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Lecture 17
Lecture 17
Capital Budgeting
Capital Budgeting
for Levered Firm
for Levered Firm
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View Full Document Three approaches
1. Adjusted Present Value (APV) approach
2. Flow to Equity (FTE) approach
3. Weighted Average Cost of Capital
(WACC) approach
Adjusted Present Value (APV) approach
Calculate NPV ignoring financing, then add NPV of financing
(NPVF)
:
APV = NPV + NPVF
Quantifiable financing side effects often include
tax shield due to debt
effects of personal taxes
floatation costs of issuing new debt or equity securities
subsidies to interest costs provided by governments
Nonfinancial effects of debt may be reflected in market interest.
In any case, they depend on :
variability of the cash flow from the project
amount of leverage the firm currently has
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View Full Document Example
Suppose bankruptcy and financial distress costs are irrelevant.
Variable
Value
Investment
I
Expected EBIT
Allequity required return
r
Corporate Tax rate
T
Leverage
B
Required return on debt
r
$10 million initial cost
$3,030,303 per year forever
20%
34%
$5 million riskless perpetual debt
10%
The NPV for the project with allequity finance is
( 29
( 29
0
10,000,000
0.2
0.34
1
3,030,303
I
r
T
1
EBIT
NPV
0
0
C
=


=


=
1.
Allequity value
Example (Continued)
2.
Additional financing sideeffect
$0.5m
5m
0.10
B
r
interest
Annual
B
=
×
=
=
B)
T
(
1.7m
0.1
$0.17m
r
B
r
T
NPVF
PV
Financing
C
B
B
C
=
=
=
=
=
$0.17m
0.5m
0.34
B
r
T
subsidy
Tax
B
C
=
×
=
=
Adjusted Present Value (APV) of the Project
$1.7
$1.7
$0
NPVF
NPV
APV
=
+
=
+
=
Immediately as the project is announced, the market value of
the original $5m equity should jump to $6.7m, and
to
$11.7m :
L
V
$5m
$6.7m
B
S
$1.7m
$10m
B
T
V
V
C
U
L
+
=
+
=
+
=
+
=
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View Full Document Example (Continued)
3.
Including Personal Taxes
With personal taxes, the PV of the tax shield would change
( 29 ( 29
B
T
1
T
1
T
1
1
to
B
T
from
B
S
C
C




4. Subsidized Financing
Since the appropriate discount rate is still
,
the PV of the tax shield becomes
10%
r
B
=
If the $5m debt is sold as a municipal bond at
B
B
r
10%
7%
'
r
=
<
=
( 29
$350,000
$5m
0.07
interest
annual
=
×
=
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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.
 Spring '06
 Bejan

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