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Unformatted text preview: WACC and APV Last time Beta equity beta, E 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 Game Plan Value a project while accounting for the appropriate cost of capital The approach so far Calculate FCFs Assume all equity financed and discount CFs at the opportunity cost of capital Now, incorporate debt: WACC APV 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 firms 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 Two Approaches Weighted Average Cost of Capital (WACC) Discount the FCF using the weighted average aftertax debt costs and equity costs Adjusted Present Value (APV) Value the project as if it was allequity 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 beforetax profits are $25 million in perpetuity. The tax rate is 40%. The firm has a target debttovalue ratio of 25%, the interest rate on debt is 7%, and the cost of equity is 12%. What is the projects NPV? WACC Example 1 Solution Step 1: Determine the aftertax CFs Aftertax CFs = $25*(1.40) = $15 million Step 2: Find the aftertax WACC WACC = D/V (1t)kd + E/V ke WACC = .25 x (1.4) x .07 + .75 x .12 = 10.05% Step 3: Determine the NPV NPV = 100 +15 / .1005 = 49.2 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 + + = 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 taxrate of the firm undertaking the project Leverage Ratio D/(D+E)...
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 Spring '08
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 Leverage

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