1. 17-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 17 Chapter Seventeen Capital Budgeting for the Levered Firm Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

2. 17-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Prospectus Recall that there are three questions in corporate finance. The first regards what long-term investments the firm should make (the capital budgeting question). The second regards the use of debt (the capital structure question). This chapter is the nexus of these questions.

3. 17-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter Outline 17.1 Adjusted Present Value Approach 17.2 Flows to Equity Approach 17.3 Weighted Average Cost of Capital Method 17.4 A Comparison of the APV, FTE, and WACC Approaches 17.5 Capital Budgeting for Projects that are Not Scale- Enhancing 17.6 APV Example 17.7 Beta and Leverage 17.8 Summary and Conclusions

4. 17-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.1 Adjusted Present Value Approach The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF): There are four side effects of financing: –The Tax Subsidy to Debt –The Costs of Issuing New Securities –The Costs of Financial Distress –Subsidies to Debt Financing

5. 17-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited APV Example Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all- equity firm are: 01 2 3 4 -$1,000$125 $250 $375 $500 The unlevered cost of equity is r 0 = 10%: The project would be rejected by an all-equity firm: NPV < 0.

6. 17-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at r B = 8%. Pearson’s tax rate is 40%, so they have an interest tax shield worth T C Br B =.40×$600×.08 = $19.20 each year.  The net present value of the project under leverage is:  So, Pearson should accept the project with debt.

7. 17-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited APV Example (continued) Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:  Which is the same answer as before.

8. 17-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.2 Flows to Equity Approach Discount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital, r S. There are three steps in the FTE Approach: –Step One: Calculate the levered cash flows –Step Two: Calculate r S. –Step Three: Valuation of the levered cash flows at r S.

9. 17-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Step One: Levered Cash Flows for Pearson Since the firm is using $600 of debt, the equity holders only have to come up with $400 of the initial $1,000. Thus, CF 0 = -$400 Each period, the equity holders must pay interest expense. The after-tax cost of the interest is B×r B ×(1-T C ) = $600×.08×(1-.40) = $28.80 01 2 3 4 -$400 $221.20 CF 2 = $250 -28.80 $346.20 CF 3 = $375 -28.80 -$128.80 CF 4 = $500 -28.80 -600 CF 1 = $125-28.80 $96.20

10. 17-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Step Two: Calculate r S for Pearson To calculate the debt-to-equity ratio, B/S, start with the debt to value ratio. Note that the value of the project is  B = $600 when V = $1,007.09 so S = $407.09.

11. 17-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Step Three: Valuation for Pearson Discount the cash flows to equity holders at r S = 11.77% 01 2 3 4 -$400 $96.20 $221.20 $346.20 -$128.80

12. 17-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.3 WACC Method for Pearson To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital. Suppose Pearson Inc. target debt to equity ratio is 1.50.

13. 17-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Valuation for Pearson using WACC To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital

14. 17-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.4 A Comparison of the APV, FTE, and WACC Approaches All three approaches attempt the same task: valuation in the presence of debt financing. Guidelines: –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. In the real world, the WACC is the most widely used approach by far.

15. 17-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Summary: APV, FTE, and WACC APVWACCFTE Initial Investment AllAllEquity Portion Cash FlowsUCFUCFLCF Discount Rates r 0 r WACC r S PV of financing effectsYesNoNo Which approach is best? Use APV when the level of debt is constant Use WACC and FTE when the debt ratio is constant

16. 17-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited A scale-enhancing project is one where the project is similar to those of the existing firm. In the real world, executives would make the assumption that the business risk of the non-scale- enhancing project would be about equal to the business risk of firms already in the business. No exact formula exists for this. Some executives might select a discount rate slightly higher on the assumption that the new project is somewhat riskier since it is a new entrant. 17.5 Capital Budgeting for Projects that are Not Scale-Enhancing

17. 17-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.5 Capital Budgeting for Projects that are Not Scale-Enhancing: An example World-Wide Enterprises (WWE) is planning to enter into a new line of business (widget industry) American Widgets (AW) is a firm in the widget industry. WWE has a D/E of 1/3, AW has a D/E of 2/3. Borrowing rate for WWE is10 % Borrowing rate for AW is 8 % Given: Market risk premium = 8.5 %, R f = 8%, T c = 40% What is the appropriate discount rate for WWE to use for its widget venture?

18. 17-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.5 Capital Budgeting for Projects that are Not Scale-Enhancing: An example A four step procedure to calculate discount rates: 1.Determining AW’s cost of Equity Capital (r s ) 2.Determining AW’s Hypothetical All-Equity Cost of Capital. (r 0 ) 3.Determining r s for WWE’s Widget Venture 4.Determining r WACC for WWE’s Widget Venture.

19. 17-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited STEP 1:Determining AW’s cost of Equity Capital (r s )

20. 17-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited STEP 2 :Determining AW’s Hypothetical All- Equity Cost of Capital. (r 0 )

21. 17-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited STEP 3 :Determining r s for WWE’s Widget Venture Assuming that the business risk of WWE and AW are the same, NOTE : r s (WWE) < r s (AW) because D/E (WWE) < D/E (AW)

22. 17-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited STEP 4: Determining r WACC for WWE’s Widget Venture.

23. 17-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: Worldwide Trousers, Inc. is considering a $5 million expansion of their existing business. The initial expense will be depreciated straight-line over five years to zero salvage value The pretax salvage value in year 5 will be $500,000. The project will generate pretax earnings of $1,500,000 per year, and not change the risk level of the firm. The firm can obtain a five-year $3,000,000 loan at 12.5% to partially finance the project. If the project were financed with all equity, the cost of capital would be 18%. The corporate tax rate is 34%, and the risk-free rate is 4%. The project will require a $100,000 investment in net working capital. Calculate the APV.

24. 17-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: Cost The cost of the project is not $5,000,000. We must include the round trip in and out of net working capital and the after-tax salvage value. Let’s work our way through the four terms in this equation: NWC is riskless, so we discount it at r f. Salvage value should have the same risk as the rest of the firm’s assets, so we use r 0.

25. 17-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: PV unlevered project The PV unlevered project is the present value of the unlevered cash flows discounted at the unlevered cost of capital, 18%. Turning our attention to the second term,

26. 17-25 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: PV depreciation tax shield The PV depreciation tax shield is the present value of the tax savings due to depreciation discounted at the risk free rate, at r f = 4% Turning our attention to the third term,

27. 17-26 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: PV interest tax shield The PV interest tax shield is the present value of the tax savings due to interest expense discounted at the firms debt rate, at r D = 12.5% Turning our attention to the last term,

28. 17-27 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.6 APV Example: Adding it all up Since the project has a positive APV, it looks like a go. Let’s add the four terms in this equation:

29. 17-28 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.7 Beta and Leverage Recall that an asset beta would be of the form:

30. 17-29 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.7 Beta and Leverage: No Corp.Taxes In a world without corporate taxes, and with riskless corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:  In a world without corporate taxes, and with risky corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

31. 17-30 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.7 Beta and Leverage: with Corp. Taxes In a world with corporate taxes, and riskless debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:  Since must be more than 1 for a levered firm, it follows that

32. 17-31 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.7 Beta and Leverage: with Corp. Taxes If the beta of the debt is non-zero, then:

33. 17-32 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.8 Summary and Conclusions 1.The APV formula can be written as: 2.The FTE formula can be written as: 3.The WACC formula can be written as

34. 17-33 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 17.8 Summary and Conclusions (cont.) 4Use the WACC or FTE if the firm's target debt to value ratio applies to the project over its life. 5The APV method is used if the level of debt is known over the project’s life. 6The beta of the equity of the firm is positively related to the leverage of the firm.

35. 17-34 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Appendix 17-A:The APV approach to Valuing Leveraged Buyouts (LBOs) An LBO is the acquisition by a small group of investors of a public or private company financed primarily with debt. In an LBO, the equity investors are expected to pay off outstanding principal according to a specific timetable. The owners know that the firm’s debt-to-equity ratio will fall and can forecast the dollar amount of debt needed to finance future operations. Under these circumstances, the APV approach is more practical than the WACC approach because the capital structure is changing.

36. 17-35 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The APV Approach to Valuing LBOs: The RJR Nabisco Buyout In 1988, the CEO of the firm announced a bid of $75 per share to take the firm private in a management buyout. Another bid of $90 per share by Kohlberg Kravis and Roberts (KKR) was followed. At the end, KKR emerged from the bidding process with an offer of $109 a share, totalling $25 billion. We use the APV technique to analyze KKR’s winning strategy.

37. 17-36 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.) KKR planned a significant increase in leverage with accompanying tax benefits. The firm issued almost $24 billion of new debt to complete the buyout with annual interest costs of $3 billion. 4 Steps for RJR LBO valuation Step1: Calculating the PV of UCF for 1989-93:

38. 17-37 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.) Step1: Calculating the PV of UCF beyond 1993: Assume :UCF grow at 3 % after 1993 TOTAL UNLEVERED VALUE = 12.224 +12.333 = $24.557 b

39. 17-38 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.) Step3: Calculating the PV of interest tax shields 1989-93: Given: average cost of debt (pretax) = 13.5 % Step4: Calculating the PV of interest tax shields beyond 1993: Assume: debt/assets ratio will be maintained at 25 %. The WACC method will be appropriate to find terminal value.

40. 17-39 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.)

41. 17-40 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.) We know that: V L = V U + PVTS PVTS = V L (1993) -V U(1993) V L (1993) (from Step4) and V u (1993) (from Step1) PVTS = $26.654 –23.746 = $2.908 billion Total value of interest tax shields = 1.544 + 3.877 (from Step3) = $5.421

42. 17-41 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The RJR Nabisco Buyout (cont.) Total value of RJR = Total unlevered value + Total value of interest tax shields = $24.557 (Step1) + 5.421 (Step 4) = $29.978 billion