ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

# Would be used to discount project zeds expected

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• BrigadierIronShark6034
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would be used to discount Project Zed’s expected future FCF to compute the value of Project Zed, Zed 0 V . Zed 0 V is the present value of the future free cash flow generated by Project Zed. Project Zed’s NPV equals Zed 0 V minus the initial cost of Project Zed. [ Zed 0 E / Zed 0 V ] = 60% is the proportion of Zed 0 V going to shareholders, and [ Zed 0 D / Zed 0 V ] = 40% is the proportion of Zed 0 V . We will now put some numbers on the variables to clarify this. 17

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Estimating the WACC, page 18 of 25 EVALUATING PROJECT ZED (optional reading) Once after tax,Zed WACC r - has been estimated, two additional key steps in investment analysis can be performed. The first is the computation of the Project Zed’s NPV (which we will call Step 4); and the second is determining the method of financing Project Zed’s initial outlay so that the target market value proportions assumed in the cost of capital estimation will be achieved (Step 5). To examine this, assume the following definitions: Zed 0 V = present value of the future free cash flow from Project Zed Zed 0 I = initial outlay for Project Zed Zed,Debt 0 I = portion of Zed 0 I that is provided by new borrowing Zed,Equity 0 I = portion of Zed 0 I that is provided by equity financing We know that: Zed 0 I = Zed,Debt 0 I + Zed,Equity 0 I (16) Zed 0 NPV = Zed 0 V - Zed 0 I (17) where Zed 0 V in (17) is the present value of the future free cash from project Zed. S TEP 4. D ETERMINE THE NPV OF P ROJECT Z ED . The NPV of Project Zed, Zed 0 NPV , is expressed in (17). To compute Zed 0 V , the free cash flow from Project Zed is forecasted and then discounted using the estimated after tax,Zed WACC r - (= 10.64%) in (15). Estimating the initial outlay, Zed 0 I , involves an analysis of the alternative methods, and the associated costs, of implementing the project, and choosing the method that is most cost-effective. Suppose that: Zed 0 V = \$150 million (18a) 18
Estimating the WACC, page 19 of 25 Zed 0 I = \$100 million (18b) It follows that Zed 0 NPV equals: Zed 0 NPV = Zed 0 V - Zed 0 I = \$150 million - \$100 million = \$50 million (19) Project Zed is acceptable because Zed 0 NPV > 0, and Project Zed would be adopted if the choice were simply whether to accept or reject the project. If Project Zed were being compared with a mutually exclusive alternative, the one with the higher positive NPV would be adopted. S TEP 5. D ETERMINE THE F INANCING OF P ROJECT Z ED S I NITIAL O UTLAY . The financing proportions in (15) ([ Zed 0 E / Zed 0 V ] and [ Zed 0 D / Zed 0 V ]) are target market value proportions set by the firm (Todd Corporation) for Project Zed; they are the fractions of the value of Project Zed ( Zed 0 V ) going to the equity and to the debt, not the fractions of the cost of Project Zed (initial outlay Zed 0 I ) that will financed with debt and equity funds (the cost fractions being [ Zed,Debt 0 I / Zed 0 I ] and [ Zed,Equity 0 I / Zed 0 I ]). These cost fractions are determined as follows.

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