AcF302: Corporate Finance

Capital Budgeting and Valuation with Leverage - Part I

Week 11

Mohamed Ghaly
[email protected]
Outline for Weeks 11 and 12
Week 11:
• Capital budgeting: Refresher.
• Capital budgeting: What is new this year?
• Capital budgeting with leverage: Main methods (WACC, APV, Flow-
to-equity).
Week 12:
• Relaxing some of the assumptions:
– Project has average risk.
– Constant debt-equity ratio.
– Corporate taxes are the only imperfection.
• Advanced topics:
– Periodically adjusted debt.
– Personal taxes.
Capital Budgeting: Refresher

• Capital budgeting was introduced in AcF214/AcF263.

• Capital budgeting is the process of analyzing investment

opportunities and deciding which ones to undertake.

• How could we evaluate a project?

– We can use techniques (decision rules) like the Net
Present Value (NPV), Internal Rate of Return (IRR), and
Payback method;
– The NPV is the most accurate evaluation method.
Capital Budgeting: Refresher

• In AcF214, the following basic procedure was outlined for

calculating the NPV of a project:
– First, you estimate the incremental free cash flows (FCF)
generated by the project;
– then you discount the FCF based on the project’s cost of
capital to determine the NPV.

• The investment rule using NPV is very simple:

– Invest if NPV > 0.
– Reject if NPV < 0.
Capital Budgeting: Refresher
• A perpetuity is a constant cash flow C paid every period,
forever.
• PV of a perpetuity is:

• An annuity is a constant cash flow C paid every period for N

periods.

• PV of an annuity is:

• In a growing perpetuity, the cash flows grow at a constant rate

g each period. The PV of a growing perpetuity is:
Capital Budgeting: Refresher (Example 1)

• Bay Properties is considering starting a commercial real

estate division. It has prepared the following four-year
forecast of free cash flows for this division:

Assume cash flows after 4 years will grow at 3% per year

forever.

a. If the cost of capital for this division is 14%, what is the

value in year 4 for cash flows after year 4 (i.e., continuation
value)?

b. What is the value today of this division?

a.The expected cash flow in year 5 is
240,000 × 1.03 = 247,200.
‣ We can value the cash flows in year 5 and beyond as
a growing perpetuity:
• Continuation Value(t = 4) = 247,200 = $2,247,273
(0.14 – 0.03)
b. We can compute the value of the division today by
discounting the free cash flows in years 1 through 4,
together with the continuation value.

-185,000 -12,000 99,000 240,000+ 2,247,273

NPV= + + + = $1,367,973
(1.14) (1.14) 2 (1.14) 3 (1.14) 4
Capital Budgeting: Refresher (Example 2)

• Forecasting Free Cash Flows:

• Calculating NPV:
Cost of Capital: Refresher
• AcF214 capital budgeting: the cost of capital was just given (e.g., last two
examples).

• Cost of capital (discount rate): The expected return on investments with

comparable risk and horizon.

• In the 2nd part of AcF214, you learned more about how to compute the cost
of equity for a company using the CAPM or multi factor models like the
Fama-French-Carhart model .
Cost of Capital: Refresher
• Asset cost of capital or unlevered cost of capital is the expected return
required by the firm’s investors (i.e., both shareholders and
debtholders) to hold the firm’s underlying assets, and is computed as
the weighted average of the firm’s equity and debt costs of capital.

• The weighted average cost of capital (WACC), measures the cost to

the firm after including the benefit of the interest tax shield.
Capital Budgeting: What is new this year?
• In AcF214, the focus was on all-equity financed projects. This year, we look at
more real-world capital budgeting decisions by considering how firm financing
can affect both the cost of capital and the set of cash flows that we discount.
• Three alternative methods to evaluate a project when it is financed by both debt
and equity:
– WACC method. .
– APV method.
– Flow-to-equity method.
• They always give the same result but in certain situations one method may be
easier to use than the others.
• In the remaining part of Week 11’s lecture, I will illustrate how to use each of
these methods.
1. Weighted Average Cost of Capital Method (WACC)

• The unlevered cost of capital (Ru) can be used to discount the cash
flows of an all equity financed project. However, when a project is
partly financed with debt, Ru is not suitable because it does not
incorporate the benefit of the interest tax shield.

E D
rU = rE + rD = Pretax WACC
E +D E+D

• The weighted average cost of capital (WACC), measures the cost to

the firm after including the benefit of the interest tax shield.

E D
rwacc = rE + rD (1 −  c )
E +D E +D
• Because the WACC incorporates the tax savings from debt, we can
compute the levered value of an investment, by discounting its future
free cash flow using the WACC.
FCF1 FCF2 FCF3
V0L = + + + ....
1 + rwacc (1 + rwacc )2
(1 + rwacc )3

• Companies could have different policies when it comes to deciding the

level or the percentage of debt in their capital structure.

• For the remaining part of this lecture (Week 11), we will assume that a
firm wants to maintain a constant debt-equity ratio, and we will see
how having such a debt policy could affect the valuation and financing
of the firm’s projects.
• For the remaining part of this lecture (Week 11), I will focus on two
examples of investments that a company named Avco is considering
to illustrate how the three valuation methods (WACC, APV and FTE)
can be used .

– First investment: Introduction of a new line of packaging (the RFX series).

– Second investment: Acquisition of another company.

Using the WACC to value a project:
Example 1 (RFX project)

• Assume Avco is considering introducing a new line of packaging,

the RFX Series.
– Technology: obsolete after 4 years (& will be depreciated
using the straight-line method).
– Annual sales: $60 million per year over the next 4 years.
– Manufacturing costs: $25 million per year.
– Operating expenses: $9 million per year.
– Upfront R&D and marketing expenses: $6.67 million
– Investment in equipment: $24 million
– No net working capital required.
– Corporate tax rate: 40%.
What is the NPV of this project?
Expected Free Cash Flow
from Avco’s RFX Project
Avco’s Current Market Value Balance Sheet ($ million)
& Cost of Capital without the RFX Project
• Avco intends to maintain a similar (net) debt-equity ratio for the
foreseeable future, including any financing related to the RFX
project. Thus, Avco’s WACC is

E D 300 300
rwacc = rE + rD (1 − c ) = (10%) + (6%)(1 − 0.40)
E +D E +D 600 600
= 6.8%
Note: that net debt (D) = 320 − 20 = $300 million.

• The value of the project, including the tax shield from debt, is
calculated as the present value of its future free cash flows.
18 18 18 18
V0L = + + + = $61.25 million
1.068 1.0682 1.0683 1.068 4

• The NPV of the project is $33.25 million

$61.25 million − $28 million = $33.25 million
Why did we use Net Debt in our calculation?

• Sometimes firms maintain large cash balances in excess of their

operating needs. This cash represents a risk-free asset on the
firm’s balance sheet, and reduces the average risk of the firm’s
assets.

• We are often interested in the risk of the firm’s underlying

business operations, separate from its cash holdings (i.e., the risk
of the firm’s enterprise value, which is the combined market value
of the firm’s equity and debt, less any excess cash).
Summary of WACC method:
1. Determine the FCF of the investment.
2. Compute the WACC.
3. Compute the value of the investment (VL) by discounting the FCF of the investment
using the WACC.

• Note: The WACC can be used throughout the firm as the

companywide cost of capital for new investments that are of
comparable risk to the rest of the firm and that will not alter
the firm’s debt-equity ratio.
Implementing a constant Debt-Equity ratio: How much
debt does Avco need to raise for the RFX project?
• By undertaking the RFX project, Avco adds new assets to the firm with
initial market value $61.25 million (VL).
– Therefore, to maintain its debt-to-value ratio, Avco must add
$30.625 million in new debt.
▪ 50% × 61.25 = $30.625
• Avco can add this debt either by reducing cash or by borrowing and
increasing debt.
– Assume Avco decides to spend its $20 million in cash and borrow
an additional $10.625 million.
▪ Because only $28 million is required to fund the project, Avco
will pay the remaining $2.625 million to shareholders through a
dividend.
$30.625 million − $28 million = $2.625 million
Avco's Current Market Value
Balance Sheet ($ Million) with the RFX Project

• The market value of Avco’s equity increases by $30.625 million.

$300 + $30.625 = $330.625
• Adding the dividend of $2.625 million, the shareholders’ total
gain is $33.25 million.
$30.625 + 2.625 = $33.25
– which is exactly the NPV calculated for the RFX project
Implementing a constant Debt-Equity ratio

• Debt Capacity
– The amount of debt at a particular date that is required to
maintain the firm’s target debt-to-value ratio.
– The debt capacity at date t is calculated as

Dt = d  Vt L

▪ Where d is the firm’s target debt-to-value ratio and VLt is

the levered value on date t.
Value and Debt Capacity of the RFX Project Over Time

Value of FCF in year t + 2 and beyond

FCFt + 1 + Vt L+ 1
Vt =
L

1 + rwacc
WACC method: Example 2 (Acquisition)

Valuing an Acquisition Using the WACC Method

Suppose Avco is considering the acquisition of another firm in its

industry that specializes in custom packaging.
The acquisition is expected to increase Avco’s free cash flow by
$3.8 million the first year, and this contribution is expected to grow
at a rate of 3% per year from then on.
Avco has negotiated a purchase price of $80 million.
After the transaction, Avco will adjust its capital structure to
maintain its current debt-equity ratio of 50%. If the acquisition has
similar risk to the rest of Avco, what is the value of this deal?
Solution
The free cash flows of the acquisition can be valued as a growing
perpetuity. Because its risk matches the risk for the rest of Avco,
and because Avco will maintain the same debt-equity ratio going
forward, we can discount these cash flows using the WACC of
6.8% (calculated earlier). Thus, the value of the acquisition is
3.8
VL = = $100 million
6.8% − 3%

Given the purchase price of $80 million, the acquisition has an

NPV of $20 million.
Debt Capacity for the Acquisition
How much debt must Avco use to finance the acquisition and still
maintain its debt-to-value ratio of 50%? How much of the acquisition cost
must be financed with equity?

Solution
From the previous slide, we know that the market value of the assets
acquired in the acquisition, VL is $100 million.
Thus, to maintain a 50% debt-to-value ratio, Avco must increase its debt
by $50 million (50% x $100 million).
The remaining $30 million of the $80 million acquisition cost will be
financed with new equity.
In addition to the $30 million in new equity, the value of Avco’s existing
shares will increase by the $20 million NPV of the acquisition, so in total
the market value of Avco’s equity will rise by $50 million.
2. Adjusted Present Value Method

• Adjusted Present Value (APV)

– A valuation method to determine the levered value of an
investment by first calculating its unlevered value and then
adding the value of the interest tax shield.

V L = APV = V U + PV (Interest Tax Shield)

• The first step in the APV method is to calculate VU: the

present value of the FCFs using the project’s cost of
capital if it were financed without leverage (ru).
The Unlevered Value of the Project (Vu)
• Unlevered Cost of Capital
– For a firm that maintains a target leverage ratio, it can be
estimated as the weighted average cost of capital computed
without taking into account taxes (pre-tax WACC).
E D
rU = rE + rD = Pretax WACC
E +D E+D

• For Avco, its unlevered cost of capital is calculated as

rU = 0.50  10.0% + 0.50  6.0% = 8.0%

• The project’s value without leverage is calculated as

18 18 18 18
VU = + 2
+ 3
+ 4
= $59.62 million
1.08 1.08 1.08 1.08
Valuing the Interest Tax Shield

Interest paid in year t = rD  Dt - 1

• The interest tax shield is equal to the interest paid multiplied

by the corporate tax rate (information on debt capacity is
from slide 25).
Valuing the Interest Tax Shield

• The next step is to find the present value of the interest tax
shield.
– Note: When the firm maintains a target leverage ratio, its
future interest tax shields have similar risk to the project’s
cash flows, so they should be discounted at the project’s
unlevered cost of capital.
0.73 0.57 0.39 0.20
PV (interest tax shield) = + + + = $1.63 million
1.08 1.082 1.083 1.084

V L = V U + PV (interest tax shield) = 59.62 + 1.63 = $61.25 million

NPV = $61.25 million − $28 million = $33.25 million

This is exactly the same value found using the WACC method
Summary of the APV Method
1. Determine the investment’s value without leverage (Vu)
2. Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield.
b. Discount the interest tax shield.
3. Add the unlevered value to the present value of the interest
tax shield to determine the value of the investment with
leverage
• The APV method has some advantages:
– It can be easier to apply than the WACC method when the
firm does not maintain a constant debt-equity ratio (Week
12).
– The APV approach also explicitly values market imperfections
(e.g., taxation) and therefore allows managers to measure
their contribution to value (Week 12).
Back to the acquisition example
Using the APV Method to value an Acquisition
Consider again Avco’s acquisition example.
The acquisition will contribute $3.8 million in FCFs the first year, which
will grow by 3% per year thereafter.
The acquisition cost of $80 million will be financed with $50 million in
new debt initially.
Compute the value of the acquisition using the APV method.

Solution
First, we compute the value without leverage. Given Avco’s unlevered
cost of capital of rU = 8% (slide 30), We get

3.8
V =
U
= $76 million
(8% − 3%)
• Avco will add new debt of $50 million initially to fund the
acquisition (slide 28).
• At a 6% interest rate, the interest expense the first year is
6% × 50 = $3 million.
which provides an interest tax shield of 40% × $3m = $1.2 million.
• Because the value of the acquisition is expected to grow by 3%
per year, the amount of debt the acquisition supports ̶ and,
therefore, the interest tax shield – is expected to grow at the same
rate.
• PV (interest tax shield) = 1.2 / (8% − 3%) = $24 million
The value of the acquisition with leverage is given by the APV:
V L = V U + PV (interest tax shiled) = 76 + 24 = $100 million

NPV of 100 − 80 = $20 million for the acquisition. Without the benefit
of the interest tax shield, the NPV would be 76 − 80 = − $4 million
3. Flow-to-Equity Method

• A valuation method that calculates the free cash flow available to

equity holders taking into account all payments to and from
debt holders.

• The cash flows to equity holders are then discounted using the
equity cost of capital.

• The first step in the FTE method is to determine the project’s free
cash flow to equity (FCFE).
▪ FCFE is the free cash flow that remains after adjusting for
interest payments, debt issuance, and debt repayments.
Expected FCFE from Avco’s RFX Project

To calculate Interest Expense & Net Borrowing, remember:

• The FCFE can also be calculated directly if you know the FCF, as

FCFE = FCF − (1 − c )  (Interest Payments) + (Net Borrowing)

After-tax interest expense

Valuing Equity Cash Flows
• Because the FCFE represent payments to equity holders, they should
be discounted at the project’s equity cost of capital.
– Given that the risk and leverage of the RFX project are the same
as for Avco overall, we can use Avco’s equity cost of capital of
10.0% to discount the project’s FCFE.

9.98 9.76 9.52 9.27

NPV (FCFE ) = 2.62 + + 2
+ 3
+ 4
= $33.25 million
1.10 1.10 1.10 1.10

• The value of the project’s FCFE represents the gain to shareholders

from the project, and it is identical to the NPV computed using the
WACC and APV methods.
Summary of the Flow-to-Equity Method

1. Determine the FCFE of the investment.

2. Determine the equity cost of capital.

3. Compute the equity value by discounting the FCFE using

the equity cost of capital.
Advantages & Disadvantages
of the Flow-to-Equity Method
• Advantages:
– It may be simpler to use if the firm’s capital structure is
complex and the market values of other securities in the
firm’s capital structure are not known.
– It may be viewed as a more transparent method for
discussing a project’s benefit to shareholders by
emphasizing a project’s implication for equity.
• Disadvantage:
– One must compute the project’s debt capacity to determine
the interest and net borrowing before capital budgeting
decisions can be made. Remember: the APV method has
the same disadvantage.
Back to the acquisition example

Using the FTE Method to Value an Acquisition

Problem
Consider again Avco’s acquisition example.
The acquisition will contribute $3.8 million in FCFs the first
year, growing by 3% per year thereafter.
The acquisition cost of $80 million will be financed with $50
million in new debt initially.
What is the value of this acquisition using the FTE method?
Solution
Because the acquisition is being financed with $50 million in new debt,
the remaining $30 million of the acquisition cost must come from equity:
FCFE0 = −80 + 50 = −$30 million

In one year, the interest on the debt will be 6% × 50 = $3 million. Because

Avco maintains a constant debt-equity ratio, the debt associated with the
acquisition is also expected to grow at a 3% rate: 50 × 1.03 = $51.5
million. Therefore, Avco will borrow an additional 51.5 − 50 = $1.5 million
in one year.
FCFE = FCF − (1 − c )  (Interest Payments) + (Net Borrowing)
FCFE1 = +3.8 − (1 − 0.40)  3 + 1.5 = $3.5 million

After year 1, FCFE will also grow at a 3% rate. Using the cost of equity
rE = 10%, we compute the NPV:
3.5
NPV (FCFE ) = −30 + = $20 million
(10% − 3%)