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Weighted Average Cost of Capital

And equivalent approaches

Review item
A

corporation is near bankruptcy. Why do the managers invest in bad risks?

Answer on bad risks


Managers

represent equity at least they are supposed to. Risk gives them a chance to pull out of bankruptcy. Equity gets the gain. A bad outcome leaves them still bankrupt. Debt suffers the loss.

Capital Budgeting for the Levered Firm


Adjusted Flows

Present Value
Average Cost of Capital

to Equity

Weighted APV

Example

Adjusted-Present-Value (APV)
NPV

for an unlevered firm NPVF = net present value of financing APV = NPV + NPVF

Unlevered NPV
Unlevered

cash flows = CF from operations - Capital Spending - Added NWC - corporate taxes for unlevered firm. Discount rate: r0 PVUCF: PV of unlevered cash flows NPV = PVUCF - Initial investment

Net present value of financing side effects


PV

of Tax Subsidy to Debt Costs of Issuing New Securities The Costs of Financial Distress Subsidies to Debt Financing

Flow-to-Equity (FTE)
LCF

= UCF - (1 - TC) x rB x B PVLCF = Present value of LCF FTE = PVLCF - Portion of initial investment from equity Required return on levered equity (rS) rS = r0 + B/SL x (1 - TC) x (r0 - rB)

Weighted-Average-Cost-ofCapital
Discount

rate: rWACC PVUCF: PV of Unlevered Cash Flows Value = PVUCF - Initial investment for entire project

Summary: APV, FTE, and WACC


APV Initial Investment Cash Flows Discount Rates PV of financing All UCF r0 Yes WACC All UCF rWACC No FTE Equity Portion LCF rS No

Which is best? Use WACC and FTE when the debt ratio is constant Use APV when the level of debt is known.

Example p. 437: Project


Cash

inflows Cash costs Operating income Corporate tax Unlevered cash flow
Cost

500 360 140 47.6 92.4


475

of project

APV
Physical

asset of project is discounted

at .2. NPV = 92.4/.2 - 475 = 462 - 475 = -13 Borrowing 126.2295 (from B/S = 1/3) rB = .1 NPVF = TC x B = 42.918 APV = -13 + 42.918 = 29.918

APV recap
Value

= 475 + 29.918 = 504.918 Debt = - 126.2295 Equity = 378.6885 Debt/Equity = 1/3 Debt/(Debt + Equity) = 1/4

Flow to Equity
Cash

inflows 500 Cash costs - 360 Interest - 12.62295 Income after interest 127.37705 Corporate tax - 43.3082 Levered cash flow 84.06885

FTE (continued)
Cost Borrowing Cost

to equity

475 - 126.2295 348.7705

FTE: Required return on equity


rS

=r0 +(B/S)(1-TC)(r0-rB) B/S = 1/3 rS = .2 +(1/3)(.66)(.2-.1) = .222

FTE valuation
NPV

= - 348.7705 + 84.06885/.22 = 29.918 Same as in APV method. Now, same thing with WACC.

Find rWACC
rWACC

= (S/(S+B))rS+(B/(B+S))(1-TC)rB =(3/4)(.222) + (1/4)(.66)(.1) = .183

WACC method continued


NPV

= - 475 + 92.4/.183 = 29.918 All methods give the same thing.

Example: Start-up, all debt financed.


Cost

of project = 30 CF of project 10 before tax, 6.6 after. Discount rate for an all equity firm .2. NPV = 6.6/.2 - 30 = 3

More APV example


Tax

shield from borrowing 30 at rB=.1 = .1(30).34 = 1.02. Discounted value = NPVF = 10.2. APV = 3 + 10.2 = 13.2.

Leverage of the start-up


Not

100%. Value is 30 + 13.2. B = 30, S = 13.2 S/(B+S) = .305555555 (cant expect a round number here)

Example continued. Do it again


Another

project, same as before. Retain debt-equity ratio. rWACC = (S/(B+S))rS + (B/(B+S))rB(1-TC) rWACC = .30555555rS +.694444 rB (.66) rS=r0 +(B/S)(1-TC)(r0-rB) rWACC= .15277777

Value, using rWACC


NPV

= -30 + 6.6/.1527777 =13.2 Lesson: WACC works when the debt equity ratio is established before the project and retained thereafter. APV works when the project changes the debt equity ratio

Cash flows to equity


Cost

to equity = 0 CFs = (10-3)*.66 = 6.6-3*.66=.462 rS = r0 + (B/S)*(r0 rB))(1- TC ) rS = .35 NPV = 4.62/.35 = 13.2

Review item
Complete

the following statement and explain briefly: nothing matters in finance except __________ and _________.

Answer: taxes and bankruptcy


Explanation.

Because of homemade leverage, capital structure doesnt matter in the absence of taxes and bankruptcy. Taxes matter because debt generates tax shields. Bankruptcy matters because financial distress damages the assets of the firm.