Unformatted text preview: 7,000 = 84,000 – 77,000 = .6 x 11,666 7 Discount Rates r0 : the unlevered firm or project discount rate, i.e., the cost of capital for an allequity firm
rB : the cost of debt
rS = r0 + (B/S)(1 TC)(r0 rB) , the cost (required return) of levered equity, from MM Prop. II with taxes WACC = wB x rB x (1 TC) + wS x rS , where wB =B/(B+S) and wS=S/(B+S), which are target ratios. 8 Capital Budgeting with Leverage The capital structure and capital budgeting decisions are related. A project of an allequity firm might be rejected, while the same project might be accepted for a levered but otherwise identical firm. Intuition: the cost of capital frequently decreases with leverage, therefore turning some negative NPV projects into positive NPV projects.
9 Valuation Methods For an unlevered firm or project, we just discount by r0 (the unlevered firm or project discount rate)
For a levered firm, we have three choices
– Weighted average cost of capital (WACC)
– Adjusted Present Value (APV)
– Flow to Equity (FTE)
In theory, these three should give identical results. In practice, exact reconciliation is often difficult
APV is useful when leverage is changing substantially over time. The other two work best with fixed debt ratios 10 WACC Discount the firm’s cash flows by the weighted average cost of capital (WACC).
Valuation Formula: NPV = Σ UCFt / (1 + WACC) t UCF: Expected, aftertax, unlevered cash flow the CF to the equityholders of an unlevered firm. WACC: Aftertax weighted average cost of capital = wB rB (1T) + wS rS If UCF is a perpetuity, then NPV = UCF / WACC 11 WACC Inputs
– Debt/equity ratio (constant: it is the target leverage ratio)
– Costs of levered equity and cost of debt
– Tax rate
– Unlevered cash flows (after tax)
Note: since WACC < r0 , the value of a project with leverage is greater than the value of the project without leverage. If B>0 then WACC < ro & WACC decreases with leverage
12 (1) WACC = (B/(S+B)) rB...
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 Spring '13

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