issues.

19-1 after-tax weighted-average cost of capital Tax-Adjusted Formula rD is the before-tax cost of debt. (1 − Tc)rD is the after-tax cost of debt. In this formula corporate taxes are taken into account. After-tax WACC = rD(1 −TC) (D/V) + rE(E/V)

19-1 after-tax weighted-average cost of capital Example: Sangria Corporation Firm has marginal tax rate of 35%. Cost of equity is 12.4%, pretax cost of debt is 6%. Given book and market-value balance sheets, what is tax-adjusted WACC? Always use the market values for calculating WACC. Here Sangria Corporation example is used for illustration.

19-1 after-tax weighted-average cost of capital Example, Continued Be careful not to use book values. Many times, market-to-book ratios are available, and then we can convert these book values to market values. Use only market value for estimating WACC.

19-1 after-tax weighted-average cost of capital Example, Continued Debt ratio = (D/V) = 500/1,250 = .4, or 40% Equity ratio = (E/V) = 750/1,250 = .6, or 60% This is the first step in the calculation of WACC. This formula gives after-tax WACC. D/V = 0.4 and E/V = 0.6 WACC = (0.06)(1- 0.35)(0.4) + (0.124)(0.6) = 0.09 = 9%

19-1 after-tax weighted-average cost of capital Example, Continued Sangria wants to invest in machine with cash flows of $1.731 million per year pre- tax. What is value of machine, given initial investment of $12.5 million? This problem assumes that the project has the same risk as the firm. After-tax cash flows are the relevant cash flows for calculating the NPV. After-tax cash flow = (1 - T) pre-tax cash flow = (1 - 0.35)(1.731) = 1.125 million

19-1 after-tax weighted-average cost of capital Example, Continued NPV = –12.5 + 1.125/0.09 = 0 The NPV of the project is zero. This is a barely acceptable project.

19-1 after-tax weighted-average cost of capital Example, Continued Here market values are shown.

19-1 after-tax weighted-average cost of capital Example, Continued After-tax interest = rD(1 – TC)(D) = (0.06) (1 – 0.35)(5) = 0.195 Expected equity income = 1.125 – interest = 1.125 – 0.195 = $0.93 Expected equity return =rE = 0.93/7.5 = 0.124 = 12.4%

19-2 valuing businesses Business value usually computed as discounted value of future cash flows (FCF) to a valuation horizon (H) Valuation horizon is also called terminal value The value of a business or project is usually computed as the discounted value of FCF out to a valuation horizon (H). The valuation horizon is also called the terminal value or horizon value.

19-2 valuing businesses In this case, r = WACC PV (free cash flows) PV (horizon value) The value of a business is the present value of free cash flows (FCF) plus the present value of horizon value. The discount rate used for valuing a business is the after-tax WACC. PV = (FCF1)/(1+WACC) +(FCF2)/(1+WACC)2 +…+ (FCFH)/(1 +WACC)H + (PVH)/(1+WACC)H Where: PVH = (FCFH+1)/(WACC – g) In this case, r = WACC

Table 19.1A free-cash-flow projections, rio corporation ($ Millions) The estimation of free cash flows is illustrated using the example of Rio Corporation. The value of a business = present value of free cash flows (FCF) + the present value of horizon value. This is a conceptually appealing and a general approach to valuation. It applies to the value-adding property.

Table 19.1b free-cash-flow projections, rio corporation ($ Millions) Here various assumptions associated with the estimation of FCF and the firm values are explicitly shown.

19-2 valuing businesses Example: Rio Corporation Free cash flow = profit after tax + depreciation + fixed assets + working capital FCF = 8.7 + 9.9 – (109.6 – 95) – (11.6 – 11.1) = $3.5 million FCF = profit after tax + depreciation + investment in fixed assets + investment in working capital FCF = 8.7 + 9.9 - (109.6 - 95.0) - (11.6 - 11.1) = $3.5 million PV(FCF) = 3.5/(1.09) + 3.2/(1.09^2) + 3.4/(1.09^3) + 5.9/(1.09^4) + 6.1/(1.09^5) + 6.0/(1.09^6) PV(FCF) = +20.3 million

19-2 valuing businesses Example, Continued Horizon value = (FCFH + 1)/(WACC – g) = 6.8/(0.09-0.03) = 113.3 PV(horizon value) = 113.3/(1.09^6) = 67.6 PV (business) = 20.3 + 67.6 = $ 87.9 million

19-2 valuing businesses Flow-to-Equity Method Discount cash flows to equity at cost of equity capital, after interest and taxes If firm has constant debt ratio over time, flow to equity will give same answer as discounting total cash flows at WACC and subtracting debt WACC method gives the total value of the firm. To get the firm’s equity value, debt value is subtracted from total value. Flow-to-equity method calculates the value of the firm’s equity directly by discounting the cash flows available to shareholders at the levered cost of equity. Discounting at WACC gives the total value of the firm (V). The flow-to-equity approach gives the value of the common equity in that case: E = [EBIT – rDD](1 - Tc)/rE where rE is the cost of levered equity. Total value of the firm is the value of equity plus the value of debt.

19-3 using wacc in practice Tricks of the Trade What should be included with debt? Long-term debt Short-term debt Cash (netted off) Receivables Deferred tax The following are included with debt: long-term debt, short-term debt, cash (netted), receivables, and deferred tax.

19-3 using wacc in practice After-Tax WACC Preferred stock and other forms of financing must be included in formula When preferred stock is included then: After-tax WACC = rD(1 - TC)(D/V) + rP(P/V) + rE(E/V)

19-3 using wacc in practice Example, Continued Calculate WACC for Sangria Corporation given preferred stock is $25 million of total equity and yields 10% When preferred stock is included, then WACC is calculated as follows: After-tax WACC = (0.08)×(1 - 0.35) × (50/125) + (0.10) × (25/125) + (50/125)(0.146) = 0.1104 = 11.04%

19-3 using wacc in practice Determining Costs of Financing Derive return on equity from market data Cost of debt set by market, rating of firm’s debt Preferred stock often has preset dividend rate Return on equity can be derived using CAPM or DCF. CAPM = rE + rf + b(rm - rf); DCF = rE = [D1/Po] + g. [Market data is used for the estimation] Cost of debt is the yield to maturity or the effective interest rate on debt. Cost of preferred equity: rP = D/Po.

19-3 using wacc in practice Example, Continued Sangria Corporation at 20% D/V Step 1: r at current debt Step 2: D/V changes to 20% Step 3: New WACC If Sangria project has 20% D/V then: At 40% debt: r = (0.4)(0.06) + (0.6)(0.124) = 0.0984 D/V changes to 20% the D/E = 0.25: rE = 0.0984 + (0.0984 – 0.06)(0.25) = 0.108 New WACC = (0.06)(1 – 0.35)(0.2) + (0.108)(0.8) = 0.0942 = 9.42%

Figure 19.1 WACC, Sangria corporation The Sangria WACC is displayed graphically. At this point, remind the students of the graphs in the prior chapter. This example links the two.

19-4 adjusted present value Adjusted Cost of Capital Modigliani and Miller formula r = Cost of equity @ all equity Tc = Corporate tax rate rMM = r(1 − TcD/V) Students need to know that there are many adjusted discount rates. WACC is only one. On this slide they are shown the M&M adjusted discount rate (ADR) formula.

19-4 adjusted present value Adjusted Cost of Capital Miles and Ezzell As a follow-up to the previous slide, another ADR is presented.

19-4 adjusted present value Adjusted Discount Rate Modify to reflect capital structure, bankruptcy risk, other factors Adjusted Present Value Assume all-equity-financed firm, adjust value based on financing A more detailed definition of the ADR and APV is presented.

19-4 adjusted present value APV = Base Case NPV + PV Impact Base case: All-equity-financed firm NPV PV impact: All costs/benefits directly resulting from project Adjusted present value (APV) = base case NPV (assuming all equity financing) + PV impact.   PV impact = all costs/benefits directly resulting from project. For example: For many international projects, governments provide direct subsidy. PV tax shield is in the form of a subsidy from the government. Flotation cost is an example of cost associated with financing a project.

19-4 adjusted present value Example Project A has $150,000 NPV. Firm must issue stock to finance project, with $200,000 brokerage cost Project NPV = 150,000 Stock issue cost = −200,000 Adjusted NPV = −50,000 Do not invest in Project A APV = base case NPV + PV impact = +150,000 – 200,000 = –50,000 Reject the project. This is a very simple example. More complicated examples are given in the book.

19-4 adjusted present value Example Project B has −$20,000 NPV. Firm can issue debt at 8% to finance project. New debt has PV tax shield of $60,000. Assume Project B is only option Project NPV = −20,000 Stock issue cost = 60,000 Adjusted NPV = 40,000 Invest in Project B Project B: Base case NPV = -20,000 (assumes al-equity financing) PV of tax shield from debt financing = +60,000 APV = base case NPV + PV impact = –20,000 + 60,000 = +40,000 Accept the project.

Table 19.2 rio corporation apv ($ millions) Rio Corporation APV is illustrated.

19-4 adjusted present value Example Rio Corporation APV APV = base case NPV + PV impact = 84.3 + 5 = $89.3 million Accept the project.