weighted average cost of capital and equivalent approaches
TRANSCRIPT
![Page 1: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/1.jpg)
Weighted Average Cost of Capital
And equivalent approaches
![Page 2: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/2.jpg)
Review item
A corporation is near bankruptcy. Why do the managers invest in bad risks?
![Page 3: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/3.jpg)
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.
![Page 4: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/4.jpg)
Capital Budgeting for the Levered Firm
Adjusted Present Value
Flows to Equity
Weighted Average Cost of Capital
APV Example
![Page 5: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/5.jpg)
Adjusted-Present-Value (APV)
NPV for an unlevered firm NPVF = net present value of financing APV = NPV + NPVF
![Page 6: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/6.jpg)
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
![Page 7: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/7.jpg)
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
![Page 8: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/8.jpg)
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)
![Page 9: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/9.jpg)
Weighted-Average-Cost-of-Capital
Discount rate: rWACC
PVUCF: PV of Unlevered Cash Flows
Value = PVUCF - Initial investment for entire project
![Page 10: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/10.jpg)
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion
Cash Flows UCF UCF LCF
Discount Rates r0 rWACC rS
PV of financing Yes No No
Which is best?Use WACC and FTE when the debt ratio is constantUse APV when the level of debt is known.
![Page 11: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/11.jpg)
Example p. 437: Project
Cash inflows 500 Cash costs 360 Operating income 140 Corporate tax 47.6 Unlevered cash flow 92.4
Cost of project 475
![Page 12: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/12.jpg)
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
![Page 13: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/13.jpg)
APV recap
Value = 475 + 29.918 = 504.918 Debt = - 126.2295 Equity = 378.6885 Debt/Equity = 1/3 Debt/(Debt + Equity) = 1/4
![Page 14: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/14.jpg)
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
![Page 15: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/15.jpg)
FTE (continued)
Cost 475 Borrowing - 126.2295 Cost to equity 348.7705
![Page 16: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/16.jpg)
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
![Page 17: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/17.jpg)
FTE valuation
NPV = - 348.7705 + 84.06885/.22… = 29.918 Same as in APV method. Now, same thing with WACC.
![Page 18: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/18.jpg)
Find rWACC
rWACC = (S/(S+B))rS+(B/(B+S))(1-TC)rB
=(3/4)(.222) + (1/4)(.66)(.1) = .183
![Page 19: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/19.jpg)
WACC method continued
NPV = - 475 + 92.4/.183 = 29.918 All methods give the same thing.
![Page 20: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/20.jpg)
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
![Page 21: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/21.jpg)
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.
![Page 22: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/22.jpg)
Leverage of the start-up
Not 100%. Value is 30 + 13.2. B = 30, S = 13.2 S/(B+S) = .305555555 (can’t expect a round number here)
![Page 23: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/23.jpg)
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
![Page 24: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/24.jpg)
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
![Page 25: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/25.jpg)
Cash flows to equity
Cost to equity = 0 CF’s = (10-3)*.66 = 6.6-3*.66=.462 rS = r0 + (B/S)*(r0 –rB))(1- TC )
rS = .35
NPV = 4.62/.35 = 13.2
![Page 26: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/26.jpg)
Review item
Complete the following statement and explain briefly: nothing matters in finance except __________ and _________.
![Page 27: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/27.jpg)
Answer: taxes and bankruptcy
Explanation. Because of homemade leverage, capital structure doesn’t 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.
![Page 28: Weighted Average Cost of Capital And equivalent approaches](https://reader036.vdocument.in/reader036/viewer/2022062307/551a83f355034643688b5819/html5/thumbnails/28.jpg)