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ECO359 – Lecture 6
Financial Leverage and Capital
Structure Policy
Ata Mazaheri
1
Prospectus
•
Recall that there are three questions in
corporate finance.
•
The first regards what longterm investments
the firm should make (the capital budgeting
question).
•
The second regards the use of debt (the capital
structure question).
•
This lecture is the nexus of these questions.
2
Lecture Outline
•
Adjusted Present Value Approach
•
Flows to Equity Approach
•
Weighted Average Cost of Capital Method
•
A Comparison of the APV, FTE, and WACC
Approaches
•
Capital Budgeting for Projects that are Not Scale
Enhancing
•
APV Example
•
Beta and Leverage
3
Adjusted Present Value Approach
•
The value of a project to the firm can be thought
of as the value of the project to an unlevered firm
(
NPV
) plus the present value of the financing side
effects (
NPVF
):
•
There are four side effects of financing:
– The Tax Subsidy to Debt
– The Costs of Issuing New Securities
– The Costs of Financial Distress
– Subsidies to Debt Financing
NPVF
NPV
APV
+
=
4
Assume MM Theory
Balance Sheet (Market Value, thousands)
Net Working Capital
150
250
Debt
Fixed Assets
825
725
Equity
Total assets
975
975
Total liabilities
Balance Sheet (Market Value, thousands)
Net Working Capital
150
250
Debt
Fixed Assets
825
725
Equity
Total assets
975
975
Total liabilities
Assume:
T
c
= 30%
r
0
= 11.32% (cost of unlevered equity)
r
B
=
10%
EBIT = $145,500 per year in
perpetuity (operating cash flow)
5
Adjusted Present Value Approach (APV)
1 What is the value of an allequityfinancedfirm (or project)?
2 What is the value of any and all additional side effects to financing?
Present Value of the Tax Shield from Debt Financing
=
T
c
(r
B
B)/r
B
=
T
c
B
{MM Prop. I}
=
.30 ($250,000) =
$75,000
=> V = $900,000+$75,000 =$975,000
2
6
Flows to Equity Approach (FTE)
(also called Equity Residual Method)
1

Calculate the levered cash flows
2. Calculate
r
S
3.
Levered Equity Value =
Cash Flow to Equity/r
E
=
$84,350/.1164=
$725,000 (approx.)
V = B + S
= $250,000 + $725,000 = $975,000
Annual aftertax cash flow to levered equity
= (EBIT  r
B
B)(1  T
c
)
= [(145,500  (.10)(250,000)] (1  .30)
= $84,350 per year
r
E
=
r
0
+ (1  T ) (B/S) (r
0
 r
D
) {MM Prop. II}
=
.1132 + (1  .3) (250/725) (.1132  .10)
=
.1164
=
11.64%
7
WACC Method
%
45
.
10
1164
.
975
725
10
.
975
250
)
30
.
1
(
=
×
+
×

=
WACC
1 Calculate the after tax WACC
2. Discount the after tax cash flow [FCF, Unlevered cash flow] by
WACC:
EBIT is $145,500 per year in perpetuity
000
,
975
$
1045
.
)
30
.
1
(
500
,
145
$
)
1
(
=

=

=
WACC
T
EBIT
Value
C
8
Another Example
Consider a project of the Pearson Company, the
timing and size of the incremental aftertax cash
flows for an allequity firm are:
0
1
2
3
4
$1,000
$125
$250
$375
$500
50
.
56
$
)
10
.
1
(
500
$
)
10
.
1
(
375
$
)
10
.
1
(
250
$
)
10
.
1
(
125
$
000
,
1
$
%
10
4
3
2
%
10

=
+
+
+
+

=
NPV
NPV
The unlevered cost of equity is
r
0
= 10%:
The project would be rejected by an allequity firm:
NPV
< 0.
9
APV Method
•
Now, imagine that the firm finances the project with
$600 of debt at
r
B
= 8%.
•