Financing and Valuation Chapter 19 Principles of Corporate Finance Tenth Edition Financing and Valuation Slides by Matthew Will McGraw Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered After Tax WACC Valuing Businesses Using WACC in Practice Adjusted Present Value Your Questions Answered

Capital Project Adjustments Adjust the Discount Rate Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors. Adjust the Present Value Assume an all equity financed firm and then make adjustments to value based on financing.

After Tax WACC Tax Adjusted Formula

After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Debt ratio = (D/V) = 500/1,250 = .4 or 40% Example - Sangria Corporation - continued Debt ratio = (D/V) = 500/1,250 = .4 or 40% Equity ratio = (E/V) = 750/1,250 = .6 or 60%

After Tax WACC Example - Sangria Corporation - continued

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

Capital Budgeting In this case r = wacc Valuing a Business or Project PV (free cash flows) PV (horizon value) In this case r = wacc

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 all-equity financed. The value of interest tax shields is picked up in the WACC formula.

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.

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.

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

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

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