1. Chapter 19 Principles of Corporate Finance Eighth Edition Financing and Valuation Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 2 McGraw-Hill/Irwin MT480 Unit 8 Seminar Chapter 19

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 3 McGraw-Hill/Irwin Topics Covered  After Tax WACC  Valuing Businesses  Using WACC in Practice  Adjusted Present Value  Your Questions Answered

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 4 McGraw-Hill/Irwin Capital Project Adjustments 1.Adjust the Discount Rate  Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors. 2.Adjust the Present Value  Assume an all equity financed firm and then make adjustments to value based on financing.

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 5 McGraw-Hill/Irwin After Tax WACC Tax Adjusted Formula

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 6 McGraw-Hill/Irwin 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?

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 7 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 8 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 9 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation - continued Debt ratio = (D/V) = 500/1,250 =.4 or 40% Equity ratio = (E/V) = 750/1,250 =.6 or 60%

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 10 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation - continued

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 11 McGraw-Hill/Irwin 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?

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 12 McGraw-Hill/Irwin 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?

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 13 McGraw-Hill/Irwin 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?

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 14 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 15 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 16 McGraw-Hill/Irwin After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 17 McGraw-Hill/Irwin 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.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 18 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 19 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 20 McGraw-Hill/Irwin Tricks of the Trade  What should be included with debt? –Long-term debt? –Short-term debt? –Cash (netted off?) –Receivables? –Deferred tax?

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 21 McGraw-Hill/Irwin 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

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 22 McGraw-Hill/Irwin Chapter 19 Practice Question 1 Table 19.3 shows a book balance sheet for the Wishing Well Motel chain. The company’s long-term debt is secured by its real estate assets, but it also uses short- term bank financing. It pays 10 percent interest on the bank debt and 9 percent interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The expected return on Wishing Well’s common stock is 18 percent. Calculate Wishing Well’s WACC. Assume that the book and market values of Wishing Well’s debt are the same. The marginal tax rate is 35 percent.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 23 McGraw-Hill/Irwin Chapter 19 Practice Question 1 If the bank debt is treated as permanent financing, the capital structure proportions are: Bank debt (rD = 10 percent) $280 9.4% Long-term debt (rD = 9 percent) 1800 60.4 Equity (rE = 18 percent, 90 x 10 million shares) 900 30.2 $2980 100.0% WACC* = [0.10x(1 - 0.35)x0.094] + [0.09x(1 - 0.35)x0.604] + [0.18x0.302] = 0.096 = 9.6%

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 24 McGraw-Hill/Irwin Chapter 19 Practice Question 2 Suppose Wishing Well is evaluating a new motel and resort on a romantic site in Madison County, Wisconsin. Explain how you would forecast the after-tax cash flows for this project. (Hints: How would you treat taxes? Interest expense? Changes in working capital?)

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 25 McGraw-Hill/Irwin Chapter 19 Practice Question 2 Forecast after-tax incremental cash flows as explained in Section 6.1. Interest is not included; the forecasts assume an all-equity financed firm.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 26 McGraw-Hill/Irwin Chapter 19 Practice Question 3 To finance the Madison County project, Wishing Well will have to arrange an additional $80 million of long-term debt and make a $20 million equity issue. Underwriting fees, spreads, and other costs of this financing will total $4 million. How would you take this into account in valuing the proposed investment?

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 27 McGraw-Hill/Irwin Chapter 19 Practice Question 3 Calculate APV by subtracting $4 million from base-case NPV.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 28 McGraw-Hill/Irwin

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 29 McGraw-Hill/Irwin Chapter 19 Practice Question 16 You are considering a five-year lease of office space for R&D personnel. Once signed, the lease cannot be canceled. It would commit your firm to six annual $100,000 payments, with the first payment due immediately. What is the present value of the lease if your company’s borrowing rate is 9 percent and its tax rate is 35 percent? Note: The lease payments would be tax-deductible.

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 30 McGraw-Hill/Irwin Chapter 19 Practice Question 16 The after-tax cash flows are: 0.65 × $100,000 = $65,000 per year. The after-tax discount rate is: 0.65 × 0.09 = 0.0585 = 5.85% The present value of the lease is equal to the present value of a five-year annuity of $65,000 per year plus the immediate $65,000 payment: $65,000 × [annuity factor, 5.85%, 5 years] + $65,000 = ($65,000 × 4.2296) + $65,000 = $339,924

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 19- 31 McGraw-Hill/Irwin Questions