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 leverage Approaches: APV method FTE method WACC method Can be used to value the firm as a whole or a project. 1. Adjusted Present Value Approach APV = value of a project to a levered firm APV = NPV + NPVF NPV of project to an unlevered firm + NPV of Financing Side effects Side 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 Debt 2. Costs of Issuing New Securities Bankers must be compensated for their help in issuing public debt 3. Costs of Financial Distress Possiblity of distress rises with debt financing, thus lowering value 4. Subsidies to Debt Financing (Value Added) Interes on debt issued by state and local govts is not taxable to the investor Thus, the yield on tax exempt debt is below that of taxable debt Corp 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 sales Initial Investment: 475,000 Tc .34 r0 .20 = Cost of capital for an all equity firm If financed w/ with equity … Cash inflows 500000 Cash costs (360000) Operating Income 140000 Corp. Tax (47500) Unlevered Cash flow (UCF) 92,400 Distinction beween present value and net present value is important PV is determed before initial investment @ date 0 is subtracted PV = 02400 / .20 = 462,000 NPV = 462000 – 475000 = -13000 (NPV negative … Reject) NOW… finances the project with 126229.50 in debt Remaining 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 + .34 x 126229.50 = 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 / rS r0 = .2 iRate = .10 Debt = 126229.50 1. Calculating Leveraged Cash Flow (LCF) Cash inflows 500000 Cash costs (360000) Interest (iRate x B) (12,622.95) Income After Tax 127,377.05 Corp. Tax (43,308.20) Levered Cash flow (LCF) 84,068.85 NOTE: one could also calculate LCF directly from UCF Difference 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 payment OR UCF – LCF = (1 – Tc) x rB x B = after tax interest payment 2. Calculating rS (From ch. 15) rS = r0 + B/S (1 – Tc)
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This note was uploaded on 10/06/2010 for the course FNCE 100 taught by Professor Jaffe during the Spring '10 term at UNC Asheville.