Financing and Valuation Principles of Corporate Finance Tenth Edition Chapter 19 Financing and Valuation Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered After Tax WACC Valuing Businesses Using WACC in Practice Adjusted Present Value Your Questions Answered 2 2 2 2 3 2

Capital Project Adjustments Adjust the Discount Rate Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors. Adjust the Present Value Assume an all equity financed firm and then make adjustments to value based on financing.

After Tax WACC Tax Adjusted Formula

After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Debt ratio = (D/V) = 500/1,250 = .4 or 40% Example - Sangria Corporation - continued Debt ratio = (D/V) = 500/1,250 = .4 or 40% Equity ratio = (E/V) = 750/1,250 = .6 or 60%

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

Capital Budgeting Valuing a Business or Project 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 sometimes called the terminal value.

Capital Budgeting In this case r = wacc Valuing a Business or Project PV (free cash flows) PV (horizon value) In this case r = wacc

Valuing a Business Example: Rio Corporation

Valuing a Business Example: Rio Corporation – continued - assumptions

Valuing a Business Example: Rio Corporation – continued 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

Valuing a Business Example: Rio Corporation – continued

Valuing a Business Example: Rio Corporation – continued

Valuing a Business Example: Rio Corporation – continued

WACC vs. Flow to Equity If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were all-equity financed. The value of interest tax shields is picked up in the WACC formula.

WACC vs. Flow to Equity The company's cash flows will probably not be forecasted to infinity. Financial managers usually forecast to a medium-term horizon -- ten years, say -- and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of post-horizon flows. Estimating the terminal value requires careful attention, because it often accounts for the majority of the value of the company.

WACC vs. Flow to Equity Discounting at WACC values the assets and operations of the company. If the object is to value the company's equity, that is, its common stock, don't forget to subtract the value of the company's outstanding debt.

Tricks of the Trade What should be included with debt? Long-term debt? Short-term debt? Cash (netted off?) Receivables? Deferred tax?

After Tax WACC Preferred stock and other forms of financing must be included in the formula

After Tax WACC Example - Sangria Corporation - continued Calculate WACC given preferred stock is $25 mil of total equity and yields 10%.

Tricks of the Trade How are costs of financing determined? Return on equity can be derived from market data Cost of debt is set by the market given the specific rating of a firm’s debt Preferred stock often has a preset dividend rate

WACC & Debt Ratios Example continued: Sangria and the Perpetual Crusher project at 20% D/V Step 1 – r at current debt of 40% Step 2 – D/V changes to 20% Step 3 – New WACC

After Tax WACC Example - Sangria Corporation - continued

Investment & Financing Interaction Adjusted Present Value vs. Adjusted Discount Rate

Investment & Financing Interaction Adjusted Cost of Capital (alternative to WACC) M&M Formula --> ADR = r (1 - Tc L ) L = Debt / Value r = Cost of equity @ all equity Tc = Corp Tax Rate alternative to WACC (almost same results)

Investment & Financing Interaction Adjusted Cost of Capital (alternative to WACC) Miles and Ezzell

Capital Project Adjustments WACC Adjust the Discount Rate Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors. Adjust the Present Value Assume an all equity financed firm and then make adjustments to value based on financing.

Adjusted Present Value APV = Base Case NPV + PV Impact Base Case = All equity finance firm NPV PV Impact = all costs/benefits directly resulting from project

Adjusted Present Value example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.

Adjusted Present Value example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Project NPV = 150,000 Stock issue cost = -200,000 Adjusted NPV - 50,000 don’t do the project

Adjusted Present Value example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.

Adjusted Present Value example: Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option. Project NPV = - 20,000 Stock issue cost = 60,000 Adjusted NPV 40,000 do the project

Adjusted Present Value Example – Rio Corporation APV

Adjusted Present Value Example – Rio Corporation APV - continued