lecture 4: chapter 18: Valuation and Capital Budgeting for the Levered Firm

Question 1

The adjusted present value (APV)

the value of a project to a levered firm (APV)

–> more than just equity

Answer 1

APV = NPV + NPVF

the value of the project to an unlevered firm (NPV)

NPV of the financing side effects (NPVF)

Question 2

The four major side effects of NPVF

Answer 2

1. The tax subsidy to debt
2. The costs of financial distress
3. The costs of issuing new securities
4. Subsidies to debt financing

Question 3

The tax subsidy to debt

Answer 3

for perpetual debt, the value of the tax subsidy is TcB

Tc is the corporate tax rate

B is the value of the deb

Question 4

The costs of financial distress

Answer 4

The possibility of financial distress, and bankruptcy in particular, arises with debt financing

–> financial distress imposes costs, thereby lowering value

Question 5

The costs of issuing new securities

Answer 5

investment bankers participate in the public issuance of corporate debt

–> These bankers must be compensated for their time and effort

–> lowers the value of the project

Question 6

Subsidies to debt financing

Answer 6

The interest rate on debt issued by the provinces and the federal government is substantially below the yield on debt issued by risky private corporations

Frequently, corporations are able to obtain loan guarantees from government, lowering their borrowing costs to a government rate

–> adds value

Question 7

the side effect with the most value

Answer 7

the tax deduction to debt

Question 8

The flow to equity (FTE) approach

Answer 8

an alternative capital budgeting approach

(cash flow from project to equity holders of a levered firm) / rs

rs = cost of capital

Question 9

three steps to the FTE approach

Answer 9

Step 1: Calculating Levered Cash Flow

Step 2: Calculating rS

Step 3: Valuation

Question 10

the weighted average cost of capital (WACC) method

Answer 10

begins with the insight that projects of levered firms are simultaneously financed with both debt and equity

The cost of capital is a weighted average of the cost of debt and the cost of equity

just use the normal formula for WACC

WACC will be our discount rate

Question 11

why is the WACC always lower than the cost of equity capital for an all-equity firm?

Answer 11

because debt financing provides a tax subsidy that lowers the average cost of capital

Question 12

APV versus WACC

similarities

Answer 12

displays the greatest similarity

both approaches put the UCF in the numerator

both approaches adjust the basic NPV formula for unlevered firms to reflect the tax benefit of leverage

Question 13

APV versus WACC

differences

Answer 13

APV approach discounts cash flows at r0, yielding the value of the unlevered project.

–> Adding the PV of the tax shield gives the value of the project under leverage

–> The WACC approach discounts UCF at WACC, which is lower than r0

The APV approach adjusts the basic NPV formula for unlevered firms to reflect the tax benefit of leverage directly

–> it simply adds in the PV of the tax shield as a separate term

–> The WACC approach makes the adjustment in a more subtle way. Here, the discount rate is lowered below r0

Question 14

why does the FTE approach subtract the firm’s contribution to the initial investment while the APV and WACC methods subtract the initial investment is in the final step

Answer 14

This occurs because under the FTE approach, only the future cash flows to the levered equityholders (LCF) are valued

–> By contrast, future cash flows to the unlevered equityholders (UCF) are valued in both the APV and WACC approaches

Question 15

what do we need to ensure the APV, FTE, and WACC yield the same dollar amount?

Answer 15

1. A perpetual cash flow,
2. A constant dollar amount of debt
3. A constant or target leverage ratio

Question 16

when is it easy to use the APV method?

Answer 16

when the debt level can be specified precisely for future periods, the APV approach is quite easy to use

–> The APV approach is based on the level of debt in each future period

Question 17

when should we use the WACC or FTE methods?

Answer 17

Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over its life