From company to project valuation

Question 1

What are the 5 different discount rates that we can choose?

Answer 1

1. The risk-free rate = rf
2. The cost of Debt = rD
3. The cost of Equity = rE
4. The cost of an all-equity firm = rA
5. WACC

Question 2

What is the APV-approach?

Answer 2

Compute a base-case NPV and add it to the NPV of the financing deciscion ensuing from project acceptance.

APV = BAse-case NPV + NPV (Financing Deciscions)

Question 3

What is the Adjusted Cost of Capital Approach?

Answer 3

Adjust the discount rate to account for the financing deciscions.

Question 4

What three ways do we have to value a company?

Answer 4

1. Using the WACC (use unlevered FCF)
2. Using the APV
3. Using the Flow to Equity (which is levered)

Question 5

What are some pros with the APV-approach?

Answer 5

1. Easy to analyze the precise impact of different actions
2. Unbundling of each factor
3. Easy to communicate
4. Easy when amount of debt is known

Question 6

What are some cons with the APV-approach?

Answer 6

1. Difficult to determine proper discount rate
2. When we have a targeted leverage ratio: Necessary to solve for debt and project value
3. Difficult to implement when D/E-ratio is variable

Question 7

There is an relationship in the APV-approach that can causes problems, which one?

Answer 7

First of, we know that the value of a firm depends on the unlevered value of the firm + the PV of the Tax Shield.

Secondly, we also know that the PV of Tax Shield depends on Debt.

Thirdly, debt however depends on the levered value of the firm….

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Question 8

What is the formula for WACC that can always be used?

Answer 8

WACC = rE(E/V) + rD(1-Tc)*(D/V)

Question 9

If we use the same WACC for the company as for the project, what are 2 traps one could end up in?

Answer 9

1) Assuming that the risk of the project is the same as the risk for the company - this might differ
2) The financing of the project might be the same as the company, that means that they have the same capital structure - this might differ as well.

Question 10

What are the 3 methods of using WACC and what do they assume?

Answer 10

1) Modligiani & Miller - Assumes Debt is constant over time - tax shield doesn’t change
2) Miles & Ezzel - Assumes that the Leverage ratio is constant over time - but Debt and Company Value can change - we know the tax shield for the first period but rest is uncertain - tax shield changes
3) Harris & Pringles - Assumes that the Leverage ratio is constant over time - but Debt and Company Value can change - tax shield is uncertain - tax shield changes

Question 11

Under the M&M assumption, I.e Debt is constant, how can we derive the WACC?

Answer 11

WACC = rA(1-TcL) where L = D/VL

Question 12

Under the Miles & Ezzel assumption, I.e Leverage ratio is constant but unknown TS after year 1, how can we derive the WACC?

Answer 12

WACC = rA - L * Tc * rD [ (1+rA) / (1+rD) ]

Question 13

Under the Harris & Pringle assumption, I.e Leverage ratio is constant but unknown TS, how can we derive the WACC?

Answer 13

WACC = rA - rD*Tc*L 
L = D/VL

Question 14

If we want to discount Unlevered FCF, which discount rate should be used to calculate the PV of the Unlevered Value of the Firm?

Answer 14

Cost of assets = rA

Question 15

If we want to discount Unlevered FCF, which discount rate should be used to calculate the PV of the Levered Value of the Firm?

Answer 15

Weighted Average Cost of Capital = WACC

Question 16

If we want to discount the Interest Tax Shield, which discount rate should be used to calculate the Present Value of the Tax Shield?

Answer 16

rTS, WHICH:

• for M&M –> rTS = rD
• for M&E –> rTS = rA
• for H&P –> rTS = rD and rA

Question 17

If we want to discount the Cash Flow to Equity, which discount rate should be used to calculate the PV of equity?

Answer 17

cost of equity = rE

Question 18

If we want to discount the Cash Flow to Debtholders, which discount rate should be used to calculate the PV of Debt?

Answer 18

Cost of debt = rD