Valuation and Capital Budgeting for the Levered Firm:A project of an all equity firm might be rejected while the same project might be accepted for a levered but otherwise identical firm. This occurs because the cost of capital decreases with leverageApproaches:APV methodFTE methodWACC methodCan be used to value the firm as a whole or a project.1. Adjusted Present Value ApproachAPV = value of a project to a levered firmAPV = NPV + NPVFNPV of project to an unlevered firm+NPV of Financing Side effectsSide effects include:1. Tax Subsidy to Debt (Ch. 15) *** Highest dollar value ***For Perpetual debt … tax subsidy = Tc x B = Corporate tax rate x value of Debt2. Costs of Issuing New SecuritiesBankers must be compensated for their help in issuing public debt3. Costs of Financial DistressPossiblity of distress rises with debt financing, thus lowering value4. Subsidies to Debt Financing (Value Added)Interes on debt issued by state and local govts is not taxable to the investorThus, the yield on tax exempt debt is below that of taxable debtCorp can receive financing from a municipality at the tax-exempt rate b/c the municipality can borrow at this rate as well. Cash inflow: 500k / year (perpetuity)Cash Cost:72% of salesInitial Investment:475,000Tc.34r0.20 = Cost of capital for an all equity firmIf financed w/ with equity …Cash inflows500000Cash costs(360000)Operating Income140000Corp. Tax (47500)Unlevered Cash flow (UCF)92,400Distinction beween present value and net present value is importantPV is determed before initial investment @ date 0 is subtractedPV = 02400 / .20 = 462,000NPV = 462000 – 475000 = -13000(NPV negative … Reject)NOW… finances the project with 126229.50 in debtRemaining initial investment = 475000 - 125229.50 = 34877.5 (w/ equity)Deabt / Present value = .25 ( debt to market value ratio)NPV of project under leverage or APV = NPV+ Tc x B =-13000 +.34x126229.50=29,918 Therefore ACCEPT!Flow to Equity Approach:Discount cash flow from the project to the equity holders of the levered firm at the cost of equity capital (rS)Cash flow from project to equity holders of levered firm / rSr0 = .2iRate = .10Debt = 126229.501. Calculating Leveraged Cash Flow (LCF)Cash inflows500000Cash costs(360000)Interest (iRate x B)(12,622.95)IncomeAfter Tax127,377.05Corp. Tax (43,308.20)Levered Cash flow (LCF)84,068.85NOTE: one could also calculate LCF directly from UCFDifference between cash flow that equity holders receive in an unlevered firm and the cash flow they receive in a levered firm is the after tax interest paymentORUCF – LCF=(1 – Tc) xrB x B=after tax interest payment2. Calculating rS (From ch. 15)
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