LECTURE17

LECTURE17 - Lecture 17 Lecture Capital Budgeting for Levered Firm Three approaches 1 Adjusted Present Value(APV approach 2 Flow to Equity(FTE

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Lecture 17 Lecture 17 Capital Budgeting Capital Budgeting for Levered Firm for Levered Firm
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Three approaches 1. Adjusted Present Value (APV) approach 2. Flow to Equity (FTE) approach 3. Weighted Average Cost of Capital (WACC) approach
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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 Non-financial 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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Example Suppose bankruptcy and financial distress costs are irrelevant. Variable Value Investment I Expected EBIT All-equity 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 all-equity 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. All-equity value
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Example (Continued) 2. Additional financing side-effect $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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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.

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LECTURE17 - Lecture 17 Lecture Capital Budgeting for Levered Firm Three approaches 1 Adjusted Present Value(APV approach 2 Flow to Equity(FTE

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