Lecture 17 ch 18 UGBA 103 2011

Lecture 17 ch 18 UGBA 103 2011 - Chapter 18 Capital...

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Chapter 18 Capital Budgeting for the Levered Firm
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2 Capital Budgeting with Leverage • Didn’t we already do capital budgeting? • Yes, but … • We pulled the cost of capital out of thin air • We ignored the effect of leverage
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3 Cost of Capital • Recall that the cost of capital is the return on a marketed investment opportunity of similar risk • You can use the CAPM to calculate the cost of capital using stock prices
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4 What happens if the project that you are evaluating is levered? • Leverage changes the risk of equity, so if you are using an equity beta in evaluating the project you have to make sure that it reflects the leverage. • Leverage has tax consequences, so you need to take those into account.
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5 So how do you go about this? • There are 3 well known methods • WACC (Weighted Average Cost of Capital method) • APV (Adjusted Present Value method) • FTE (Flow-to-Equity method)
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6 • The return on the claims to the assets must equal the return generated by the assets themselves: • Rearranging terms In a NORMAL market, we must have
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7 WACC cont’d • Dividing both sides by and simplifying • Substituting and Rearranging terms provides • NOTE: Holds no matter what leverage policy the firm adopts!
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8 Why then do we want to assume a target debt equity ratio? • Because the WACC is constant with a target debt equity ratio!
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9 WACC Method • Discount the FCFs using the WACC to provide an estimate of the value of the project.
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10 Example – Avco RFX project • RFX project characteristics: • New product with a 4 year life • Expected annual sales $60MM/year • Manufacturing Costs $25 MM/year • Operating expenses $9MM/year • Development • R&D and Marketing $6.67MM • Capital Investment $24MM • NO Working Capital implications • AVCO Firm characteristics: • Equity cost of capital: 10% • Debt cost of capital: 6% • Current Assets: $ 600 mil • Currrent Debt: $320 mil • Current Cash: $20 mil • Corporate tax rate of 40% • AVCO intends to keep constant D/E ratio (i.e., constant leverage ratio).
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11 Solution with WACC method • Step 1 • Calculate the FCF • Step 2 • Determine the target D/E ratio • Step 3 • Calculate the WACC • Step 4 • Calculate the NPV • Why don’t we always use this method? • Because it is complicated to implement if the firm does not maintain a target debt equity ratio.
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Step 1 Calculate the FCF
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