An increase in the debt ratio affects the value of the firm in two ways The

An increase in the debt ratio affects the value of

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An increase in the debt ratio affects the value of the firm in two ways: The value increases by the additional value of the interest tax shield in the absence of taxes, the cost of capital equals the cost of unlevered equity, irrespectively of leverage The tax shield gain is partially offset by the increase in the cost of equity because leverage magnifies systematic risk Thus, small fluctuations in leverage do not have a significant impact on the value of the firm However, for persistent changes in the debt ratio the tax shield may dominate over the increase in the cost of capital and have a significant effect on the value of the firm
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9 2. LBO Valuation Models: Valuation with Changing Capital Structure Copyright © Ignacio Muñoz-Alonso The problem with the WACC method and the capital structure: the circularity of Equity Value in the determination of the WACC Enterprise Value WACC Equity Value Leverage Ratio Large changes in the capital structure of the firm, such as in LBOs, will lead to significant deviations in value. When there is no indication of the equity value of the company at the beginning of the valuation period, as is the case of listed companies, the determination of the value of the equity should not be the target , the comparables or any other exogenous metric but any of the following: 1. A value method independent from leverage 2. A method accounting for the leverage resulting from the cash flow model used for the valuation
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10 2. LBO Valuation Models: Valuation with Changing Capital Structure Copyright © Ignacio Muñoz-Alonso The problem with the WACC method and the capital structure: the circularity of Equity Value in the determination of the WACC ?? = 1 ??? (1 + ????) 𝑛 𝐾 ? = 𝑅 ? + ? 𝑙 [?(?𝑃) ] ???? = 1 − ? 𝐾 ? ? + 𝐾 ? ? ?? ? 𝑙 = ? ? [1 − (1 − ?) ? ? ??? = ?? − ? ?? = ??? + ?
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11 2. LBO Valuation Models: Valuation with Changing Capital Structure Copyright © Ignacio Muñoz-Alonso We will examine three valuation methods under two changing debt policies : (1) The level of debt is known: and is expected to follow a predetermined trajectory independent of the value of the firm: Adjusted Present Value (APV) method (2) The debt ratio is expected to follow a predetermined path: but the level of debt in each year adjusts with value of the enterprise to maintain the planned debt ratio during that year : Recursive WACC Compressed APV, a simplified method also used when the debt ratio is expected to follow a predetermined set of values These are the most common departures from standard WACC valuation and are specifically indicated to analyze value in situations where capital structure changes over the valuation period
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12 2. LBO Valuation Models: (1) The Adjusted Present Value Model (APV) Copyright © Ignacio Muñoz-Alonso A detailed Example of APV Valuation ?𝑃? = 1 𝑛 ????????? ???
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