1. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 1 Topics Covered  After Tax WACC  Tricks of the Trade  Capital Structure and WACC  Adjusted Present Value

2. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 2 Alternative Specifications  Tax-adjusted required rate where t = marginal corporate tax rate D/V = virtual debt ratio r = r F +  (r M – r F )

3. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 3 After Tax WACC  The tax benefit from interest expense deductibility must be included in the cost of funds.  This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate. Old Formula

4. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 4 After Tax WACC Tax Adjusted Formula

5. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 5 After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

6. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 6 After Tax WACC Example - Sangria Corporation - continued

7. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 7 After Tax WACC Example - Sangria Corporation - continued

8. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 8 After Tax WACC Example - Sangria Corporation - continued Debt ratio = (D/V) = 50/125 =.4 or 40% Equity ratio = (E/V) = 75/125 =.6 or 60%

9. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 9 After Tax WACC Example - Sangria Corporation - continued

10. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 10 After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

11. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 11 After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

12. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 12 After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

13. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 13 After Tax WACC  Preferred stock and other forms of financing must be included in the formula.

14. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 14 After Tax WACC Example - Sangria Corporation - continued Calculate WACC given preferred stock is $25 mil of total equity and yields 10%.

15. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 15 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.

16. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 16 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

17. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 17 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

18. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 18 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

19. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 19 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

20. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 20 Topics Covered  Leveraged Buyouts  Spin-offs and Restructuring  Conglomerates  Private Equity Partnership  Control and Governance

21. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 21 Definitions  Corporate control -- the power to make investment and financing decisions.  Corporate governance -- the role of the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions.  Financial architecture -- the financial organization of the business.

22. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 22 Leveraged Buyouts  The difference between leveraged buyouts and ordinary acquisitions: 1. A large fraction of the purchase price is debt financed. 2. The LBO goes private, and its share is no longer trade on the open market.

23. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 23 Leveraged Buyouts  The three main characteristics of LBOs: 1. High debt 2.Incentives 3.Private ownership

24. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 24 Leveraged Buyouts 10 Largest LBOs in 1980s and 1997/98 examples

25. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 25 Private Equity Partnership Investment PhasePayout Phase General Partner put up 1% of capital General Partner get carried interest in 20% of profits Limited partners put in 99% of capital Limited partners get investment back, then 80% of profits Investment in diversified portfolio of companies Sale or IPO of companies Partnership Company 1 Company 2 Company N Mgmt fees