LN7_notes - Lecture 7 Interaction between Investment and Financing Decisions 1 Outline 1 Introduction 2 Adjusted Present Value(APV I The APV Formula II

LN7_notes - Lecture 7 Interaction between Investment and...

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1 Lecture 7: Interaction between Investment and Financing Decisions
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2 Outline 1. Introduction 2. Adjusted Present Value (APV) I. The APV Formula II. Discounting Debt Tax Shields III. Unlevering Betas in a World with Taxes 3. Weighted Average Cost of Capital (WACC) 4. APV versus WACC 5. Examples
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3 1. Introduction In Lecture 6 we saw two channels through which debt finance can affect the value of a firm: 1. Debt finance reduces the firm s tax bill because interest payments (but not dividends) are tax deductible. 2. Debt finance increases the likelihood of bankruptcy and therefore the expected costs of financial distress.
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4 The expected costs of financial distress are difficult to measure and commonly left out in valuation exercises. On the other hand, the tax benefits of debt are relatively easy to compute. In Lecture 6 we computed them in simple examples. In this lecture we will learn how to compute them in more complex (and more realistic) examples. There are two alternative methods how to incorporate the tax benefits of debt into NPV calculations: Adjusted Present Value ( APV ) method. Weighted Average Cost of Capital ( WACC ) method.
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5 In Lecture 6 we learned that (ignoring the hard-to-measure expected costs of financial distress) the value of a levered firm equals the value of the unlevered firm plus the PV of tax shields. A firm is simply a bundle of projects. Hence we can apply the same rule also to individual projects: Value of levered project = Value of unlevered project + PV tax shields 2. Adjusted Present Value (APV)
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6 The method of writing the PV of a levered project as the sum of the PV of the unlevered project and the PV of financing side effects is known as Adjusted Present Value (APV) method. Besides tax shields we can also include other financing side effects such as issuance costs, loan subsidies and (if we can measure them) expected costs of financial distress. I. The APV Formula
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7 Using the APV formula we can compute the NPV of a levered project as follows: where C t denotes the unlevered project cash flows, T is the corporate tax rate, and D is the (incremental) amount of debt raised because the project is undertaken. The image cannot be displayed. Your computer may not have enough memory to open the image, or the image may have been corrupted. Restart your computer, and then open the file again. If the red x still appears, you may have to delete the image and then insert it again.
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8 Base-case NPV refers to the NPV of the unlevered project, i.e., the NPV of the project if it was all-equity financed. Unlevered cash flows do not include interest payments. Unlevered cash flows are discounted at the expected return on assets r A .
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