1. Capital budgeting and valuation with leverage
Chapter 18

2. outline Focus on constant debt to equity ratio
Present WACC valuation method
WACC/APV link
Project based WACC
Levering up and WACC

3. Capital budgeting procedure
Remember the steps we follow
Estimate the incremental cash flows generated by the project
Discount the free cash flow based on the project’s cost of capital to determine the NPV
How to estimate the appropriate cost of capital?
How does the financing decision affect the free cash flows and the project’s cost of capital?

4. Some simplifying assumptions
To lay out the method of valuation we require three simplifying assumptions
The project has average risk (same as the firm’s)
The firm’s debt-to-equity ratio is fixed over time
Corporate taxes are the only imperfection
We will simplify some assumptions later on

5. rwacc = E/(E+D) rE + D/(E+D) rD(1-τc)
The WACC method
To calculate project value
Calculate project’s (unlevered) FCFs
see chapter 7
Discount using WACC
rwacc = E/(E+D) rE + D/(E+D) rD(1-τc)
VL = PV(FCF’s, rwacc)

6. Deriving the WACC method

7. Deriving the WACC method

8. Using WACC an Example Example page 577
Avco, Inc. is a manufacturer of custom packaging products and is considering a new line of packaging (RFX) that includes an embedded radio-frequency identification tag. This improved technology will become absolute after 4 years. In the meanwhile it is expected to increase sales by $60 million per year. Manufacturing costs and operating expenses are expected to be $25 million and $9 million respectively per year.

9. Using WACC an Example Example continued
Developing the product will require upfront R&D and marketing expenses of $6.67 million together with an investment of $24 million in equipment. The equipment will be obsolete in four years and will depreciate via straight-line method over that period. Avco bills its customers in advance, and it expects no net working capital requirements for the project. Avco’s tax rate is 40%.

10. First step: predicting FCF’s
This implies the following steam of expected future cash flows

11. Calculating WACC
The market risk of RFX is expected to be similar to that for the company’s other lines of business.
We will use WACC to discount the cash flows generated from the project
We need information on the Avco’s capital structure
This can be found in the firm’s balance sheet

12. The data we need

13. NPV calculation

14. Using the APV method when D/E ratio is fixed
See chapter 15 for the case of fixed $D
Alternative method of valuation
First, calculate the unlevered value VU by discounting FCF’s using rU. With constant D/E ratio we can estimate rU by:
Second, calculate the value of the interest tax shield. With constant D/E ratio we discount the tax shield with rate rU
APV: VL = APV = VU + PV(int. tax shield)
rU = (D/(E+D))rD + (E/(D+E))rE

15. Deriving the unlevered cost of capital

16. Deriving the unlevered cost of capital

17. The unlevered value of the project
The RFX project has initial investment of $28 million and 4 annual FCF’s of $18 million
We discount FCF’s using Avco’s unlevered cost of capital (with target leverage ratio)

18. The WACC/APV link

19. Financing the project with fixed D/E ratio
The value of leveraged project (in $millions):
To maintain the ratio D/E=1
time 1 2 3 4
VLt
61.24
47.42
32.64
16.86
time 1 2 3 4
Debt
30.62
23.71
16.32
8.43
Equity

20. Finding expected interest payments
Given debt levels (in $millions):
We calculate interest payments and tax shield with tax rate of 40% and interest of 6%
time 1 2 3 4
Debt
30.62
23.71
16.32
8.43
time 1 2 3 4
interest
1.84
1.42
0.97
0.505
Tax shield
0.73
0.57
0.39
0.20

21. Discounting interest tax shield

22. One more example
Example – Avco is considering an acquisition of another firm in the same industry. Expected FCF’s will increase by $3.8 t=1, and will grow at annual rate of 3% from then on. The purchase price is $80 million will be financed with $50 million in new debt initially. Avco maintain a constant D/E ratio for the acquisition.

23. Valuation the acquisition using APV

24. Valuation using WACC

25. Project-based cost of capital

26. Project-based cost of capital how to find WACC of project?
Up to now we assumed that the project is in the same line of business as the rest of the firm and that it is financed while maintaining the same capital structure
This allowed us to assume that the cost of capital of the project equals the firm’s WACC
Sometimes these assumptions do not apply
Consider GE
GE Commercial Finance, GE Aviation, GE Healthcare, GE Energy, NBC Universal, among others

27. Project-based cost of capital
Comparable firms
Firm
project
rU (comp. firms) = rU (project)

28. Project-based cost of capital
Calculating WACC for project
Identify comparable firms in the same industry of the project (comparable risk)
Calculate average unleveraged cost of capital of comparable firms
Use this as the project’s unleveraged cost of capital
Given debt cost of capital you can calculate the project equity cost of capital
Then, given tax rate and firm’s capital structure you can calculate WACC for the project

29. Project-based cost of capital
Numerical example
Suppose now that Avco launches a new plastics manufacturing division with different market risk than its main packaging business
WACC of Avco is no longer relevant to us
Instead, we estimate the unlevered cost of capital (rU) of other plastic manufacturers
Remember this represents the underlying risk of the firm’s assets before we account for leverage effects

30. Step one: calculate unlevered cost of capital for comparable firms
You identify two single-division plastics firms that have similar business risk

31. Step two: calculate equity cost of capital for project
Back to our project
Remember, our project will be financed with debt and equity and therefore we will benefit from the interest tax shield
Suppose Avco maintains its capital structure (equal mix of debt and equity) when adopting the project, and that it will continue to borrow at 6%
Then, Avco’s equity cost of capital is

32. Step 3: calculate WACC for project
Once we have the equity cost of capital, the debt cost of capital, and marginal tax rate we can compute the project’s WACC

33. Changing Capital Structure and
WACC

34. Levering up and WACC
What happens to WACC when the firm increases leverage?
Example page 592
Consider a firm with debt-to-equity ratio of 25%, debt cost of capital of 6.67%, equity cost of capital of 12%, and tax rate of 40%
Its current WACC is,

35. rWACC (new) = 0.5 x 12% + 0.5 x 6.67% x (0.6) = 9%
Levering up and WACC
Example continued
Now suppose that the firm changes its debt-to-equity ratio to 50%
What is wrong with the calculation:
rWACC (new) = 0.5 x 12% x 6.67% x (0.6) = 9%

36. Levering up and WACC Two things can happen when levering up
First with higher leverage payments to equity holders bear more risk
Second with higher leverage the required rate of return on the firm’s debt by investors might increase
Suppose that now debt holders require 7.34% instead of 6.67%
To recalculate the firm’s WACC lets go back and calculate the firm’s unlevered cost of capital

37. Levering up and WACC

38. Assigned problems
Problems page
2, 5,14