1. Valuation and Capital Budgeting for the Levered Firm

2. Key Concepts and Skills
Understand the effects of leverage on project value
Value levered projects using
Adjusted Present Value (APV)
Flows to Equity (FTE)
WACC

3. Leverage and Project Value
Why might leverage affect the value of a project?
What will/should happen to the value of the project as more debt is used to finance the project?

4. Adjusted Present Value Approach
Project value =
No debt (NPV)
plus PV of financing (NPVF)
APV = NPV + NPVF

5. APV Example
Consider a project with perpetual cash flows of $140,000 per year.
If the tax rate is 34%, should the firm take the project if it costs $475,000?
The unlevered cost of equity is rE = 20%:
PV =
NPV =

6. APV Example
Now, assume the firm uses 126, of debt to help finance the project, the cost of debt is 10%
We can adjust the unlevered firms NPV by adding the tax shied to find the levered value of the project
APV = NPV + PV(Tax Shield)

7. Flow to Equity Approach
Discount cash flows to equity holders of the levered firm at the cost of levered equity capital, rE
Calculate the levered cash flows to equity (LCFs)
Calculate rE
Value the LCFs at rE

8. First Find Re of the Levered Firm

9. Calculating LCF The project makes $140,000 per year
What do the equity holders get?

10. Alternative LCF Calculation
The only difference between the unlevered firm’s cash flow to equity and the levered firm’s is the after tax interest payment
Unlevered: 92,400
After Tax Interest Payment:
Cash flow to equity :

11. Flow to Equity NPV
Eq. PV =
Eq. NPV =

12. WACC Method Discount the unlevered cash flows at the levered WACC
D = 126,229.50; V = 504,918; E = 378,688.5

13. WACC Valuation
Unlevered Cash flows = 92,400
WACC = 18.3%
NPV =

14. Notes on APV, FTE, & WACC
Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over the life of the project.
Use the APV if the project’s level of debt is known over the life of the project.
WACC is the most widely used in practice.

15. Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion
Cash Flows UCF UCF LCF
Discount Rates rU rWACC rE

16. Summary The APV formula can be written as:
The FTE formula can be written as:
The WACC formula can be written as