Capital Budgeting for the Levered Firm

Question 1

Financing side effects NPVF

Answer 1

1. The tax subsidy to debt : This was discussed in Chapter 16, where we pointed out that for perpetual debt, the value of the tax subsidy is T C B . ( T C is the corporate tax rate and B is the value of the debt.) The material about valuation under corporate taxes in Chapter 16 is actually an application of the APV approach.
2. The costs of issuing new securities : As we will discuss in detail in Chapter 20, investment bankers participate in the public issuance of corporate debt. These bankers must be compensated for their time and effort, a cost that lowers the value of the project.
   3.The costs of financial distress : The possibility of financial distress, and bankruptcy in particular, arises with debt financing. As we discussed in a previous chapter, financial distress imposes costs, thereby lowering value.
3. Subsidies to debt financing : The interest on debt issued by state and local governments is not taxable to the investor. Because of this, the yield on tax-exempt debt is generally substantially below the yield on taxable debt. Frequently, corporations can obtain financing from a municipality at the tax-exempt rate because the municipality can borrow at that rate. As with any subsidy, this subsidy adds value.

Question 2

Flow to Equity approach

Answer 2

The flow to equity (FTE) approach is an alternative valuation approach. The formula calls for discounting the cash flow from the project to the equityholders of the levered firm at the cost of equity capital, R S . For a perpetuity,

Question 3

A comparison of APV, FTE and WACC methods.

Answer 3

Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over its life.
Use APV if the project’s level of debt is known over the life of the project.
APV is a valuation technique that breaks down the project’s cash flows into different components, such as the value of the operating assets, the value of tax shields (interest tax shield), and any other side effects, like subsidies or other financing benefits.
It explicitly considers the impact of financing decisions, such as debt and equity, on the project’s value.
FTE is a valuation method that focuses on the cash flows available to equity shareholders after all other financial claims, such as debt and taxes, have been satisfied.
It considers only the equity investors’ perspective and is especially useful for evaluating projects when the capital structure remains constant over time.
WACC is a discount rate used to evaluate investment projects and represents the average cost of capital for a company, considering both debt and equity.
It incorporates the cost of equity and the cost of debt, weighted by their respective proportions in the company’s capital structure.

Question 4

Flotation Costs

Answer 4

Under International Financial Reporting Standards, flotation
costs directly attributable to an investment in a particular asset
should be depreciated using the same method as the asset itself.
Depreciation is charged on the flotation costs using 25 percent
reducing balance. Flotation costs are paid immediately but are deducted from taxes by amortizing on a 25 percent reducing balance basis over the life of the loan.