1. Chapter 19 Principles PrinciplesofCorporateFinance Tenth Edition Financing and Valuation Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 2 McGraw Hill/Irwin Topics Covered  After Tax WACC  Valuing Businesses  Using WACC in Practice  Adjusted Present Value  Your Questions Answered

3. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 3 McGraw Hill/Irwin Capital Project Adjustments 1.Adjust the Discount Rate  Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors. 2.Adjust the Present Value  Assume an all equity financed firm and then make adjustments to value based on financing.

4. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 4 McGraw Hill/Irwin After Tax WACC Tax Adjusted Formula

5. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 5 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

6. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 6 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

7. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 7 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

8. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 8 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued Debt ratio = (D/V) = 500/1,250 =.4 or 40% Equity ratio = (E/V) = 750/1,250 =.6 or 60%

9. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 9 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

10. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 10 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

11. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 11 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

12. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 12 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

13. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 13 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

14. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 14 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

15. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 15 McGraw Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

16. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 16 McGraw Hill/Irwin Capital Budgeting  Valuing a Business or Project PV (free cash flows)PV (horizon value) In this case r = wacc

17. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 17 McGraw Hill/Irwin 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 all- equity financed. The value of interest tax shields is picked up in the WACC formula.

18. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 18 McGraw Hill/Irwin 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.

19. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 19 McGraw Hill/Irwin 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.

20. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 20 McGraw Hill/Irwin Tricks of the Trade  What should be included with debt? –Long-term debt? –Short-term debt? –Cash (netted off?) –Receivables? –Deferred tax?

21. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 21 McGraw Hill/Irwin After Tax WACC  Preferred stock and other forms of financing must be included in the formula

22. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 20- 22 McGraw Hill/Irwin 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