TOPIC 4: VALUATION AND CAPITAL BUDGETING FOR THE LEVERED FIRM

Chapter 9
1. Explain when firms should discount projects using the cost of equity. When should they
use the WACC instead? When should they use neither?
Only firms with no debt in their capital structure should use the cost of equity to discount
project cash flows, and only those projects that are very similar to a firms existing assets
should be discounted using that rate. Firms with both debt and equity should use the
WACC as long as they are evaluating a project that is similar to their existing assets.
When a firm is making an investment that is very different from its existing investments,
then it shouldnt use the companys cost of equity or its WACC.
2. If a firm takes actions that increase its operating leverage, we might expect to see an
increase in its equity beta. Why?
Operating leverage makes a firms profits and cash flows more variable and more
sensitive to changes in sales. An increase in operating leverage will therefore make a
firms stock price more sensitive to general economic conditions, and the stocks beta will
increase.
3. In its 2008 annual report, the Coca-Cola Company reported sales of $31.9 billion for
fiscal year 2008 and $28.9 billion for fiscal year 2007. The company also reported
operating income (roughly equivalent to EBIT) of $8.4 billion and $7.2 billion in 2008
and 2007 respectively. Meanwhile, arch-rival PepsiCo, Inc. reported sales of $43.2
billion in 2008 and $39.5 billion in 2007. PepsiCos operating profit was $6.9 billion in
2008 and $7.2 billion 2007. Based on these figures, which company has higher operating
leverage?
Using equation 9-2, simply divide the percentage change in EBIT by the percentage
change in sales for each firm. The firm with the higher ratio has more operating
leverage. Given the numbers in this problem, as shown below, PepsiCo has slightly
higher operating leverage (0.86) than Coca-Cola (0.72).
Coca-Cola:

[($7.2 $6.3) $6.3] [($28.9 $24.1) $24.1] = 0.72

PepsiCo:

[($7.2 $6.5) $6.5] [($39.5 $35.1) $35.1] = 0.86

4. ASIC Inc. has assets worth $6.9 million. Two million dollars is financed with debt that
costs 10% a year in interest. If ASICs contribution margin is $175 per unit, then how
many units must be sold to cover the interest payments? If ASIC sells 2,500 units this
year, how much return on a pre-tax basis (i.e., return based on earnings before taxes) do
shareholders receive? How much pre-tax return would they receive if ASIC had no debt?
Interest payment: $2 million * 10% = $200,000
Debt coverage in units sold: $200,000 $175.00 = 1,142.86
Earnings prior to taxes: 2500*($175.00) $200,000 = $237,500

Shareholders return: $237,500 [$6.9 million $2 million] = 4.85%

Shareholders return assuming no debt: 2500*($175.00) $6.9 million = 6.34%.

5. A firm has an asset base with a market value of $5.3 million. Its debt is worth $2.5
million. If $0.2 million is paid in interest annually and the shareholders expect a 16%
annual return, what is the weighted average cost of capital assuming no corporate taxes?
What is the WACC if corporate taxes are 45%?
Debt ratio: $2.5 million $5.3 million = 47.17%
Equity ratio: 100% 47.17% = 52.83%
Return on debt: $0.2 million $2.5 million = 8.00%
WACC (no tax) = 47.17%*8% + 52.83%*16% = 12.224%
WACC (with tax) = 47.17%*8%*(1 45%) + 52.83%*16% = 10.528%

Chapter 14
6. Which valuation method would you use to assess an investment project that involved
modernizing a firms existing plant? The project will not affect the firms target debt-toequity ratio.
In this case you would use WACC or FTE.

7. A firm has 1,000,000 shares of stock outstanding, and each share is currently worth $20.
The stock has a beta of 1.2. The firm also has 10-year bonds outstanding with a par value
of $10,000,000, a coupon rate of 6% and a yield to maturity of 7%. The yield on the bonds
is currently 2 percentage points above the risk-free rate and 4 percentage points below the
expected return on the overall market. What is the firms WACC if the corporate tax rate is
35%?
The market value of equity is $20 million. The market value of debt is approximately $9.3 million.
From the CAPM, we can calculate the required return on equity as 5% + 1.2 x (11% - 5%) =
12.2%. The required return on debt is 7%. Therefore, the WACC is 9.8%, or
(1-0.35)*(0.07)*(9.3/29.3) + (0.122)*(20/29.3).

8. A project can generate unlevered cash flow of $4 million per year in perpetuity. Suppose
the firm considering this project finances its operations with an equal mix of debt and
equity. The required return on debt is 5%, and the required return on equity is 15%. The
marginal corporate tax rate is 30%. What is the projects NPV if the initial outlay is $20
million?
WACC = [50% x (1 30%) x 5%)] + [50% x 15%] = 9.25%;
NPV = -$20 + 4/0.0925 = $23.2 million

9. Torino Corp. is considering a project that will produce annual cash flows of $1.8 million
for the next 22 years. The firm has a debt-to-equity ratio of 1.5, where the debt has a
yield of 8% and the cost of equity is 18%. Assuming a 38% tax rate, what is the WACC
for Torino? Assuming that the project will be funded in the same manner as Torinos

existing capital structure, what is the NPV of the project based on a cost of $10 million?
Equity ratio = 1/(1.5+1) = 40%, debt ratio = 1-40% = 60%
WACC = 60%*8%*(1-38%) + 40%*18% = 10.176%
NPV =

$ 1.8(138 )
1
1
$ 10=$ 0.3337 million
10.176
(1+ 10.176 )22

10. The NPV of a project based on the cost of equity is -$5.85 million. To complete the APV
analysis, the debt shield must be calculated based on a tax rate of 30%. The firm can
issue $10 million of 7% debt over a 20-year period or it can issue $15 million of 6%
debt over 15 years (assume that all debt is issued at par). Which debt issue will provide
the better APV? Will the project be acceptable?
20-year debt
30

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7 $ 10
1
1
=$ 2.225 million
7
(1+7 )20

15-year debt
30

6 $ 1 5
1
1
=$ 2. 622 million
6
(1+6 )15

The 15-year debt will provide the better APV, but the project will still not be acceptable
because the APV is negative.