Capital Budgeting and Valuation with Leverage

Question 1

Capital budgeting

Answer 1

• Capital budgeting is the process of analysing investment opportunities and deciding which to accept.
• Three methods for capital budgeting with leverage and market imperfections are:
  1. Weighted-Average Cost of Capital (WACC)
  2. Adjusted Present Value (APV) Method
  3. Flow to Equity Method

Question 2

Assumptions of WACC

Answer 2

Assumptions:
– The firm maintains a constant debt-equity ratio and,
– The WACC remains constant over time

Question 3

Adjusted present value method

Answer 3

A valuation method to determine the levered value of an investment by first calculating its unlevered value and then adding the value of the interest tax shield

1. Calculate the value of the free cash flows using the
   project’s cost of capital if it were financed without leverage.
2. Calculate the Tax Shield

• The firm’s unlevered cost of capital equals its pretax WACC because it represents investors’ required return for holding the entire firm (equity and debt).
• This argument relies on the assumption that the overall risk of the firm is independent of the choice of leverage.
• The tax shield will have the same risk as the firm if the firm maintains a target leverage ratio.

Question 4

Target leverage ratio

Answer 4

– When a firm adjusts its debt proportionally to a project’s value or its cash flows (where the proportion need not remain constant).
– A constant market debt-equity ratio is a special case.

Question 5

Discounting for the ITS

Answer 5

When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at the project’s unlevered cost of capital.

Question 6

The Flow-To-Equity method

Answer 6

A valuation method that calculates the free cash flow available to equity holders taking into account all payments to and from debt holders.

• – The cash flows to equity holders are then discounted using the equity cost of capital.

Question 7

Free cash flow to equity (FCFE)

Answer 7

• Free Cash Flow to Equity (FCFE)
  – The free cash flow that remains after adjusting for interest payments, debt issuance, and debt repayments.
• The first step in the FTE method is to determine the project’s free cash flow to equity.

Question 8

Valuing equity cash flows

Answer 8

• Because the FCFE represent payments to equity holders, they should be discounted at the project’s equity cost of capital

– Given that the risk and leverage of the RFX project are the same as for Avco overall, we can use Avco’s equity cost of capital of 10.0% to discount the project’s FCFE

The value of the project’s FCFE represents the gain to shareholders from the project, and it is identical to the NPV computed using the WACC and APV methods.

Question 9

FTE method advantages

Answer 9

• – It may be simpler to use when calculating the value of equity for the entire firm if the firm’s capital structure is complex and the market values of other securities in the firm’s capital structure are not known.
• – It may be viewed as a more transparent method for discussing a project’s benefit to shareholders by emphasizing a project’s implication for equity.

Question 10

FTE disadvantage

Answer 10

One must compute the project’s debt capacity to determine the interest and net borrowing before capital budgeting decisions can be made.

Question 11

Project based cost of capital

Answer 11

• In the real world, a specific project may have different market risk than the average project for the firm.
• In addition, different projects may vary in the amount of leverage they will support.

Question 12

Determining the incremental leverage of a project

Answer 12

• To determine the equity or weighted average cost of capital for a project, the incremental financing that results if the firm takes on the project needs to be calculated.
  In other words, what is the change in the firm’s total debt (net of cash) with the project versus without the project.

– Note: The incremental financing of a project need not correspond to the financing that is directly tied to the project.

Question 13

Incremental financing

Answer 13

• The following important concepts should be considered when determining a project’s incremental financing
• – Cash Is Negative Debt
• – A Fixed Payout Policy Implies 100% Debt Financing
• – Optimal Leverage Depends on Project and Firm Characteristics
• – Safe Cash Flows Can Be 100% Debt Financed

Question 14

Other Leverage policies

Answer 14

§ Constant interest coverage
§ Predetermined debt levels

Question 15

Constant interest coverage ratio

Answer 15

When a firm keeps its interest payments equal to a
target fraction of its free cash flows

§ If the target fraction is k, then
Interest Paid in Year t = k x FCF t

With a constant interest coverage policy, the value of the interest tax shield is proportional to the project’s unlevered value.

Question 16

Predetermined debt levels

Answer 16

Rather than set debt according to a target debt-equity ratio or interest coverage level, a firm may adjust its debt according to a fixed schedule that is known in advance

When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt cost of capital.

Question 17

Comparing valuation methods

Answer 17

• Typically, the WACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the life of the investment
• For alternative leverage policies, the APV method is usually the simplest approach
• The FTE method is typically used only in complicated settings where the values in the firm’s capital structure or the interest tax shield are difficult to determine

Question 18

Other market imperfections associated with leverage

Answer 18

1. Issuance and Other Financing Costs
2. Security Mispricing
3. Financial Distress and Agency Costs

Question 19

Issuance and other financing costs

Answer 19

• – When a firm raises capital by issuing securities, the banks that provide the loan or underwrite the sale of the securities charge fees
• – These fees should be included as part of the project’s required investment, reducing the NPV of the project

Question 20

Security mispricing

Answer 20

• If management believes that the securities they are issuing are priced differently than their true value, the NPV of the transaction should be included in the value of the project

– The NPV of the transaction is the difference between the actual money raised and the true value of the securities sold

• If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for existing shareholders
• It should be deducted from the project NPV in addition to other issuance costs

Question 21

Homemade leverage

Answer 21

if the investor holds equity in a levered firm, the risk on its equity is higher due to leverage. This is because, in case of financial distress, debtholders have priority over the firm’s assets. Under perfect capital markets, equity holders will undo the effect of leverage by owing/buying both the firm’s equity and debt such that if the firm is in financial distress, it gets priority over the firm’s assets. If equity holders are unable to buy/own the firm’s debt, they could own a debt similar to the firm’s debt. In the question, this will be risk-free debt because of the perfect capital market assumption.