19. Financing and Valuations Flashcards
Discuss the advantages and limitations of using the weighted average cost of capital as a
discount rate to evaluate capital budgeting projects
WACC is relatively simple to calculate and use. It has the disadvantage in that it applies only
to projects that have a business risk the same as the firm’s. It also implies that the debt-equity
ratio is held constant. It can be used when debt-ratio is known. The value of the debt need not
be known. It automatically takes into the tax-shield effect of debt.
Why is after tax WACC used the most by managers?
The after-tax weighted average cost of capital (WACC) method is the most often used method
in practice. It is because it is conceptually easy to understand and communicate. It relates well
with the NPV and IRR methods. It is also used for valuing businesses.
Briefly explain how WACC can be used for valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows
(FCF) generated by a firm using WACC as the discounts rate for the life of the firm. FCF is
estimated by adding profits after taxes, depreciation, investments in fixed assets, and
investments in working capital. From a practical point of view, FCFs are estimated for a few
years and the present value of the horizon value is calculated using a reasonable constant
growth rate for the rest of the years. The value of the firm is the present value of free cash
flows plus the present value of the horizon value
explain how the beta of equity of a firm changes with changes in debt-equity ratio
when taxes are considered.
The equity beta of a firm increases linearly with changes in debt-equity ratio. This is modified
by the tax factor. The exact relationship is obtained by combining capital asset pricing model
and Modigliani-Miller proposition II with taxes. The relationship is given by:
bE = bA + (1 - TC)(bA - bD)(D/E)
explain how the rate of return on equity of a firm changes with changes in debtequity ratio when taxes are considered
The rate of return on equity of a firm increases linearly with changes in debt-equity ratio. This
is modified by the tax factor. The exact relationship is obtained by combining capital asset
pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by:
rE = rA + (1 - TC)(rA - rD)(D/E)
. Under what circumstances would it be better to use the Adjusted Present Value approach?
The APV approach is better if there are many side effects to financing. For example, if a firm
is getting a subsidized loan for a project then the APV method should be used. It is used when
the amount of debt is known.
how APV can be used for valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows
(FCF) generated by a firm using opportunity cost of capital as the discounts rate for the life of
the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields
are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the
borrowing rate to get the present value of interest tax shields. The value of the firm is the
base-case NPV plus the present value of interest tax shields.
What discount rate should be used for calculating the present value of safe, nominal cash
flows?
The discount rate used for finding the present value of safe, nominal cash flows is the aftertax cost of debt. This present value is also the value of an equivalent loan that can be paid off
using the cash flows.
What method would you use for evaluating international projects?
Generally, international projects have numerous and important side effects like special
contracts with governments, suppliers, and customers. They also have special project
financing packages. All these effects can be explicitly considered by using the APV method.
3 things to remember when discounting the WACC
- 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 not ignored, because the after-tax cost of debt is used in the WACC formula.)
- Unlike most projects, companies are potentially immortal. But that does not mean that you need to forecast every year’s cash flow from now to eternity. Financial managers usually forecast to a medium-term horizon and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of all subsequent cash flows. Estimating the terminal value requires careful attention because it often accounts for the majority of the company’s value.
- 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.
Flow to equity method
Discount cash flows to equity after interest and after taxes, at the cost of equity capital.
this is the same as using WACC then subtracting value of debt (if firm’s debt ratio is constant over time)
Difference btw free CF and net income
Income is the return to shareholders, calculated after interest expense. Free cash flow is calculated before interest.
Income is calculated after various non-cash expenses, including depreciation. Therefore, we will add back depreciation when we calculate free cash flow.
Capital expenditures and investments in working capital do not appear as expenses on the income statement, but they do reduce free cash flow.
How do you alter the WACC when the D & E weights change and( thus change the risk)?
- calculate opportunity cost of capital by finding WACC and cost of equity at 0 debt (r =rd(D/V) + re(E/V)
- estimate cost of debt at new debt ratio and find new cost of equity:
re= r +(D/E)(r-rd) - relcalulate WACC using new financing weights and new re and rd
how to relever the beta
- Unlever beta using :Be = Ba + (D/E)(Ba-Bd)
what do we assume when we do rebalancing?
that whatever the starting debt ratio, the firm is assumed to rebalance to maintain that ratio in the future
