Lecture 6 - Valuation and capital budgeting for the levered firm Flashcards
Main steps of project evaluation
- Estimate free cash flow from project
- Discount it at the project’s cost of capital
- Calculate NPV
- Implement project if it has positive NPV
Advantages and disadvantages of projects financed by debt
Pros
- Tax benefits
- Cheaper to secure
Cons
- Distress
- Bankruptcy
3 Techniques to account for debt in project valuation
Adjusted Present Value
Flow to equity
WACC
Adjusted present value technique
Separate valuations for unleveraged cash flows discounted using R0
Unlevered cost of equity capital and financing cash flows discounted using Rb (NPVF)
APV = NPV + NPVF
Flow to equity technique
Divide leveraged cash flows available to shareholders, Rs, By the leveraged cost of equity capital giving the value of equity
WACC technique
Discounts the unlevered cash flows using the WACC
Unlevered cash flows
After tax cash flows from operating activities
Levered cash flows
After tax cash flows from operating activities less financing cash flows
Financing cash flows
Cash flows from financing
Rs
Levered cost of equity capital
R0
Unlevered cost of capital
Rb
Cost of debt capital
What is included in levered cash flows that isn’t in unlevered?
Interest payments on the debt
Calculating project cash flow using APV
- Calculate UCF
- Discount rate = R0
- NPV of all equity = -Cost + UCF/Ro
How to work out APV
APV = NPV + NPVF
NPVF = Tc x B (Not for perpetuity)
Difference between debt to value and debt to equity ratios?
Debt to value:
- Debt/ Total value
Debt to equity:
- Debt/ Equity
Debt to equity figures should add up to total value rather than being a percentage of total value
If we use APV with a perpetuity, What do we use for PV?
Rs rather than Ro
Flown equity steps for project valuation?
- Calculate levered cash flow
- Calculate levered cost of equity
- Valuation
Using WACC form project valuation
Value of project = UCF/ WACC
NPV = -Costs + Value
When should you use APV?
Use APV if the project’s absolute level of debt is known over the life of the project
When to use Flow t equity method?
If the firm’s target debt to value ratio applies to the project over its life
When to use WACC method?
Use WACC if the firms target debt to value ratio applies to the project over its life
