Capital Budgeting for the Levered Firm_lesson8

7/24/2019 Capital Budgeting for the Levered Firm_lesson8

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Capital budgeting for a levered rm

Capital budgeting decisions for a leveredrm

Three methods can be used to value a rmas a whole or a project when leverage isemployed:

The adjusted present value method (APV

The !ow"to"e#uity method ($T%

The weighted average cost of capitalmethod (&ACC

Although they loo' dierent) they providethe same value estimates


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The adjusted present value (APV)

APV*+PV,+PV$APV*adjusted present value of a project for alevered rm

+PV*net present value of a project for an

unlevered rm+PV$*net present value of the nancing sideeect (additional eects of debt

Additional eects of debt: ta- eects)nancial distress costs) !otation costs)interest subsidies.

/t can be rewritten as:investmentinitialdebteffectsaddit

r

UCFAPV

tt

u

t ...)1(1

++

=

=

0C$ * the project after"ta- C$s to stoc'holders of anunlevered rm


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%-. A project of the 1inger.Co. of which:C$s*233)3334 each year in perpetuity

Costs*567 of the sales

/nitial investment*852)3334

Tc*987 ru*637ebt*;6boo' valueratio*;>8

/f both the project and the rm are nanced

with only e#uity:Sales 500,000$Costs (360,000$)

Operating Income 140,000$

Corporate tax (34%) (4,600$)

!C" #,400$


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/n perpetuity and considering only the ta-subsidy as nancing side eect:

DTIr

UCFAPV c

u

+= 0

$#1,#5.#,16&34.0000,450.0

400,#=+=APV

+PV*";9)333

The project should be rejected by an e#uity"rm? however) it is accepted by a levereged

rm@

PV of the Ta-shield


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Flow-to-euit! (FT")

$T% method consists in discounting the C$sfrom the project to shareholders of the leveredrm at the cost of e#uity capital:

/n perpetuity:

)..()1(1

borrowedamountinvestmentinitialr

LCFNPV

t te

t

+

=

=

C$ * the project after"ta- C$s to stoc'holders of a leveredrm

)( 0 DIr

LCFNPV

e

=


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Flow-to-euit! (FT")

$rom the previous e-ample) assume an interestrate of ;37 on debt.

C$ can be also calculated from 0C$:

Sales 500,000$

Costs (360,000$)

Interest (10%) (1,6.#5$)

Income a'ter interest 1,3.05$

Corporate tax (34%) (43,30.0$)

C" 4,06.5$

$5.06,4$5.#,16&10.0&)34.01($400,#

)1(

)1(

=

=

=

LCFDrTUCF

DrTLCFUCF

dC

dC


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Flow-to-euit! (FT")

Calculate the discount rate re.

The value of the project according to $T%approach:

3

1)10.00.0)(34.01(0.0.0

))()(1(

+=

+=E

DrrTrr ducue

$#1%,#)5.##,16000,45(.0

%5.06%,%4

)( 0

==

=

NPV

DI

r

LCFNPV

e


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#eighted-average $ost of $apital(#ACC)

&ACC method consists in discounting the unleveredC$s at the r&ACC:

/n perpetuity:

$rom the previous e-ample:

)1(

.)1(1

cDEWACC

tt

WACC

t

TrDE

Dr

DE

Er

investmentinitialr

UCFNPV

+

++

=

+

=

=

0Ir

UCFNPV

WACC

=

13.0)34.01(&10.0&4

1.0&

4

3=+=WACCr

$#1,#000,4513.0

400,#==NPV


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#hi$h approa$h to use%

/f the rmBs target >V ratio applies to theproject over its life) use &ACC or $T%.

oth reand r&ACCwill remain constant

/f the projectBs level of debt is 'nown over the

life of a project) use APV.&ACC is the most widely used method) followedby $T%

APV is preferred in leveraged buyouts (Ds

because it is 'nown the schedule of debtreduction in the future and ta- shields can beeasily calculated. Also when !otation costs andinterest subsidies are involved) APV is preferred.


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&is$ount rates

APV)$T%)&ACC employ respectively ru) reandr&ACCas discount rates

%-. $irm A has a >V ratio*;>8 (or >% ratio*;>9./t e-pects to borrow at ;37. /t has just one

competitor) rm ) nanced with 837 of e#uityand


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&is$ount rates

$T% needs re. /f you have previously estimated

ru from reof ) you can calculate refor rm A:

1$5.0

6.0

4.0%)1$)(40.01(%5.$0

))()(1(

=

+=

+=

u

uu

ducue

r

rr

E

DrrTrr

3

1%)10%$5.1)(40.01(%$5.1%#.1# +=

refor rm A (;=.=7 is less than refor rm

(63.527) because rm has a higher >% ratio@


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&is$ount rates

&ACC needs r&ACC.

%45.16)4.01(1.04

1

%#.1#4

3

)1(

=+=

+

++

=

WACC

cDEWACC

r

TrDE

Dr

DE

Er


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&ividend Poli$!

A dividend is a cash distribution of earnings toshareholders

ividend policy can provide information toshareholders concerning rm performance.

The decision to pay dividends has to beapproved by the board of directors

ierent types of dividends:

Cash dividends

1toc' dividends

1toc' split


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&ividend Poli$!

Cash dividendCompanies can pay regular cash dividends (e-.8times a year and sometimes e-tra cash dividends.

Dthers may decide not to pay dividends.

1toc' dividend

A distribution of additional shares of stoc' tostoc'holders on a pro"rata basis (on the basis of the7 of shares held and without any cost for the

shareholders

/t increases the number of shares outstanding giventhe same value of the rm) thereby reducing thevalue of each share.

1toc' price was


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Capital Budgeting for the Levered Firm_lesson8

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