Chapter Seventeen Capital Budgeting for the Levered Firm.docx

1、Chapter Seventeen Capital Budgeting for the Levered FirmChapter Seventeen Capital Budgeting for the Levered FirmCorporate Finance Ross ? Westerfield ? JaffeSixth Edition17Chapter Seventeen Capital Budgeting for the Levered FirmPrepared byGady JacobyUniversity of Manitobaand Sebouh AintablianAmerican

2、 University of BeirutProspectusRecall that there are three questions in corporate finance.The first regards what long-term investments the firm should make (the capital budgeting question).The second regards the use of debt (the capital structure question).This chapter is the nexus of these question

3、s.Chapter Outline17.1 Adjusted Present Value Approach17.2 Flows to Equity Approach17.3 Weighted Average Cost of Capital Method17.4 A Comparison of the APV, FTE, and WACC Approaches17.5 Capital Budgeting for Projects that are Not Scale-Enhancing17.6 APV Example17.7 Beta and Leverage17.8 Summary and C

4、onclusions17.1 Adjusted Present Value ApproachThe value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF):There are four side effects of financing:The Tax Subsidy to DebtThe Costs of Issuing N

5、ew SecuritiesThe Costs of Financial DistressSubsidies to Debt FinancingAPV ExampleConsider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: 0 1 2 3 4 -$1,000 $125 $250 $375 $500The unlevered cost of equity is r0 = 10%:The proje

6、ct would be rejected by an all-equity firm: NPV < 0.APV Example (continued)Now, imagine that the firm finances the project with $600 of debt at rB = 8%. Pearsons tax rate is 40%, so they have an interest tax shield worth TCBrB = .40$600.08 = $19.20 each year.The net present value of the project u

7、nder leverage is:So, Pearson should accept the project with debt.APV Example (continued)Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, lets calculate the actual NPV of the loan:Which is the same answer as before.17.2

8、Flows to Equity ApproachDiscount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital, rS.There are three steps in the FTE Approach:Step One: Calculate the levered cash flowsStep Two: Calculate rS.Step Three: Valuation of the levered cash flo

9、ws at rS.Step One: Levered Cash Flows for PearsonSince the firm is using $600 of debt, the equity holders only have to come up with $400 of the initial $1,000.Thus, CF0 = -$400Each period, the equity holders must pay interest expense. The after-tax cost of the interest is BrB(1-TC) = $600.08(1-.40)

10、= $28.80 0 1 2 3 4-$400 $221.20CF2 = $250 -28.80$346.20CF3 = $375 -28.80-$128.80 CF4 = $500 -28.80 -600CF1 = $125-28.80$96.20Step Two: Calculate rS for PearsonTo calculate the debt-to-equity ratio, B/S, start with the debt to value ratio. Note that the value of the project isB = $600 when V = $1,007

11、.09 so S = $407.09. Step Three: Valuation for PearsonDiscount the cash flows to equity holders at rS = 11.77% 0 1 2 3 4 -$400 $96.20 $221.20 $346.20 -$128.80 17.3 WACC Method for PearsonTo find the value of the project, discount the unlevered cash flows at the weighted average cost of capital.Suppos

12、e Pearson Inc. target debt to equity ratio is 1.50.Valuation for Pearson using WACCTo find the value of the project, discount the unlevered cash flows at the weighted average cost of capital17.4 A Comparison of the APV, FTE, and WACC ApproachesAll three approaches attempt the same task: valuation in

13、 the presence of debt financing.Guidelines:Use WACC or FTE if the firms target debt-to-value ratio applies to the project over the life of the project.Use the APV if the projects level of debt is known over the life of the project.In the real world, the WACC is the most widely used approach by far.S

14、ummary: APV, FTE, and WACC APV WACC FTEInitial Investment All All Equity PortionCash Flows UCF UCF LCFDiscount Rates r0 rWACC rSPV of financing effects Yes No NoWhich approach is best?Use APV when the level of debt is constantUse WACC and FTE when the debt ratio is constantA scale-enhancing project

15、is one where the project is similar to those of the existing firm.In the real world, executives would make the assumption that the business risk of the non-scale-enhancing project would be about equal to the business risk of firms already in the business.No exact formula exists for this. Some execut

16、ives might select a discount rate slightly higher on the assumption that the new project is somewhat riskier since it is a new entrant.17.5 Capital Budgeting for Projects that are Not Scale-Enhancing17.5 Capital Budgeting for Projects that are Not Scale-Enhancing: An exampleWorld-Wide Enterprises (W

17、WE) is planning to enter into a new line of business (widget industry)American Widgets (AW) is a firm in the widget industry.WWE has a D/E of 1/3, AW has a D/E of 2/3.Borrowing rate for WWE is10 % Borrowing rate for AW is 8 % Given: Market risk premium = 8.5 %, Rf = 8%, Tc= 40%What is the appropriat

18、e discount rate for WWE to use for its widget venture?17.5 Capital Budgeting for Projects that are Not Scale-Enhancing: An exampleA four step procedure to calculate discount rates:Determining AWs cost of Equity Capital (rs)Determining AWs Hypothetical All-Equity Cost of Capital. (r0)Determining rs f

19、or WWEs Widget VentureDetermining rWACC for WWEs Widget Venture.STEP 1:Determining AWs cost of Equity Capital (rs)STEP 2 :Determining AWs Hypothetical All- Equity Cost of Capital. (r0)STEP 3 :Determining rs for WWEs Widget VentureAssuming that the business risk of WWE and AW are the same,NOTE : rs (

20、WWE) < rs (AW) because D/E (WWE) < D/E (AW) STEP 4: Determining rWACC for WWEs Widget Venture.17.6 APV Example: Worldwide Trousers, Inc. is considering a $5 million expansion of their existing business.The initial expense will be depreciated straight-line over five years to zero salvage valueT

21、he pretax salvage value in year 5 will be $500,000. The project will generate pretax earnings of $1,500,000 per year, and not change the risk level of the firm. The firm can obtain a five-year $3,000,000 loan at 12.5% to partially finance the project. If the project were financed with all equity, th

22、e cost of capital would be 18%. The corporate tax rate is 34%, and the risk-free rate is 4%. The project will require a $100,000 investment in net working capital.? Calculate the APV.17.6 APV Example: CostThe cost of the project is not $5,000,000.We must include the round trip in and out of net work

23、ing capital and the after-tax salvage value. Lets work our way through the four terms in this equation:NWC is riskless, so we discount it at rf. Salvage value should have the same risk as the rest of the firms assets, so we use r0.17.6 APV Example: PV unlevered projectThe PV unlevered project is the

24、 present value of the unlevered cash flows discounted at the unlevered cost of capital, 18%.Turning our attention to the second term,17.6 APV Example: PV depreciation tax shieldThe PV depreciation tax shield is the present value of the tax savings due to depreciation discounted at the risk free rate

25、, at rf = 4%Turning our attention to the third term,17.6 APV Example: PV interest tax shieldThe PV interest tax shield is the present value of the tax savings due to interest expense discounted at the firms debt rate, at rD = 12.5%Turning our attention to the last term,17.6 APV Example: Adding it al

26、l upSince the project has a positive APV, it looks like a go.Lets add the four terms in this equation:17.7 Beta and LeverageRecall that an asset beta would be of the form:17.7 Beta and Leverage: No Corp.TaxesIn a world without corporate taxes, and with riskless corporate debt, it can be shown that t

27、he relationship between the beta of the unlevered firm and the beta of levered equity is:In a world without corporate taxes, and with risky corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:17.7 Beta and Leverage: with Corp

28、. TaxesIn a world with corporate taxes, and riskless debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:Since must be more than 1 for a levered firm, it follows that17.7 Beta and Leverage: with Corp. TaxesIf the beta of the debt is no

29、n-zero, then:17.8 Summary and ConclusionsThe APV formula can be written as:The FTE formula can be written as:The WACC formula can be written as17.8 Summary and Conclusions (cont.)Use the WACC or FTE if the firm's target debt to value ratio applies to the project over its life.5 The APV method i

30、s used if the level of debt is known over the projects life.6 The beta of the equity of the firm is positively related to the leverage of the firm.Appendix 17-A:The APV approach to Valuing Leveraged Buyouts (LBOs)An LBO is the acquisition by a small group of investors of a public or private company

31、financed primarily with debt.In an LBO, the equity investors are expected to pay off outstanding principal according to a specific timetable.The owners know that the firms debt-to-equity ratio will fall and can forecast the dollar amount of debt needed to finance future operations.Under these circumstances, the APV approach is more practical than the WACC approach because the capital structure is changing.The APV Approach to Valuing LBOs:The RJR Nabisco BuyoutIn 1988, the CEO of the firm announced a bid of $75 per share to take the firm private in a management buyout.Another bid of