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**Unformatted text preview: **Valuation and Capital Budgeting with Leverage 1 There are two common methods of incorporating financing effects into valuation and capital budgeting. These are known as the Adjusted Present Value (APV) method and the Weighted Average Cost of Capital (WACC) method. When used correctly, they will always give the same answer. In many applications, one is easier to apply than the other. APV is most useful if you know the dollar amount of the debt while WACC is most useful if the firm will have a constant ratio of debt to equity. APV Method The APV method is a direct application of the Modigliani and Miller Proposition with corporate taxes. Recall that PV of firm = PV if all-equity financed + PV of tax shield . The APV applies this formula to a project. The NPV of the project if it is all-equity financed is sometimes called the base-case NPV . The following example illustrates the method: Example The SAW Corporation has the opportunity to invest $475K now and expects a pre-tax cash flow of $140K one year from now into the indefinite future. The tax rate is 34%. The appropriate cost of capital with all-equity financing 20%. Suppose that as part of the project, SAW can issue $100K of perpetual debt. Solution We first calculate base-case NPV. To calculate cash flows to the project, note the after-tax cash flow is (1- . 34)140 = 92 . 4 . 1 Notes for Finance 100 (sections 301 and 302) prepared by Jessica A. Wachter. Therefore base-case NPV =- 475 + 92 . 4 . 2 =- 13 Because debt is perpetual, the interest is 100 r D , and the value of the tax shield equals:...

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