1. CAPITAL STRUCTURE VALUATION & CAPITAL BUDGETING FEUI Program Studi Maksi – PPAK Manajemen Keuangan Kuliah II 13.04.2009 RWJ CH. 17 Sugeng Purwanto Ph.D, FRM Note: Submit a summary of Chapter 15&16. 1

2. 2 2 CAPITAL STRUCTURE AND FIRM VALUE PV of tax shield Zero leverage firm value Leveraged firm value PV of financial distress costs Value of the firm (V = S + B) Debt Ratio B/S or B/V

3. 3 CAPITAL ASSET PRICING MODEL (CAPM) “Common method to determine the cost of equity of risky assets” Expected Return E[R] Β (Systematic Risk) Security Market Line :”SML” E[Ri] = Rf + β (E[Rm] – Rf) E[Ri] Expected return stock “I” E[Rm]Expected market return RfRisk-free rate (T-Bill rate, SBI rate) β Systematic risk (non-diversiable risk, market tisk) E[Rm]-Rf Risk Premium Rf

4. CAPITAL BUDGETING Review METHODS (1) Pay back period (PBP) (2) Discounted pay back period (DPBP) (3) NPV (net present value) (4) IRR (internal rate of return) 4

5. CAPITAL BUDGETING 3 APPROACHES: (1) ADJUSTED PRESENT VALUE (2) FLOW TO EQUITY (FTE) (3) WEIGHTED AVERAGE COST OF CAPITAL (WACC) Note: All of the above approaches are using NPV method. 5

6. ADJUSTED PRESENT VALUE APPROACH APV = NPV + NPFV APV = Adjusted Present Value NPV = Value of the project to an unlevered firm NPVF = Net Present Value of the financing side effect NPVAF Side Effects. There are 4 side effects (can be “+” or “-”: 1). The tax subsidy to debt (tax benefits from debt) 2). The costs of issuing new securities 3). The costs of financial distress 4). Subsidies to debt financing 6

7. TAX SUBSIDY (BENEFITS FROM TAX) Example I.A. APV APPROACH. FOR UNLEVERED FIRM Consider a project of the P.B. Singer Co. with the following characteristics: Cash inflows: $500,000 per-year for the indefinite future Cash costs: 72% of sales Initial investment: $475,000 TC (Corporate Tax): 34% R0 (the cost of capital for a project of an all-equity firm) : 20% Calculate the Net Present value (NPV) of project! 7

8. Answer: I.A. Cash inflows$500,000 Cash costs = 72%x$500,000-$360,000 Operating income$140,000 Corporate Tax: 34%x$140,000-$47,600 Unlevered Cash Flow (UCF)$92,400 Present Value of annuity of $92,400 with a discount rate R0 of 20% is: PV = $92,400/20% = $462,000 NPV = PV – Initial Investment = $462,500 - $475,000 = - $13,000 Zero DebtB = 0 ---- NPVF = 0 APV= NPV + NPVF APV= -$13,000 + 0 = -$13,000 The project is not feasible! 8

9. Example continue: Example I.B. APV APPROACH FOR LEVERED FIRM Now assume that the firm finances the project with US$126,229.50 in debt. So that the remaining investment of $475,000 - $126,229.50 = $348,770.50 is financed with equity. Evaluate the project feasibility! Answer: APV = NPV + NPVF = NPV + TC x B APV= -$13,000 + 34% x $126,229.50 = -$13,000 + $42,918 = $29,918 The APV IS POSITIVE. THE PROJECT IS FEASIBLE. 9

10. Example II. Evaluate the project feasibility with FLOW TO EQUITY (FTE) Approach. Answer: FTE Approach steps. Step 1.Calculating Levered Cash Flow (LCF) Step 2.Calculating the Discount Rate of Leverage Equity Rs Rs = R0 + B/S (1 – Tc) (R0 – RB) Step 3.Valuation NPV = LCF/Rs 10

11. Step 1. Calculating LCF Cash Inflows$500,000 Cash costs: 72% x $500,000-$360,000 Interest: 10% x $126,229.50-$12,622.95 Income after interest$127,377.05 Corporate Tax: 34%x$127,377.05-$43,377.20 Levered Cash Flow (LCF)$84,068.85 Note: You can calculate LCF with a formula: LCF = UCF – (1 – Tc) x RB x B UCF = Unlevered Cash Flow = $92,400 RB = 10% B = $126,229.50 LCF = $92,400 – (1-34%)x10%x$126,229.50 = $84,068.,85 11

12. Step 2. Calculating Discount Rate of Levered Equity Rs Rs= R0 + B/S (1 – Tc) (R0 – RB) Rs= 20% + 1/3 x (1-34%) (20% - 10%) = 22.2% Note: Target Debt-to-Equity ratio is 1/3 Target Debt-to-Value ratio is 1/4 B/S = 1/3 Debt-to-Equity ratio 12

13. Step 3. VALUATION OF PROJECT The Present Value of the project levered cash flow (LCF) is PV= LCF/Rs = $84,068.85/22.2% = $378,688.50 Initial Investment$475,000 Debt$126,299.50 Equity = $475,000 - $126,299.50 = $348,770.50 NPV = PV – Equity Invested = $378,688.50 - $348,770.50 = $29,918. ---- NPV Positive! The project is feasible! The same result with APV approach. 13

14. Example III. Evaluate the project feasibility with WEIGHTED AVERAGE COST OF CAPITAL METHOD (WACC) Answer: R WACC = S/(S+B) x Rs + B/(S+B) x RB (1 – Tc)S Equity B Debt Tc Corp Tax ∞UCF NPV = ∑ - Initial Investment t=1(1 + R WACC ) t UCF = UNLEVERED CASH FLOW PERPETUITY OF UCF : NPV= UCF/R WACC - Initial Investment 14

15. Example III continue R WACC = 3/4 x 22.2% + ¼ x 10% (1 – 34%) = 18.3% PV of project = UCF/R WACC = $92,400/ 18.3% = $504,918 NPV= $504,918 - $475,000 = $29,918 NPV Positive, the project is feasible The same result with APV Approach or FTE Approach. 15

16. WHICH APPROACH TO BE USED? Suggested guideline USE WACC OR FTE IF THE FIRM’s TARGET DEBT-TO- EQUITY RATIO APPLIES TO THE PROJECT OVER ITS LIFE. USE APV IF THE PROJECT’s LEVEL OF DEBT IS KNOWN OVER THE LIFE OF THE PROJECT. 16

17. ESTIMATION OF DISCOUNT RATE Procedure to calculate Discount Rate Step 1. Determining of Cost of Equity Capital of industry Rs = Rf + β (Rm – Rf)CAPM Method To find Rs Step 2. Determining Cost of Capital if ALL Equity Rs = R0 + B/S (1-Tc) (R0 – RB) To find R0 Step 3. Determining Rs for the firm evaluated Step 4. Determining R WACC for the firm evaluated DO EXERCISES!! Example 17.1 17

18. EXERCISES (AND/OR HOMEWORK) RWJ Text Book page 496 – 500 Example 17.1 Determination of Cost of capital. Example 17.2 APV Example. 18

19. BETA AND LEVERAGE The No-Tax Case β Equity = β Asset [1 + Debt/equity] The Corporate Tax Case β Equity = [1 + (1-Tc)xDebt/Equity] β Unlevered firm 19

20. Example 17.3. BETA AND LEVERAGE C.F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is considered riskless. The corporate tax rate is 34%. Regression analysis indicates that the beta of the firm’s equity is 2. the risk-free rate is 10%, and the expected market premium is 8.5%. What would the project’s discount rate be in the hypothetical case that C.F.Lee Inc is all equity? 20

21. Example 17.3. Answer Beta of hypothetical all-equity firm. β Equity = [1 + (1-Tc)xDebt/Equity] β Unlevered firm Unlevered Beta: β Unlevered firm = β Equity / [1 + (1-Tc)xDebt/Equity] β Unlevered firm = 2/ [1 + (1-34%)x$100m/$200m] = 1.5 Discount Rate: Rs = R0 +β (Rm – Rf) Rs = 10% + 1.5 x 8.5% = 22.75% 21

22. Example 17.3. The J.Lowers corp which currently manufacture staples is considering a $1 million investment in a project in the aircraft adhesive industry. The corporation estimates unlevered aftertax cash flows (UCF) of $300,000 per year into perpetuity from the project. The firm will finance the project with a debt-to-value ratio of 0.5 (or equivalently a debt-to- equity ratio of 1:1). The three competitors in this new industry are currently unlevered with betas of 1.2, 1.3, and 1.4. assuming a risk-free rate of 5%, a market risk premium of 9% and a corporate tax of 34%, what is the net present value of the oproject? 22

23. Example 17.3. Answer 1.Calculating the average unlevered beta in the industry. Avg unlevered beta = (1.2 + 1.3 + 1.4)/3 = 1.3 2.Calculating the levered beta for J.lower’s new project β Equity = [1 + (1-Tc) Debt/Equity] β Unlevered firm = [1 + (1-34%) 1/1] = 2.16 3. Calculating the cost of levered equity for the project Rs = Rf + β (Rm – Rf) = 5% + 2.16x9% = 24.4% 4. Calculating the WACC for the project R WACC = B/V RB (1-Tc) + S/V Rs = 1/2x5% (1-34%)+1/2x24.4% = 13.9% 5. The project Val ue. NPV = UCF/R WACC – Initial Investment = $300,000/13.9% - $1million = $1.16 million 23

24. 24 THE END