Lecture_6___Interaction_Fall08

Lecture_6___Interaction_Fall08 - Corporate Financial...

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Corporate Financial Policy (NBA 558) Interaction of Investment and Financing Decisions Johnson Graduate School of  Management Fall 2008 Prof. Mark Leary
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2 Calculating Present Values Assume a project: Generates an expected perpetual after-tax free cash flow (under all-equity financing) of UCF Has a required rate of return of under all- equity financing Without financing effects: With financing effects: APV approach: WACC approach: ( 29 financing NPV NPV APV U + = Investment r UCF NPV L - = Investment r UCF NPV U U - = U r
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3 The Tax-Adjusted WACC When to use: Financial policy is to maintain a constant leverage ratio (D/V) First some notation: The expected return on the assets of the firm (or project) if it were all-equity financed. Note that for an all-equity firm, this is equal to The expected return on the assets of the levered firm. Also known as the Tax- Adjusted Weighted Average Cost of Capital (WACC). The expected return on the firm’s equity (remember this changes with the leverage of the firm). The (pre-tax) expected return of the firm’s debt . E r U r D r L r E r
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4 Tax-Adjusted WACC - First Formula Effective (after-tax) cost of debt: Substitute into our old WACC formula: Why is this the discount rate applied to the unlevered cash flows? Consider a firm financed with D in debt and E in equity. Assume perpetual cash flows.
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