Chapter 18

Valuation and Capital Budgeting for the

Levered Firm

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand the effects of leverage on the
value created by a project
 Be able to apply Adjusted Present Value
(APV), the Flows to Equity (FTE) approach,
and the WACC method for valuing projects
with leverage

18-1
Chapter Outline
18.1 Adjusted Present Value Approach
18.2 Flows to Equity Approach
18.3 Weighted Average Cost of Capital Method
18.4 A Comparison of the APV, FTE, and WACC
Approaches
18.5 Capital Budgeting When the Discount Rate Must
Be Estimated
18.6 APV Example
18.7 Beta and Leverage
18-2
18.1 Adjusted Present Value Approach
APV = NPV + NPVF
 The 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 Debt
 The Costs of Issuing New Securities
 The Costs of Financial Distress
 Subsidies to Debt Financing 18-3
APV Example
Consider a project of the Pearson Company. The timing and size
of the incremental after-tax cash flows for an all-equity firm are:

–$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is R0 = 10%:
$125 $250 $375 $500
NPV10%  $1,000    
(1.10) (1.10) (1.10) (1.10) 4
2 3

NPV10%  $56.50
The project would be rejected by an all-equity firm: NPV < 0. 18-4
APV Example
 Now, imagine that the firm finances the project with
$600 of debt at RB = 8%.
 Pearson’s 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 under leverage is:
APV = NPV + NPV debt tax shield
4
$19.20
APV  $56.50   t
t 1 (1.08)
APV  $56.50  63.59  $7.09
 So, Pearson should accept the project with debt. 18-5
18.2 Flow to Equity Approach
 Discount 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 flows (LCFs)
 Step Two: Calculate RS.
 Step Three: Value the levered cash flows at RS.

18-6
Step One: Levered Cash Flows
 Since the firm is using $600 of debt, the equity
holders only have to provide $400 of the initial
$1,000 investment.
 Thus, CF0 = –$400
 Each period, the equity holders must pay interest
expense. The after-tax cost of the interest is:
B×RB×(1 – TC) = $600×.08×(1 – .40) = $28.80

18-7
Step One: Levered Cash Flows

CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600

CF2 = $250 – 28.80
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

18-8
Step Two: Calculate RS
B
RS  R0  (1  TC )( R0  RB )
S
B B
To calculate the debt to equity ratio, , start with
S V
4
$125 $250 $375 $500 19.20
PV   2
 3
 4
 t
(1.10) (1.10) (1.10) (1.10) t 1 (1.08)
P V = $943.50 + $63.59 = $1,007.09
B = $600 when V = $1,007.09 so S = $407.09.

$600
RS  .10  (1  .40)(.10  .08)  11.77%
$407.09 18-9
Step Three: Valuation
 Discount the cash flows to equity holders at RS =
11.77%
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

$96.20 $221.20 $346.20 $128.80

NPV  $400    
(1.1177) (1.1177) (1.1177) (1.1177) 4
2 3

NPV  $28.56

18-10
18.3 WACC Method
S B
RW ACC  RS  RB (1  TC )
SB SB
 To find the value of the project, discount the
unlevered cash flows at the weighted average cost of
capital.
 Suppose Pearson’s target debt to equity ratio is 1.50

18-11
WACC Method
B 1.5S  B
1.50 
S
B 1.5S 1.5 S
   0.60  1  0.60  0.40
S  B S  1.5S 2.5 SB

RW ACC  (0.40)  (11.77%)  (0.60)  (8%)  (1  .40)

RW ACC  7.58%

18-12
WACC Method
 To find the value of the project, discount the
unlevered cash flows at the weighted average
cost of capital
$125 $250 $375 $500
NPV  $1,000    
2 3
(1.0758) (1.0758) (1.0758) (1.0758) 4

NPV7.58% = $6.68

18-13
18.4 A Comparison of the APV, FTE,
and WACC Approaches
 All three approaches attempt the same task:
valuation in the presence of debt financing.
 Guidelines:
 Use WACC or FTE if the firm’s target debt-to-value
ratio applies to the project over the life of the project.
 Use the APV if the project’s level of debt is known
over the life of the project.
 In the real world, the WACC is, by far, the most
widely used.
18-14
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing
effects Yes No No
18-15
Summary: APV, FTE, and WACC
Which approach is best?
 Use APV when the level of debt is constant

 Use WACC and FTE when the debt ratio is

constant
 WACC is by far the most common
 FTE is a reasonable choice for a highly levered
firm

18-16
18.5 Capital Budgeting When the
Discount Rate Must Be Estimated
 A scale-enhancing project 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 executives
might select a discount rate slightly higher on the
assumption that the new project is somewhat riskier
since it is a new entrant.
18-17
18.7 Beta and Leverage
 Recall that an asset beta would be of the
form:

Cov(UCF , Market)
β Asset 
σ 2Market

18-18
Beta and Leverage: No Corporate Taxes
 In a world without corporate taxes, and with riskless
corporate debt (bDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm
and the beta of levered equity is:
Equity
β Asset   β Equity
Asset
 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:
Debt Equity
β Asset   β Debt   β Equity
Asset Asset
18-19
Beta and Leverage: With Corporate
Taxes
 In 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:
 Debt 
β Equity  1   (1  TC ) β Unleveredfirm
 Equity 
 Debt 
 Since 1   (1  TC )  must be more than 1 for a
 Equity 
levered firm, it follows that bEquity > bUnlevered firm

18-20
Beta and Leverage: With Corporate
Taxes
 If the beta of the debt is non-zero, then:
B
β Equity  β Unlevered firm  (1  TC )(β Unlevered firm  β Debt ) 
SL

18-21
Summary
1. The APV formula can be written as:

Additional
UCFt Initial
APV    effects of 
t 1 (1  R0 )
t
investment
debt
2. The FTE formula can be written as:

LCFt  Initial Amount 
FTE      
t 1 (1  RS )
t
 investment borrowed 

3. The WACC formula can be written as

 Initial
UCFt
NPVW ACC   
t 1 (1  RW ACC )
t
investment 18-22
Summary
4 Use the WACC or FTE if the firm's target debt to
value ratio applies to the project over its life.
 WACC is the most commonly used by far.
 FTE has appeal for a firm deeply in debt.
5 The APV method is used if the level of debt is
known over the project’s life.
 The APV method is frequently used for special
situations like interest subsidies, LBOs, and leases.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.
18-23
Quick Quiz
 Explain how leverage impacts the value
created by a potential project.
 Identify when it is appropriate to use the APV
method? The FTE approach? The WACC
approach?

18-24