ECO359S-6 - Prospectus ECO359 Lecture 6 Recall that there are three questions in corporate finance The first regards what long-term investments the firm

ECO359S-6 - Prospectus ECO359 Lecture 6 Recall that there...

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1 0 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 long-term 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 all-equityfinancedfirm (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
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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 after-tax 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 after-tax cash flows for an all-equity 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 all-equity firm: NPV < 0. 9 APV Method Now, imagine that the firm finances the project with $600 of debt at r B = 8%.
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