17_Oheads

17_Oheads - Lecture Notes 17 Capital Budgeting for the...

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1 Lecture Notes 17 Capital Budgeting for the Levered Firm Only cor porate tax effects consider ed • Throughout, we assume that the net effects of debt can be ap- proximated by its effects on corporate tax liability alone. For per- petual cash flows, the value of the firm is then given by: • With personal taxes, the PV of the tax shield would be: With progressive personal tax schedules, however, and many in- vestors being tax-exempt, T S and T B are difficult to estimate and the effects of personal taxes are difficult to quantify. • The non-financial effects of debt may be reflected in market rates of return on debt and equity, but in any case depend on: i. the variability of the cash flow from the project, and V L V U T c B + = 1 1 T c () 1 T S 1 T B ---------------------------------------- B
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2 ii. the amount of leverage the firm currently has. • The optimal debt level should be chosen to maximize the market value of the firm. This is likely to imply that the net effects of debt could be approximated by the corporate tax benefits alone. • As illustrated, B * is likely to be close to B 1 . This may be partic- ularly so when there is asymmetry in the non-tax effects of debt. Then bankruptcy costs are much larger and the firm is likely to want to stay more conservative in taking on debt. Value of firm ( V ) Debt ( B ) V U V B * V L V U 1 1 T c () 1 T S 1 T B ---------------------------------------- B + = Net agency and bankruptcy costs B 0 V L V U T c B + = B 1
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3 A ppr oaches to measuring the net benefi ts of le v erage • Three different approaches can be used to calculate the NPV of an investment project when debt is used to help financing: i. adjusted present value (APV) ii. weighted average cost of capital (WACC) iii. flow to equity (FTE) • The APV approach calculates the project NPV ignoring financ- ing, then adds NPV of financing. • The WACC approach reduces the discount rate to reflect the tax benefits of debt financing. • The FTE approach views the project entirely from the perspec- tive of equity holders. • In principle, the approaches ought to give the same result, but in practice one approach often is easier to use than the others. • We can see that APV and WACC should give the same results from the following. The required return on equity should be:
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4 so the weighted average cost of capital can be written: • Under the APV approach, the tax benefits of debt are added to the NPV evaluated for an all-equity firm: Moving the T c B to the left side, we can write this as and since , and hence we can divide through by the common positive factor to obtain: • We can see that APV and FTE should give the give the same re- r S r 0 1 T c () B S --- r 0 r B + = r W S SB + ------------ r S 1 T c B + r B + r 0 1 T c B +   == V L EBIT 1 T c r 0 ---------------------------------- T c B + 1 T c r W ---------------------------------- 1 T c B V L --------- T c B + V L 1 T c B V L 1 T c r W T c B V L = V U 1 T c r 0 0 > = V L V U T c B + T c B > = V L 1 T c r W =
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5 sults from the following argument. Suppose an all-equity firm has no assets except for the right to fund a positive NPV project.
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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17_Oheads - Lecture Notes 17 Capital Budgeting for the...

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