1.  Interactions of Investment and Financing Decisions Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 19 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

2. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 2 Topics Covered  After Tax WACC  Tricks of the Trade  Capital Structure and WACC  Adjusted Present Value

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

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

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

18. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 18 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 41-equity financed. The value of interest tax shields is picked up in the WACC formula.

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

20. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 20 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.

21. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 21 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.

22. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 22 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

23. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 23 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

24. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 24 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

25. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 25 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

26. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 19- 26 Miles and Ezzell