Chapter 17
Valuation and Capital Budgeting for the Levered Firm
17.1 AdjustedPresentValue Approach (APV)
APV = NPV + NPVF
o
Value of a project to a levered firm (APV) = Project of unlevered firm
+
NPV of
financing side effects
Side effects:
1.
Tax subsidy to debt 
for perpetual debt, value of tax subsidy is T
C
B
2.
Cost of issuing new securities
3.
Cost of financial distress
4.
Subsidies to debt financing →
Interest on debt issued by state/local government is
not taxable to the investor (Subsidy adds value)
Present value
of a project is determined before initial investment at date 0 is subtracted
→The initial investment is subtracted for the calculation of
net present value
Lend a fixed percentage of market value of a project not a fixed percentage of initial
investment
Net present value of project under leverage APV = NPV + T
C
* B
17.2 FlowstoEquity Approach (FTE)
r
s
= Cost of equity capital for perpetuity
FTE
=
s
r
firm
levered
of
ers
equityhold
project to
from
flow
Cash
Step 1: Calculating Levered Cash Flow (LCF)
Cash inflow

Cash costs

Interest
.
Income after interest

Corporate Tax
.
Levered cash flow
Alternatively
o
Difference between cash flow that equity holders receive in an unlevered firm and
cash flow that equity holders receive in a levered firm is aftertax interest payment
LCF = UCF  (1T
C
)*r
B*
B
Step 2: Calculating r
s
r
S
= r
0
+
S
B
* (1  T
C
) * (r
0
 r
B
)
Step 3: Valuation
Present value of LCF =
s
r
LCF
PV of project is simply difference between PV of project’s LCF and investment not borrowed
(cash inflow – debt)
PV project = LCF – (cash inflow – debt)
1
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Valuation and Capital Budgeting for the Levered Firm
17.3 WeightedAverageCostofCapital Method (WACC)
r
WACC
=
B
S
S
+
*
r
s
+
B
S
B
+
*r
B
* (1T
c
)
The target ratios are generally expressed in terms of market value.
Discount unlevered cash flow of project at the weighted average cost of capital r
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 Spring '09
 HH
 Net Present Value, Weighted average cost of capital, APV, initial investment

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