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CAPITAL STRUCTURE VALUATION & CAPITAL BUDGETING FEUI Program Studi Maksi – PPAK Manajemen Keuangan Kuliah II 13.04.2009 RWJ CH. 17 Sugeng Purwanto Ph.D, FRM Note: Submit a summary of Chapter 15&16. 1

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2 2 CAPITAL STRUCTURE AND FIRM VALUE PV of tax shield Zero leverage firm value Leveraged firm value PV of financial distress costs Value of the firm (V = S + B) Debt Ratio B/S or B/V

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3 CAPITAL ASSET PRICING MODEL (CAPM) “Common method to determine the cost of equity of risky assets” Expected Return E[R] Β (Systematic Risk) Security Market Line :”SML” E[Ri] = Rf + β (E[Rm] – Rf) E[Ri] Expected return stock “I” E[Rm]Expected market return RfRisk-free rate (T-Bill rate, SBI rate) β Systematic risk (non-diversiable risk, market tisk) E[Rm]-Rf Risk Premium Rf

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CAPITAL BUDGETING Review METHODS (1) Pay back period (PBP) (2) Discounted pay back period (DPBP) (3) NPV (net present value) (4) IRR (internal rate of return) 4

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CAPITAL BUDGETING 3 APPROACHES: (1) ADJUSTED PRESENT VALUE (2) FLOW TO EQUITY (FTE) (3) WEIGHTED AVERAGE COST OF CAPITAL (WACC) Note: All of the above approaches are using NPV method. 5

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ADJUSTED PRESENT VALUE APPROACH APV = NPV + NPFV APV = Adjusted Present Value NPV = Value of the project to an unlevered firm NPVF = Net Present Value of the financing side effect NPVAF Side Effects. There are 4 side effects (can be “+” or “-”: 1). The tax subsidy to debt (tax benefits from debt) 2). The costs of issuing new securities 3). The costs of financial distress 4). Subsidies to debt financing 6

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TAX SUBSIDY (BENEFITS FROM TAX) Example I.A. APV APPROACH. FOR UNLEVERED FIRM Consider a project of the P.B. Singer Co. with the following characteristics: Cash inflows: $500,000 per-year for the indefinite future Cash costs: 72% of sales Initial investment: $475,000 TC (Corporate Tax): 34% R0 (the cost of capital for a project of an all-equity firm) : 20% Calculate the Net Present value (NPV) of project! 7

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Answer: I.A. Cash inflows$500,000 Cash costs = 72%x$500,000-$360,000 Operating income$140,000 Corporate Tax: 34%x$140,000-$47,600 Unlevered Cash Flow (UCF)$92,400 Present Value of annuity of $92,400 with a discount rate R0 of 20% is: PV = $92,400/20% = $462,000 NPV = PV – Initial Investment = $462,500 - $475,000 = - $13,000 Zero DebtB = 0 ---- NPVF = 0 APV= NPV + NPVF APV= -$13,000 + 0 = -$13,000 The project is not feasible! 8

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Example continue: Example I.B. APV APPROACH FOR LEVERED FIRM Now assume that the firm finances the project with US$126,229.50 in debt. So that the remaining investment of $475,000 - $126,229.50 = $348,770.50 is financed with equity. Evaluate the project feasibility! Answer: APV = NPV + NPVF = NPV + TC x B APV= -$13,000 + 34% x $126,229.50 = -$13,000 + $42,918 = $29,918 The APV IS POSITIVE. THE PROJECT IS FEASIBLE. 9

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Example II. Evaluate the project feasibility with FLOW TO EQUITY (FTE) Approach. Answer: FTE Approach steps. Step 1.Calculating Levered Cash Flow (LCF) Step 2.Calculating the Discount Rate of Leverage Equity Rs Rs = R0 + B/S (1 – Tc) (R0 – RB) Step 3.Valuation NPV = LCF/Rs 10

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Step 1. Calculating LCF Cash Inflows$500,000 Cash costs: 72% x $500,000-$360,000 Interest: 10% x $126,229.50-$12,622.95 Income after interest$127,377.05 Corporate Tax: 34%x$127,377.05-$43,377.20 Levered Cash Flow (LCF)$84,068.85 Note: You can calculate LCF with a formula: LCF = UCF – (1 – Tc) x RB x B UCF = Unlevered Cash Flow = $92,400 RB = 10% B = $126,229.50 LCF = $92,400 – (1-34%)x10%x$126,229.50 = $84,068.,85 11

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Step 2. Calculating Discount Rate of Levered Equity Rs Rs= R0 + B/S (1 – Tc) (R0 – RB) Rs= 20% + 1/3 x (1-34%) (20% - 10%) = 22.2% Note: Target Debt-to-Equity ratio is 1/3 Target Debt-to-Value ratio is 1/4 B/S = 1/3 Debt-to-Equity ratio 12

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Step 3. VALUATION OF PROJECT The Present Value of the project levered cash flow (LCF) is PV= LCF/Rs = $84,068.85/22.2% = $378,688.50 Initial Investment$475,000 Debt$126,299.50 Equity = $475,000 - $126,299.50 = $348,770.50 NPV = PV – Equity Invested = $378,688.50 - $348,770.50 = $29,918. ---- NPV Positive! The project is feasible! The same result with APV approach. 13

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Example III. Evaluate the project feasibility with WEIGHTED AVERAGE COST OF CAPITAL METHOD (WACC) Answer: R WACC = S/(S+B) x Rs + B/(S+B) x RB (1 – Tc)S Equity B Debt Tc Corp Tax ∞UCF NPV = ∑ - Initial Investment t=1(1 + R WACC ) t UCF = UNLEVERED CASH FLOW PERPETUITY OF UCF : NPV= UCF/R WACC - Initial Investment 14

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Example III continue R WACC = 3/4 x 22.2% + ¼ x 10% (1 – 34%) = 18.3% PV of project = UCF/R WACC = $92,400/ 18.3% = $504,918 NPV= $504,918 - $475,000 = $29,918 NPV Positive, the project is feasible The same result with APV Approach or FTE Approach. 15

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WHICH APPROACH TO BE USED? Suggested guideline USE WACC OR FTE IF THE FIRM’s TARGET DEBT-TO- EQUITY RATIO APPLIES TO THE PROJECT OVER ITS LIFE. USE APV IF THE PROJECT’s LEVEL OF DEBT IS KNOWN OVER THE LIFE OF THE PROJECT. 16

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ESTIMATION OF DISCOUNT RATE Procedure to calculate Discount Rate Step 1. Determining of Cost of Equity Capital of industry Rs = Rf + β (Rm – Rf)CAPM Method To find Rs Step 2. Determining Cost of Capital if ALL Equity Rs = R0 + B/S (1-Tc) (R0 – RB) To find R0 Step 3. Determining Rs for the firm evaluated Step 4. Determining R WACC for the firm evaluated DO EXERCISES!! Example 17.1 17

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EXERCISES (AND/OR HOMEWORK) RWJ Text Book page 496 – 500 Example 17.1 Determination of Cost of capital. Example 17.2 APV Example. 18

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BETA AND LEVERAGE The No-Tax Case β Equity = β Asset [1 + Debt/equity] The Corporate Tax Case β Equity = [1 + (1-Tc)xDebt/Equity] β Unlevered firm 19

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Example 17.3. BETA AND LEVERAGE C.F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is considered riskless. The corporate tax rate is 34%. Regression analysis indicates that the beta of the firm’s equity is 2. the risk-free rate is 10%, and the expected market premium is 8.5%. What would the project’s discount rate be in the hypothetical case that C.F.Lee Inc is all equity? 20

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Example 17.3. Answer Beta of hypothetical all-equity firm. β Equity = [1 + (1-Tc)xDebt/Equity] β Unlevered firm Unlevered Beta: β Unlevered firm = β Equity / [1 + (1-Tc)xDebt/Equity] β Unlevered firm = 2/ [1 + (1-34%)x$100m/$200m] = 1.5 Discount Rate: Rs = R0 +β (Rm – Rf) Rs = 10% + 1.5 x 8.5% = 22.75% 21

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Example 17.3. The J.Lowers corp which currently manufacture staples is considering a $1 million investment in a project in the aircraft adhesive industry. The corporation estimates unlevered aftertax cash flows (UCF) of $300,000 per year into perpetuity from the project. The firm will finance the project with a debt-to-value ratio of 0.5 (or equivalently a debt-to- equity ratio of 1:1). The three competitors in this new industry are currently unlevered with betas of 1.2, 1.3, and 1.4. assuming a risk-free rate of 5%, a market risk premium of 9% and a corporate tax of 34%, what is the net present value of the oproject? 22

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Example 17.3. Answer 1.Calculating the average unlevered beta in the industry. Avg unlevered beta = (1.2 + 1.3 + 1.4)/3 = 1.3 2.Calculating the levered beta for J.lower’s new project β Equity = [1 + (1-Tc) Debt/Equity] β Unlevered firm = [1 + (1-34%) 1/1] = 2.16 3. Calculating the cost of levered equity for the project Rs = Rf + β (Rm – Rf) = 5% + 2.16x9% = 24.4% 4. Calculating the WACC for the project R WACC = B/V RB (1-Tc) + S/V Rs = 1/2x5% (1-34%)+1/2x24.4% = 13.9% 5. The project Val ue. NPV = UCF/R WACC – Initial Investment = $300,000/13.9% - $1million = $1.16 million 23

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24 THE END

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