WACC and APV Flashcards
how is bankruptcy cost calculated in APV?
loss in case of default*probability of default
how to calculate levered beta when Debt is kept constant in dollar terms
Beta-unlevered(1+(1-t)D/E) with t being tax rate and D and E at market value
which are the firms for which CoC is better suited?
firms that are still growing and that will reach steady state in several years. firms that have unstable/changing leverage as that makes it hard to correctly estimate FCFE. firms that maintain a given leverage ratio.
when do APV and CoC results differ largely?
- Bankruptcy costs
The two models consider bankruptcy costs very differently: the APV provides more flexibility in
allowing consideration of indirect bankruptcy costs. To the extent that these costs do not show
up or show up inadequately in the pretax cost of debt, the APV approach will yield a more
conservative estimate of value - Tax benefit
The APV considers the tax benefit from a dollar debt value, usually based on existing debt. The CoC estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future - Discount rate
The APV approach often uses the pre-tax cost of debt as the discount rate to estimate
the value of the tax savings from debt; there are variations on the APV that discount the tax savings back at the WACC or the unlevered ke that yield values that are closer to those obtained in the CoC approach.
how is growth g estimated under APV?
reinvestment rate* return on capital
how is g estimated in CoC? what is the maximum value you can assume for g?
reinvestment rate*return on capital, at most the growth of the GDP in perpetuity. other firm characteristics should support assumptions about g.
can you account for higher risks related to leverage when using WACC?
yes, by increasing Ke and Kd at higher levels of debt.
what is firm value under CoC with cashflows growing at a steady rate in perpetuity?
EV=FCFO1/(WACC-g) with FCFO1 being the free cash flow next year.
what are APV’s limitations?
errors in estimating bankrupcy costs and probability of default are common. need to modify the way in which you calculate TB (debt*t) if the current interest expense does not reflect cost of debt. only suited for firms that maintain constant debt.
what are the limitations of CoC?
sensitive to assumptions about g (more than APV given that WACC is lower than Ku) and about CAPEX. using WACC to discount equates to assuming that the firm can freely rebalance their capital structure which isn’t always true. assumes the firm keeps a constant D/E ratio in perpetuity.
advantages of APV
separates debt benefits into different components each discounted at its own rate. extremely practical and widely used when considering transactions that are funded largely through debt (leveraged buyouts)
does EQ.V calculated by subtracting market value of net debt from EV equate that you obtain by discounting FCFE?
generally no. for this to happen you need: that the values of D and E used to compute WACC are the same you obtain from the valuation. there must be no extraordinary items that affect NI but do not appear in operating income. interest expense must be exactly the cost of debt used to calculate WACC times the market value of debt. if a company has any old debt in the books the 2 will not equate.
what is firm value under CoC given a company that reaches steady state after n years?
sum of all FCFO discounted at present using the high-growth WACC + the value in perpetuity of the firm= FCFO(n+1)/(WACC(steady state)-g) discounted at PV using the high growth WACC compounded n times.
what is the effect of leverage on WACC and firm value (under APV)?
leverage increases the weight of Kd in the WACC formula and thus reduces the rate, however, high levels of debt imply an increase in the levered BETA and in Ke (also Kd might increase as default risk is higher). there is a level of D/E that minimizes WACC. same thing for firm value under APV, higher debt increases PV of tax benefits but also increases bankruptcy costs. a certain level of leverage maximizes firm value.
