QDai for FEUNL Finanças Nov 30. QDai for FEUNL Topics covered Capital budgeting with debt Adjusted Present Value Approach Flows to Equity Approach Weighted.
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QDai for FEUNL Topics covered Capital budgeting with debt Adjusted Present Value Approach Flows to Equity Approach Weighted Average Cost of Capital Method
QDai for FEUNL Adjusted Present Value Approach The value of a project to the firm can be thought of as side effects of financing :
QDai for FEUNL APV Example 01 2 3 4 –$1,000$125 $250 $375 $500 The unlevered cost of equity is r 0 = 10%: Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are:
QDai for FEUNL APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at r B = 8%. Pearson’s tax rate is 40% The net present value of the project under leverage is:
QDai for FEUNL APV Example (continued) Another way to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:
QDai for FEUNL Flows to Equity Approach Discount the cash flow from the project to _________________________________ at the cost of _________________________ Three steps in the FTE Approach
QDai for FEUNL Step One: Levered Cash Flows for Pearson Since the firm is using $600 of debt, the equity holders only have to come up with Thus, CF 0 = Each period, the equity holders must pay interest expense.
QDai for FEUNL Step Two: Calculate r S for Pearson B S B V To calculate the debt to equity ratio,, start with
QDai for FEUNL Step Three: Valuation for Pearson Discount the cash flows to equity holders at r S = 11.77%
QDai for FEUNL WACC Method for Pearson To find the value of the project, discount ___________________________________ at ____________________________________ Suppose Pearson’s target debt to equity ratio is 1.50
QDai for FEUNL Valuation for Pearson using WACC To find the value of the project, discount the unlevered cash flows at the weighted average cost of capital
QDai for FEUNL A Comparison of the APV, FTE and WACC All three approaches attempt the same task: Guidelines: Use WACC or FTE if Use the APV if In the real world
QDai for FEUNL Summary: APV, FTE, and WACC APVWACCFTE Initial Investment Cash Flows Discount Rates PV of financing effects Which approach is best? Use APV Use WACC and FTE when the most common for a highly levered firm
QDai for FEUNL Estimating the discount rate Firm A wants to finance a new project with a B/S ratio of 1/3. Its borrowing rate is 10%. Firm B in the same industry has a B/S ratio of 2/3. The beta of its equity is 1.5. Firm B’s borrowing rate is 12%. Corporate tax rate = 40%. Market risk premium = 8.5% Rf = 8% What is the discount rate for Firm A’s new project?
QDai for FEUNL Estimating the discount rate Firm B’s cost of equity Firm B’s cost of capital if unlevered
QDai for FEUNL Estimating the discount rate APV FTE WACC