1. Chapter 19 Financing and Valuation Principles of Corporate Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Chapter 19
Financing and Valuation
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered After Tax WACC Tricks of the Trade
Capital Structure and WACC
Adjusted Present Value
Discounting Safe, Nominal Cash Flows

3. After Tax WACC
The tax benefit from interest expense deductibility must be included in the cost of funds.
This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.
Old Formula

4. After Tax WACC
Tax Adjusted Formula

5. After Tax WACC Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

6. After Tax WACC
Example - Sangria Corporation - continued

7. After Tax WACC
Example - Sangria Corporation - continued

8. After Tax WACC Example - Sangria Corporation - continued
Debt ratio = (D/V) = 50/125 = .4 or 40%
Equity ratio = (E/V) = 75/125 = .6 or 60%

9. After Tax WACC
Example - Sangria Corporation - continued

10. After Tax WACC Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax.
Given an initial investment of $12.5 million, what is the value of the machine?

11. After Tax WACC Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

12. After Tax WACC Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

13. After Tax WACC
Preferred stock and other forms of financing must be included in the formula

14. After Tax WACC Example - Sangria Corporation - continued
Calculate WACC given preferred stock is $25 mil of total equity and yields 10%.

15. Tricks of the Trade What should be included with debt? Long-term debt?
Short-term debt?
Cash (netted off?)
Receivables?
Deferred tax?

16. Tricks of the Trade How are costs of financing determined?
Return on equity can be derived from market data
Cost of debt is set by the market given the specific rating of a firm’s debt
Preferred stock often has a preset dividend rate

17. WACC vs. Flow to Equity
If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were 41-equity financed. The value of interest tax shields is picked up in the WACC formula.

18. WACC vs. Flow to Equity
The company's cash flows will probably not be forecasted to infinity. Financial managers usually forecast to a medium-term horizon -- ten years, say -- and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of post-horizon flows. Estimating the terminal value requires careful attention, because it often accounts for the majority of the value of the company.

19. WACC vs. Flow to Equity
Discounting at WACC values the assets and operations of the company. If the object is to value the company's equity, that is, its common stock, don't forget to subtract the value of the company's outstanding debt.

20. WACC & Debt Ratios
Example continued: Sangria and the Perpetual Crusher project at 20% D/V
Step 1 – r at current debt of 40%
Step 2 – D/V changes to 20%
Step 3 – New WACC

21. Adjusted Present Value
APV = Base Case NPV
+ PV Impact
Base Case = All equity finance firm NPV
PV Impact = all costs/benefits directly resulting from project

22. Adjusted Present Value
example:
Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.

23. Adjusted Present Value
example:
Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.
Project NPV = 150,000
Stock issue cost = -200,000
Adjusted NPV - 50,000
don’t do the project

24. Adjusted Present Value
example:
Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.

25. Adjusted Present Value
example:
Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.
Project NPV = - 20,000
Stock issue cost = 60,000
Adjusted NPV 40,000
do the project

26. Miles and Ezzell

27. Equivalent Loan