•Financing & Valuation

•Topics Covered

•After Tax WACC

•Valuing Businesses

•Using WACC in Practice

•Adjusted Present Value

•Your Questions Answered

•Consistency

•Consider a simple perpetuity:

•

•Many combinations of C and r* will give V.

•Also note that

•

•The moral is simple: The discount rate r* has to be defined consistently with C to get the correct V.

•C in turn needs to be consistent with V

•Very simple, but a frequent source of error.

•Which Cash Flow?

•We start by using the same cash flow as we used in capital investment appraisal.

–The unlevered cash flow after corporate tax:

•

•Note that this cash flow is measured before the deduction of interest and before we account for the interest tax shield.

•It is the cash flow for an unlevered firm.

•This cash flow values the asset

–= working capital + fixed assets

–= financial debt + equity

•Capital Project Adjustments

●

1.Adjust the Discount Rate

ØModify the discount rate to reflect capital structure, bankruptcy risk, and other factors.

2.Adjust the Present Value

ØAssume an all equity financed firm and then make adjustments to value based on financing.

•19-1 after-tax weighted-average

cost of capital

•Tax-Adjusted Formula

•19-1 after-tax weighted-average

cost of capital

•Example: Sangria Corporation

•Firm has marginal tax rate of 35%. Cost of equity is 12.4%, pretax cost of debt is 6%. Given book and market-value balance sheets, what is tax-adjusted WACC?

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•Debt ratio = (D/V) = 500/1,250 = .4, or 40%

•Equity ratio = (E/V) = 750/1,250 = .6, or 60%

•

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•Sangria wants to invest in machine with cash flows of $1.731 million per year pre-tax. What is value of machine, given initial investment of $12.5 million?

•19-1 after-tax weighted-average

cost of capital

1)WACC gives the right discount rate only for projects that are just like the firm undertaking it. It is incorrect for projects that are safer or riskier than the average of the firms existing assets. It is incorrect for projects whose acceptance would lead to an increase or decrease of firms target debt ratio.

●

2)WACC is based on the firms current characteristics, thus if the firms business risk and debt ratio are expected to change , discounting its cash flows by WACC is only approximately correct. WACC needs to be adjusted.

●

3)The MARKET VALUE LEVERAGE RATIO is assumed constant

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%.

•19-1 after-tax weighted-average

cost of capital

•Example, Continued

•If the perpetual crusher had a different business risk than Sangria’s other assets, or if the acceptance of the project would lead to a change in debt ratio, the shareholders would require a return other than the 12.4% expected return on their equity investment.

•19-2 valuing businesses

•Business value usually computed as discounted value of future cash flows (FCF) to a valuation horizon (H)

•Valuation horizon is also called terminal value

•19-2 valuing businesses

•Table 19.1A free-cash-flow projections,

rio corporation ($ Millions)

•Table 19.1b free-cash-flow projections,

rio corporation ($ Millions)

•19-2 valuing businesses

•Example: Rio Corporation

•1.5 million shares outstanding and debt market value of $36 million

•Free cash flow = profit after tax + depreciation + fixed assets + working capital

•FCF1 = 8.7 + 9.9 – (109.6 – 95) – (11.6 – 11.1)

= $3.5 million

•19-2 valuing businesses

•Example, Continued

•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.

•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.

•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.

•

•19-3 using wacc in practice

•Tricks of the Trade

•What should be included with debt?

•Long-term debt

•Short-term debt

•Cash (netted off)

•Receivables

•Deferred tax

•19-3 using wacc in practice

•After-Tax WACC

•Preferred stock and other forms of financing must be included in formula

•19-3 using wacc in practice

•Example, Continued

•Calculate WACC for Sangria Corporation given preferred stock is $25 million of total equity and yields 10%

•SILLY EXAMPLE WACC SHOULD BE UNCHANGED AT 9% BECAUSE RISK & TAX SHIELD ARE UNCHANGED

•

•Tricks of the Trade

•How are costs of financing determined?

–Return on equity can be derived from market data. eg using the CAPM.

–Cost of debt is the market interest rate (for debt of the same rating grade as the firm’s debt.)

•How are weights determined?

–Use target capital structure OR

–If using actual capital structure to infer the target

•Values for listed equity usually are obtained from the market.

•Debt may not traded so an estimated market value is used, but for floating rate debt book values are often used as approximating market value.

¢

•19-3 using wacc in practice

•Example, Continued

•Sangria Corporation at 20% D/V

•Step 1: r at current debt

•

•Step 2: D/V changes to 20%

•

•Step 3: New WACC

•

•Figure 19.1 WACC, Sangria corporation

•Investment & Financing Interaction

Adjusted Present Value

vs.

Adjusted Discount Rate

•Investment & Financing Interaction

Adjusted Cost of Capital

(alternative to WACC – continuous rebalancing)

M&M Formula (perpetual debt) –> ADR = r (1 – Tc L )

L = Debt / Value

r = Cost of equity @ all equity

Tc = Corp Tax Rate

alternative to WACC (almost same results)

•Investment & Financing Interaction

Adjusted Cost of Capital

(alternative to WACC)

代写•Financing & Valuation

•Rebalancing

•Calculating WACC at its existing capital structure requires that capital structure does not change, in other words, the company must rebalance its capital structure to maintain the same market-value debt ratio for the relevant future.

•Example : Sangria Corporation. Debt-to-value ratio = 40% and market value = $12.5.

Suppose Sangria’s products do unexpectedly well in the market and market value increases to $15. Rebalancing means that it will increase debt to 0.4 *15 = $6 mil. The proceeds could be paid out to the stockholders. If market values instead falls, pay down debt proportionally.

•Real companies do not rebalance in such a way. It is sufficient to assume gradual but steady adjustment toward a long-run target. If firm plan’s significant changes in capital structure, then the APV method should be used.

•Capital Project Adjustments

1.WACC

2.Adjust the Discount Rate

ØModify the discount rate to reflect capital structure, bankruptcy risk, and other factors.

●

3.Adjust the Present Value

ØAssume an all equity financed firm and then make adjustments to value based on financing.

•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

•19-4 adjusted present value

•Example

•Project A has $150,000 NPV. Firm must issue stock to finance project, with $200,000 brokerage cost

•Project NPV = 150,000

•Stock issue cost = −200,000

•Adjusted NPV = −50,000

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