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Chapter171Chapter17ValuationandCapitalBudgetingfortheLeveredFirmChapter172ExecutiveSummary•FinancingandInvestmentdecisionsareactuallyrelated.•Aprojectofanall-equityfirmmightberejected,whilethesameprojectmightbeacceptedforaleveredbutotherwiseidenticalfirm.•Previouslyweassumethatthefirmisfinancedwithequityonly.Thegoalofthischapteristovalueaproject,orthefirmitself,whenleverageisemployed.Chapter173ExecutiveSummary•Threestandardapproachestovaluationunderleverage:–APV(adjusted-present-value)–FTE(flow-to-equity)–WACC(weighted-average-cost-of-capital)Chapter17417.1Adjusted-Present-ValueApproach•APV=NPV+NPVF–APV:adjustedpresentvalue–NPV:valueoftheprojecttoanunleveredfirm–NPVF:netpresentvalueofthefinancingsideeffects.Chapter17517.1Adjusted-Present-ValueApproach•Onecangenerallythinkoffoursideeffects–TheTaxSubsidytoDebt–TheCostsofIssuingNewSecurities–ThecostsofFinancialDistress–SubsidiestoDebtFinancing•Weconsiderthetaxsubsidyonlyinthefollowingexample.•ExampleOne(page469)Chapter17617.1Adjusted-Present-ValueApproach•Conclusionfromtheexample:–Thevalueoftheprojectwhenfinancedwithsomeleverageisequaltothevalueoftheprojectwhenfinancedwithallequityplusthetaxshieldfromthedebt.Chapter17717.2Flow-To-EquityApproach•TheFlow-to-Equityapproachisanalternativecapitalbudgetingapproach.Thefomulasimplycallsfordiscountingthecashflowfromtheprojecttotheequityholdersoftheleveredfirmatthecostofequitycapital,rs.Chapter17817.2Flow-To-EquityApproach•TherearethreestepstotheFTEapproach–Step1:CalculatingLeveredCashFlow(LCF)–Step2:Calculatingrs–Step3:ValuationChapter17917.3Weighted-Average-Cost-of-CapitalMethodInvestmentInitialUCFttWACCrt1)1(Chapter171017.4AComparisonoftheAPV,FTE,andWACCApproaches•Capitalbudgetingtechniquesintheearlychaptersofthistextappliedtoall-equityfirms.Capitalbudgetingfortheleveredfirmcouldnotbehandledearlyinthebookbecausetheeffectsofdebtonfirmvalueweredeferreduntiltheprevioustwochapters.Chapter171117.4AComparisonoftheAPV,FTE,andWACCApproaches•Debtincreasesfirmvaluethroughtaxbenefitsbutdecreasesvaluethroughbankruptcyandrelatedcosts.•APVfirstvaluestheprojectonanall-equitybasis,andthenaddthenetpresentvalueofthedebt.Chapter171217.4AComparisonoftheAPV,FTE,andWACCApproaches•TheFTEapproachdiscountstheafter-taxcashflowfromaprojectgoingtotheequityholdersofaleveredfirm(LCF).Thediscountrateisrs,whichshowsthatleverageraisestherisktotheequityholders.Chapter171317.4AComparisonoftheAPV,FTE,andWACCApproaches•Allthreeapproachesperformthesametask:valuationinthepresenceofdebtfinancing,allthreeprovidethesamevaluationestimate.•Thethreeapproachesaremarkedlydifferentintechnique.Chapter171417.4AComparisonoftheAPV,FTE,andWACCApproaches•Comparison:–APVversusWACC•APVandWACCdisplaythegreatestsimilarity.•Bothapproachesputtheunleveredcashflow(UCF)inthenumerator.•However,theAPVdiscountsatr0,theWACCdiscountsatrWACC.•BothapproachesadjustthebasicNPVformulaforunleveredfirmsinordertoreflectthetaxbenefitofleverage.Chapter171517.4AComparisonoftheAPV,FTE,andWACCApproaches•Comparison:–EntityBeingValued.•TheFTEapproachappearsatfirstglancetobefardifferentfromtheothertwo.•FortheFTE,onlythefirm’scontributiontotheinitialinvestmentissubtractedout.•UnderFTE,onlythefuturecashflowstotheleveredequityholdersarevalued.Chapter171617.4AComparisonoftheAPV,FTE,andWACCApproaches•AsuggestedGuideline–NPVofprojectisexactlythesameundereachofthethreemethods.–However,onemethodusuallyprovidesaneasiercomputationthananother,and,inmanycases,oneormoreofthemethodsarevirtuallyimpossiblecomputationally.Chapter171717.4AComparisonoftheAPV,FTE,andWACCApproaches•ASuggestedGuideline–UseWACCorFTEifthefirm’stargetdebt-to-valueratioappliestotheprojectoveritslife.–UseAPViftheproject’slevelofdebtisknownoverthelifeoftheproject.Chapter171817.5CapitalBudgetingWhenTheDiscountRateMustBeEstimated•TheprevioussectionsofthischapterintroducedAPV,FTE,andWACC—thethreebasicapproachestovaluingaleveredfirm.•Oneimportantdetailremains,weassumedadiscountrate.•Wenowwanttoshowhowthisrateisdeterminedforreal-worldfirmswithleverage.Chapter171917.6APVExample•Iffirmssetatargetdebt-to-equityratio,weuseWACCandFTEforcapitalbudgeting.•However,aswementionedearlier,APVisthepreferredapproachwhentherearesidebenefitsandsidecoststodebt.•Anexample,inadditiontothetaxsubsidytodebt,bothflotationcostsandinterestsubsidiescomeintoplay.Chapter172017.7BetaandLeverage•Chapter12(page318)providestheformulafortherelationshipbetweenthebetaofthecommonstockandleverageofthefirminaworldwithouttaxes.•Formula17.3•Thisrelationshipholdsundertheassumptionthatthebetaofdebtiszero.Chapter172117.7BetaandLeverage•Thecorporate-taxcase.Formula17.4.•Itcanbeseenthatleveerageincreasestheequitybetalessrapidlyundercorporatetaxes.•Thisoccursbecause,undertaxes,leveragecreatesarisklesstaxshield,therebyloweringtheriskoftheentirefirm.Chapter172217.7BetaandLeverage•Exampleofscale-enhancingproject.•Exampleofnotscale-enhancingproject.Chapter1723SummaryandConclusionsChapter1724