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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Presentation transcript:

QDai for FEUNL Finanças Nov 30

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 –$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