Valuation & Capital Budgeting for the Levered Firm (W7)

Question 1

Adjusted Present Value Approach (APV)

Answer 1

Value of a project to the firm = value of the project to an unlevered firm (NPV all equity) plus the present value of financing side effects (NPVF)

Question 2

4 side effects of financing

Answer 2

Tax subsidy to debt
Cost of issuing new securities
Cost of financial distress
Subsidies to debt financing

Question 3

Flow to Equity Approach

Answer 3

Discount the cash flow from the project to equity holders of the levered firm at cost of levered equity, Rs

Question 4

Steps in FTE Approach

Answer 4

1. Calculate levered cash flows (LCFs)
2. Calculate Rs
3. Value the levered cash flows at Rs

Question 5

WACC Method

Answer 5

Discount the unlevered cash flows at WACC

Question 6

Which valuation approach is best?

Answer 6

APV - when level of debt is known
WACC (most common) and FTE - (reasonable) when the debt ratio is constant

Question 7

What do you do when the discount rate must be estimated? Scale enhancing vs. non-scale enhancing

Answer 7

Scale enhancing - select discount rate of a project similar to that of the firms existing assets
Non-scale enhancing - select a discount rate slightly higher, identify pure play

Question 8

Pure Play Firm Identification

Answer 8

Select a comparison firm (Single Segment Business - rarely exist)
Unlever the pure-plays equity beta to get B0
Relever to get the equity beta for the project using the debt ratio of the firm
Use CAPM to determine Rs for the project