1. Hanoi April 20001 Capital budgeting with the Net Present Value rule 3. Impact of financing Professor André Farber Solvay Business School University of Brussels, Belgium

2. Hanoi April 20002 Capital budgeting for the levered firm With debt and equity, decision depends on financing mix. Why? –Tax subsidy to debt –Cost of issuing new securities –Subsidies to debt financing –Cost of financial distress 3 methods: –Adjusted-Present Value –Flow-to-equity –Weighted-average cost of capital

3. Hanoi April 20003 Adjusted-Present-Value Divide and conquer! Step 1: Calculate NPV for unlevered project NPV Step 2: Calculate NPV of financing side NPVF Step 3: Add up. APV = NPV + NPVF

4. Hanoi April 20004 APV - example Initial investment = 500 Expected future EBIT = 140 per year for indefinite future Corporate tax rate = 40% Cost of capital, all equity r 0 = 20% Unlevered cash flow (UCF) = 140 (1 - 0.40) = 84 Present value of UCF = 84 / 0.20 = 420 NPV = -500 + 420 = -80 Unlevered project would be rejected!

5. Hanoi April 20005 APV example: Introducing debt Now imagine the company borrows 300 Remaining investment (500 - 300 = 200) financed with equity. Borrowing rate = 10% Income statement unleveredlevered EBIT140140 Interest 0 30 Taxes 56 44 Earnings 84 66 Cash to investors 84 96 Tax saving = 56 - 44 = 12 = 40% x 30

6. Hanoi April 20006 Valuing the Tax Shield Annual tax shield from debt = TaxRate  Interest rate  Value of debt = T C r B B Present value (perpetuity) = (T C r B B)/r B =T C B In our example: PV(TaxShield) = 0.40  300 = 120

7. Hanoi April 20007 APV calculation (finished) We now have the following for our project: Net Present Value (all equity) - 80 Present Value of Tax Shield+120 Adjusted Present Value + 40

8. Hanoi April 20008 Flow-to-Equity Approach Valuation of cash flows from the project to the equityholders of levered firm (levered cash flow LCF). LCF = UCF - (1-T C ) x r B x B = UCF - r B x B + T C x r B x B Interest TaxShield In our example: LCF = 84 - 30 + 12 = 66

9. Hanoi April 20009 Discounting Levered Equity Cash Flows Because of debt, equity is more risky. Discount rate should take this additional risk into account. The formula for the discount rate is: r S = r 0 + (r 0 - r B ) x L/(1-L) with L : debt-to-value ratio In our example: L = 300 /(420 + 120) = 0.5555 r S = 0.20 + (0.20 - 0.10) x 0.60 x 1.25 = 27.50% Present value of levered cash flows = 66/.275 = 240 NPVfor stockholders = 240 - 200 = 40 … same as APV

10. Hanoi April 200010 Weighted-Average-Cost-of-Capital Approach Discount unlevered cash flow using adjusted cost of capital. r WACC = r s (1-L) + r B (1-T C ) L (Remember: L = B/V so 1-L = S/V) In our example: r WACC = 0.275 x 0.445 + 0.10 x 0.60 x.555 = 15.57% Net present value = -500 + 84 / 0.1557 = 40

11. Hanoi April 200011 Alternative WACC formulas Modigliani Miller : r WACC = r 0 (1-T C L) –perpetuity –debt level constant Miles-Ezzel: r WACC = r 0 - L r B T C (1+r 0 )/(1+r B ) –any set of cash flows –debt ratio constant B t = L x V t

12. Hanoi April 200012 Comparing APV, FTE and WACC Which approach is best? APV –any type of side effect –unbundles present value –use APV when level of debt known WACC, FTSE –takes into account interest tax shield –use WACC or FTSE when debt ratio constant