(Previously assumed a discount rate)Currently one firm in the industry:FinancingDebt:.40 Equity:.60 Beta:1.5 iRate:.12Tc=.40Mkt Risk premium=.085Riskless iRate=.08rB=.10What is the appropriate discount rate for this venture for firm 2Could use APV, FTE or WACC thus the appropriate discount rates are r0, rS, and rWACC1. Determing Firm 1’s cost of equity Capital (rS)(Use security market line (SML) of Chapter 10)Rs=RF +Betax(RbarM - RF)=.08 +1.5x.085=.2075NOTE:RbarM = the expected return on the market portfolioRF = the risk-free rate2. Determing Firm 1’s Hypothetical All-Equity Cost of Capital (r0) (**APV**)rS=r0+B/S(1 – Tc)(r0 – rB).2075=r0+.4/.6(.6)(r0 - .12)r0=.1825At this pont … assume risk of their venture is about equal to the risk of firms in industryThus, hypothetical discount rate of Firm 1 if all-equity financed = .1825.NOTE: This would be used if APV approach since APV uses r03. Determine rS (*** FTE approach ***)rS=r0+B/S (1-Tc)x(r0 – rB)=.1825+1/3 (.60)x(.1825 - .10)=.199Firm 1’s cost of equity capital (.199)<Firm 2’s (.2075)NOTE:This occutrs b/c Firm 2 has a higher debt / equityNote both firms are assumed to have the same business risk4. Determing rWACC (***WACC approach***)rWACC =B/ S+B xrB (1-Tc)+S/ S+BxrS=1/4x.10 (.6)+3/4x.199=.16425NOTE: rS is determined from the beta of the firm’s stock.SEE ch. 12 … beta can easily be estimated for any publicly traded firmAPV Example:*Firms generally set a target Debt / Equity ratio(Thus … use WACC and FTE)APV does not work here but is preferred when there are side benefits andside costs to debtIn this example: TAX SUSIDY to debt, FLOTATION COSTSand INTEREST SUBSIDYcome into play.10MM (1) project that will last five yearsThis implies straight –line depreciation of 2MM/yrCash Revenue-Cash Expenses=3.5MMTc=.34Risk-free raterB=.10Cost of unlevered Equityr0=.20Depreciation tax shield=Depreciationx(Tc)=2MMx.34=680k (2)Rev - Expenses=Rev-Expensesx(1-Tc)=3.5Mx(.66)=2.31M (3)Cash Flow ProjectionsC0C1C2C3C4C5(1)Initial10M(2)Dep. Tax Sh.680k680k680k680k680k(3)Rev – expenses2.31M2.31M2.31M2.31M2.31MTo use APV approach:Sum(All-equity value + Additional effects of debt)(A)(B)(A) All Equity ValueNPV=Initial Cost+Depreciation Tax Shield+ PV(Cash Rev – expenses)=-10MM+680kx 1 - ( 1 )^5+ 2.310Mx 1 - ( 1 )^18.104.22.168 1.20=-513,951Depreciation tax shield is discounted at the riskless rate of .10Revenue and Expenses are discounted at the higher rate of .20Equity flotation costs would make the NPV more negative.