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1、Chapter 17Valuation and Capital Budgeting for the Levered Firm2021/9/232021/9/231 1Chapter 17Chapter 17Executive SummaryFinancing and Investment decisions are actually Financing and Investment decisions are actually related.related.A project of an all-equity firm might be rejected,A project of an al
2、l-equity firm might be rejected,while the same project might be accepted for a while the same project might be accepted for a levered but otherwise identical firm.levered but otherwise identical firm.Previously we assume that the firm is financed Previously we assume that the firm is financed with e
3、quity only.The goal of this chapter is to with equity only.The goal of this chapter is to value a project,or the firm itself,when leverage value a project,or the firm itself,when leverage is employed.is employed.2021/9/232021/9/232 2Chapter 17Chapter 17Executive SummaryThree standard approaches to v
4、aluation under leverage:APV(adjusted-present-value)APV(adjusted-present-value)FTE(flow-to-equity)FTE(flow-to-equity)WACC(weighted-average-cost-of-capital)WACC(weighted-average-cost-of-capital)2021/9/232021/9/233 3Chapter 17Chapter 1717.1 Adjusted-Present-Value ApproachAPV=NPV+NPVFAPV:adjusted presen
5、t valueAPV:adjusted present valueNPV:value of the project to an unlevered firmNPV:value of the project to an unlevered firmNPVF:net present value of the financing side NPVF:net present value of the financing side effects.effects.2021/9/232021/9/234 4Chapter 17Chapter 1717.1 Adjusted-Present-Value Ap
6、proachOne can generally think of four side effectsThe Tax Subsidy to DebtThe Tax Subsidy to DebtThe Costs of Issuing New SecuritiesThe Costs of Issuing New SecuritiesThe costs of Financial DistressThe costs of Financial DistressSubsidies to Debt FinancingSubsidies to Debt FinancingWe consider the ta
7、x subsidy only in the following We consider the tax subsidy only in the following example.example.Example One(page 469)Example One(page 469)2021/9/232021/9/235 5Chapter 17Chapter 1717.1 Adjusted-Present-Value ApproachConclusion from the example:The value of the project when financed with The value o
8、f the project when financed with some leverage is equal to the value of the some leverage is equal to the value of the project when financed with all equity plus the project when financed with all equity plus the tax shield from the debt.tax shield from the debt.2021/9/232021/9/236 6Chapter 17Chapte
9、r 1717.2 Flow-To-Equity ApproachThe Flow-to-Equity approach is an alternative capital budgeting approach.The fomula simply calls for discounting the cash flow from the project to the equityholders of the levered firm at the cost of equity capital,rs.s.2021/9/232021/9/237 7Chapter 17Chapter 1717.2 Fl
10、ow-To-Equity ApproachThere are three steps to the FTE approachStep 1:Calculating Levered Cash Flow(LCF)Step 1:Calculating Levered Cash Flow(LCF)Step 2:Calculating rStep 2:Calculating rs sStep 3:ValuationStep 3:Valuation2021/9/232021/9/238 8Chapter 17Chapter 1717.3 Weighted-Average-Cost-of-Capital Me
11、thod2021/9/232021/9/239 9Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesCapital budgeting techniques in the early chapters of this text applied to all-equity firms.Capital budgeting for the levered firm could not be handled early in the book because the effects of debt on fi
12、rm value were deferred until the previous two chapters.2021/9/232021/9/231010Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesDebt increases firm value through tax benefits but decreases value through bankruptcy and related costs.APV first values the project on an all-equity b
13、asis,and then add the net present value of the debt.2021/9/232021/9/231111Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesThe FTE approach discounts the after-tax cash flow from a project going to the equityholders of a levered firm(LCF).The discount rate is rs s,which shows
14、that leverage raises the risk to the equityholders.2021/9/232021/9/231212Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesAll three approaches perform the same task:valuation in the presence of debt financing,all three provide the same valuation estimate.The three approaches a
15、re markedly different in technique.2021/9/232021/9/231313Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesComparison:APV versus WACCAPV versus WACCAPV and WACC display the greatest similarity.APV and WACC display the greatest similarity.Both approaches put the unlevered cash f
16、low Both approaches put the unlevered cash flow(UCF)in the numerator.(UCF)in the numerator.However,the APV discounts at rHowever,the APV discounts at r0 0,the WACC,the WACC discounts at rdiscounts at rWACCWACC.Both approaches adjust the basic NPV formula for Both approaches adjust the basic NPV form
17、ula for unlevered firms in order to reflect the tax benefit unlevered firms in order to reflect the tax benefit of leverage.of leverage.2021/9/232021/9/231414Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesComparison:Entity Being Valued.Entity Being Valued.The FTE approach ap
18、pears at first glance to be far The FTE approach appears at first glance to be far different from the other two.different from the other two.For the FTE,only the firms contribution to the For the FTE,only the firms contribution to the initial investment is subtracted out.initial investment is subtra
19、cted out.Under FTE,only the future cash flows to the Under FTE,only the future cash flows to the levered equityholders are valued.levered equityholders are valued.2021/9/232021/9/231515Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesA suggested GuidelineNPV of project is exac
20、tly the same under each NPV of project is exactly the same under each of the three methods.of the three methods.However,one method usually provides an However,one method usually provides an easier computation than another,and,in easier computation than another,and,in many cases,one or more of the me
21、thods are many cases,one or more of the methods are virtually impossible computationally.virtually impossible computationally.2021/9/232021/9/231616Chapter 17Chapter 1717.4 A Comparison of the APV,FTE,and WACC ApproachesA Suggested GuidelineUse WACC or FTE if the firms target debt-to-Use WACC or FTE
22、 if the firms target debt-to-value ratio applies to the project over its life.value ratio applies to the project over its life.Use APV if the projects level of debt is known Use APV if the projects level of debt is known over the life of the project.over the life of the project.2021/9/232021/9/23171
23、7Chapter 17Chapter 1717.5 Capital Budgeting When The Discount Rate Must Be EstimatedThe previous sections of this chapter introduced APV,FTE,and WACCthe three basic approaches to valuing a levered firm.One important detail remains,we assumed a discount rate.We now want to show how this rate is deter
24、mined for real-world firms with leverage.2021/9/232021/9/231818Chapter 17Chapter 1717.6 APV ExampleIf firms set a target debt-to-equity ratio,we use WACC and FTE for capital budgeting.However,as we mentioned earlier,APV is the preferred approach when there are side benefits and side costs to debt.An
25、 example,in addition to the tax subsidy to debt,both flotation costs and interest subsidies come into play.2021/9/232021/9/231919Chapter 17Chapter 1717.7 Beta and LeverageChapter 12(page 318)provides the formula for the relationship between the beta of the common stock and leverage of the firm in a
26、world without taxes.Formula 17.3This relationship holds under the assumption that the beta of debt is zero.2021/9/232021/9/232020Chapter 17Chapter 1717.7 Beta and LeverageThe corporate-tax case.Formula 17.4.It can be seen that leveerage increases the equity beta less rapidly under corporate taxes.Th
27、is occurs because,under taxes,leverage creates a riskless tax shield,thereby lowering the risk of the entire firm.2021/9/232021/9/232121Chapter 17Chapter 1717.7 Beta and LeverageExample of scale-enhancing project.Example of not scale-enhancing project.2021/9/232021/9/232222Chapter 17Chapter 17Summary and Conclusions2021/9/232021/9/232323Chapter 17Chapter 172021/9/232021/9/232424Chapter 17Chapter 17