Session 7 Flashcards
What is the impact of leverage on capital budgeting decisions?
Leverage (debt financing) affects capital budgeting by incorporating both costs (interest payments, financial distress risk) and benefits (tax shields). It influences the cost of capital, which affects project profitability and valuation.
How does debt financing impact the cost of capital and project valuation?
Debt financing introduces:
- Tax advantages: Interest payments are tax-deductible, reducing taxable income and increasing project value.
- Financial distress risks: Higher debt increases default risk, which can erode firm value.
- Cost of capital impact: Debt is often cheaper than equity, but excessive leverage raises overall risk to equity holders, increasing required returns.
What is the Adjusted Present Value (APV) approach, and how is it calculated?
Adjusted Present Value (APV) is a valuation method that separates the value of a project from the effects of financing decisions. It is useful when debt levels are expected to change over time.
Steps to Calculate APV:
- Calculate NPV (Net Present Value):
- Value the project assuming it is fully equity-financed.
- Discount free cash flows using the unlevered cost of capital.
- Calculate NPVF (Net Present Value of Financing side effects):
- Includes financing effects such as tax shields, issuance costs, and financial distress =
- Sum the two components:
- APV = NPV + NPVF => APV = NPV + tc x D
Components of NPVF:
- Tax subsidy on debt (interest tax shield)
- Costs of issuing new securities
- Costs of financial distress
- Other subsidies related to debt financing (e.g., government support)
What are the key advantages of using the Adjusted Present Value (APV) approach?
- APV is more flexible than traditional NPV because it explicitly considers financing effects.
- It is useful for projects where debt financing plays a significant role.
- Firms that maintain a target debt-to-market-value ratio often use APV.
What is the Flow to Equity (FTE) approach, and what are its key steps?
Flow to Equity (FTE) is a valuation method that focuses only on the equity portion of a project, considering the cash flows available to shareholders after debt payments (interest, issuance, and repayments).
- Calculate Free Cash Flow to Equity (FCFE) / Levered Cash Flow (LCF):
- Determine cash flows available to shareholders after deducting interest payments and debt repayments.
- Discount FCFE using the Cost of Equity (rE):
- rE is the appropriate discount rate since FTE values only the equity portion.
- rE is calculated based on the firm’s leverage.
- Compare Present Value of Equity Cash Flows to the Equity Investment:
* If NPV is positive, the project should be accepted.
Example:
What are the key takeaways of the Flow to Equity (FTE) approach?
- FTE focuses on equity holders rather than the entire firm.
- Interest and debt repayments are explicitly considered in cash flows.
- The cost of equity (rE) is used instead of the weighted average cost of capital (WACC).
- NPV decision remains the same as with the APV approach.
What is the Weighted Average Cost of Capital (WACC), and how is it calculated?
WACC is a method used to discount unlevered free cash flows (UCF), representing a firm’s overall cost of capital, considering both equity and debt financing. It implicitly accounts for the tax benefit of debt, as the cost of debt is adjusted for tax savings.
How is the WACC approach used in project valuation, and how is NPV calculated with WACC?
The WACC approach values a project by discounting unlevered cash flows (UCF) or free cash flow to the firm (FCFF) at the weighted average cost of capital (WACC). This method assumes financing through both debt and equity.
How it Works:
- Unlike APV (which separates financing effects) or FTE (which considers only equity cash flows), WACC blends the costs of debt and equity into a single discount rate.
- Since debt financing has tax benefits, WACC automatically adjusts the cost of debt for tax shields.
What are the key takeaways of the WACC approach to project valuation?
- WACC incorporates both debt and equity financing, adjusting for the tax benefits of debt.
- It assumes a constant target debt-to-value ratio.
- FCFF (firm-level cash flows) are discounted using rWACC.
- The NPV result is identical to the APV and FTE methods.
What is the debt-to-value ratio (D/V), and how is it calculated?
The debt-to-value ratio (D/V) represents the proportion of a company’s total financing that comes from debt.
How is the debt-to-equity ratio (D/E) different from the debt-to-value ratio (D/V), and how do you convert between them?
How do the APV, WACC, and FTE methods differ in project valuation?
When should you use WACC/FTE versus APV in project valuation?
Use WACC or FTE when:
- The company maintains a constant debt-to-value ratio.
- The proportion of debt to equity remains stable throughout the project.
- Financial managers prefer keeping a stable capital structure.
Use APV when:
- The total amount of debt is known in advance.
- The debt level changes over time and requires precise tax shield calculations.
- Example: In leveraged buyouts (LBOs), where companies take on high debt initially and repay it gradually.
What is the key difference between WACC/FTE and APV in project valuation?
- WACC/FTE is best when debt remains proportionally stable throughout the project.
- APV is better when debt fluctuates predictably, allowing for precise adjustments in tax shields and financing benefits.
