RSM333 lecture5 - WACC, FTE, APV Outline Adjusted Present...

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WACC, FTE, APV 5 Outline I. Project leads to a change in capital structure: s Adjusted Present Value (APV) s Weighted Average Cost of Capital (WACC) s Flow to Equity (FTE) II. Project risk is different from firm risk III. CAPM with and without taxes
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1 Sabrina Buti, Rotman School of Management, RSM 333 Back to the investment decision Initial part of the course: – Firms consider projects that are similar to their “average” existing investments s Same risk s Independent from financing decisions – Simple to evaluate projects in this case: s Calculate the firm’s weighted average cost of capital s Discount the unlevered cash flows of the project using K wacc as the discount rate (1 ) wacc e d C S D K K K T D S D S = × + × × - + +
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2 Sabrina Buti, Rotman School of Management, RSM 333 The investment decision Now: What if these assumptions are violated? 1) What if the investment leads to a significant change in the firm’s capital structure? Leverage influences the cost of capital 2) What if the risk of the project is different from the risk of the overall firm? Discount rate depends on the risk of the project
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3 Sabrina Buti, Rotman School of Management, RSM 333 Change in the capital structure: 3 methods s The Adjusted Present Value (APV) method – Calculate CFs for the unlevered firm – Calculate CFs coming from debt financing separately s The WACC – Discount unlevered cash flows using the weighted average cost of capital s The Flow-To-Equity (FTE) method – Isolate cash flows to shareholders – Discount these CFs with K e of a leveraged firm
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4 Sabrina Buti, Rotman School of Management, RSM 333 An example Consider the following project: – The initial investment is $440,000 – Sales will be $500,000 per year in perpetuity – Operating (cash) costs will be 72% of sales, so $360,000 per year in perpetuity – The corporate tax rate is 40% – Cost of capital for an all-equity firm is K 0 = 20% – The project has the same risk as the overall firm – The firm will finance the project with $116,666.67 of perpetual debt (D/S = 1/3), which costs K d = 10%
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5 Sabrina Buti, Rotman School of Management, RSM 333 The Adjusted Present Value Approach s Principle – The value of a project for a levered firm is the value of the project for an unlevered firm ( NPV ) plus the present value of the financing side effects ( NPVF ) s The side effects of financing – The interest tax subsidy of debt – The costs of issuing new securities – The costs of financial distress APV NPV NPVF = +
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RSM333 lecture5 - WACC, FTE, APV Outline Adjusted Present...

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