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06WACCandAPV

# 06WACCandAPV - WACC and APV Last time"Beta equity beta E E...

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WACC and APV

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Last time… “Beta”   equity beta,  β E β E depends on financial risk imposed by the  leverage ratio Asset betas can be computed by unlevering the equity beta Equity betas can be computed using regression analysis or comparables analysis Use betas to obtain the required return on equity ( 29 - + = t E D E A 1 1 β β
Game Plan Value a project while accounting for the  appropriate cost of capital The approach so far Calculate FCF’s Assume all equity financed and discount CF’s at  the opportunity cost of capital Now, incorporate debt:  WACC APV

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Review about FCF Assume all equity financed when calculating Differs from income on income statement 1. Income is calculated after interest expense. FCF  is calculated before interest. 2. Income is calculated after noncash expenses,  including depreciation. FCF adds back  depreciation. 3. CAPX and investment in WC are not expenses on  the income statement, but they do reduce FCF.
Review about FCF FCF calculation for a firm gives you the value of  the firm, as a whole Adjust to get a price per share for firm’s equity To calculate equity value, you must subtract value  of debt from the total value of the firm Divide equity value by total number of shares  outstanding

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Two Approaches Weighted Average Cost of Capital (WACC) Discount the FCF using the weighted average  after-tax debt costs and equity costs Adjusted Present Value (APV) Value the project as if it was all-equity financed Add the PV of the tax shield of debt and other side  effects
WACC Example 1 An Example: You are evaluating a new project. The project  requires an initial investments of \$100 million.  The forecasted before-tax profits are \$25 million  in perpetuity. The tax rate is 40%. The firm has a  target debt-to-value ratio of 25%, the interest  rate on debt is 7%, and the cost of equity is 12%.  What is the project’s NPV?

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WACC Example 1 Solution Step 1: Determine the after-tax CF’s After-tax CF’s = \$25*(1-.40) = \$15 million Step 2: Find the after-tax WACC  WACC =  Step 3: Determine the NPV NPV =
WACC What if there are more than 2 sources of finance? For example, the capital structure could include  both common and preferred stock which require  different rates of return.  If V = D + P + E, then  ( 29 V E k V P k t 1 k V D WACC E P C D + + - =

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WACC Project specific Debt worth D and with an expected return k D Equity worth E and with an expected return k E t is the marginal tax-rate of the firm undertaking  the project
Leverage Ratio D/(D+E) D/(D+E)  Target capital structure Use market values Common Mistakes Use a priori capital structure

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