1
Lecture 7: Interaction between
Investment and Financing Decisions

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

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.

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.

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)

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

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.
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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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- Fall '13
- Corporate Finance, Net Present Value, Weighted average cost of capital, APV, debt-to-value ratio, constant debt-to-value ratio