Lecture 6 - Valuation and capital budgeting for the levered firm

Question 1

Main steps of project evaluation

Answer 1

1. Estimate free cash flow from project
2. Discount it at the project’s cost of capital
3. Calculate NPV
4. Implement project if it has positive NPV

Question 2

Advantages and disadvantages of projects financed by debt

Answer 2

Pros
- Tax benefits
- Cheaper to secure

Cons
- Distress
- Bankruptcy

Question 3

3 Techniques to account for debt in project valuation

Answer 3

Adjusted Present Value
Flow to equity
WACC

Question 4

Adjusted present value technique

Answer 4

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

Question 5

Flow to equity technique

Answer 5

Divide leveraged cash flows available to shareholders, Rs, By the leveraged cost of equity capital giving the value of equity

Question 6

WACC technique

Answer 6

Discounts the unlevered cash flows using the WACC

Question 7

Unlevered cash flows

Answer 7

After tax cash flows from operating activities

Question 8

Levered cash flows

Answer 8

After tax cash flows from operating activities less financing cash flows

Question 9

Financing cash flows

Answer 9

Cash flows from financing

Question 10

Rs

Answer 10

Levered cost of equity capital

Question 11

R0

Answer 11

Unlevered cost of capital

Question 12

Rb

Answer 12

Cost of debt capital

Question 13

What is included in levered cash flows that isn’t in unlevered?

Answer 13

Interest payments on the debt

Question 14

Calculating project cash flow using APV

Answer 14

1. Calculate UCF
2. Discount rate = R0
3. NPV of all equity = -Cost + UCF/Ro

Question 15

How to work out APV

Answer 15

APV = NPV + NPVF

NPVF = Tc x B (Not for perpetuity)

Question 16

Difference between debt to value and debt to equity ratios?

Answer 16

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

Question 17

If we use APV with a perpetuity, What do we use for PV?

Answer 17

Rs rather than Ro

Question 18

Flown equity steps for project valuation?

Answer 18

1. Calculate levered cash flow
2. Calculate levered cost of equity
3. Valuation

Question 19

Using WACC form project valuation

Answer 19

Value of project = UCF/ WACC

NPV = -Costs + Value

Question 20

When should you use APV?

Answer 20

Use APV if the project’s absolute level of debt is known over the life of the project

Question 21

When to use Flow t equity method?

Answer 21

If the firm’s target debt to value ratio applies to the project over its life

Question 22

When to use WACC method?

Answer 22

Use WACC if the firms target debt to value ratio applies to the project over its life