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1、ProspectusRecall that there are three questions incorporatefinance.Thefirstregardswhatlong-terminvestments the firm should make(thecapitalbudgetingquestion).Thesecondregardstheuseofdebt(thecapitalstructurequestion).This chapter is the nexus of thesequestions.ChapterOutline17.1AdjustedPresentValueApp
2、roach17.2FlowstoEquityApproach17.3 Weighted Average Cost of CapitalMethod17.4 A Comparison of the APV,FTE,andWACCApproaches17.5CapitalBudgetingWhentheDiscountRateMustBeEstimated17.6APVExample17.7BetaandLeverage17.8SummaryandConclusions17.1AdjustedPresentValueApproachThevalueofaprojecttothefirmcanbet
3、houghtofasthevalueoftheprojecttoanunleveredfirm(NPV)plusthepresentvalueofthefinancingsideeffects(NPVF):Therearefoursideeffectsoffinancing:TheTaxSubsidytoDebtTheCostsofIssuingNewSecuritiesTheCostsofFinancialDistressSubsidiestoDebtFinancingAPVExampleConsideraprojectofthePearsonCompany,thetimingandsize
4、oftheincrementalafter-taxcashflowsforanall-equityfirmare:01 2 3 4 -$1,000$125$250$375$500The unlevered cost of equity is r0=10%:The project would be rejected by an all-equity firm:NPV 0.APVExample(continued)Now,imaginethatthefirmfinancestheprojectwith$600ofdebtatrB=8%.Pearsonstaxrateis40%,sotheyhave
5、aninteresttaxshieldworthTCBrB=.40$600.08=$19.20eachyear.The net present value of the project under leverage is:So,Pearson should accept the project with debt.APVExample(continued)NotethattherearetwowaystocalculatetheNPVoftheloan.Previously,wecalculatedthePVoftheinteresttaxshields.Now,letscalculateth
6、eactualNPVoftheloan:Which is the same answer as before.17.2FlowstoEquityApproachDiscountthecashflowfromtheprojecttotheequityholdersoftheleveredfirmatthecostofleveredequitycapital,rS.TherearethreestepsintheFTEApproach:StepOne:CalculatetheleveredcashflowsStepTwo:CalculaterS.StepThree:Valuationofthelev
7、eredcashflowsatrS.StepOne:LeveredCashFlowsforPearsonSincethefirmisusing$600ofdebt,theequityholdersonlyhavetocomeupwith$400oftheinitial$1,000.Thus,CF0=-$400Eachperiod,theequityholdersmustpayinterestexpense.Theafter-taxcostoftheinterestisBrB(1-TC)=$600.08(1-.40)=$28.80 01 2 3 4-$400$221.20CF2=$250-28.
8、80$346.20CF3=$375-28.80-$128.80 CF4=$500-28.80-600CF1=$125-28.80$96.20StepTwo:CalculaterSforPearsonTocalculatethedebttoequityratio,B/S,startwiththedebttovalueratio.NotethatthevalueoftheprojectisB=$600 when V=$1,007.09 so S=$407.09.StepThree:ValuationforPearsonDiscountthecashflowstoequityholdersatrS=
9、11.77%01 2 3 4 -$400$96.20$221.20$346.20 -$128.80 17.3WACCMethodforPearsonTofindthevalueoftheproject,discounttheunleveredcashflowsattheweightedaveragecostofcapital.SupposePearsonInc.targetdebttoequityratiois1.50ValuationforPearsonusingWACCTofindthevalueoftheproject,discounttheunleveredcashflowsatthe
10、weightedaveragecostofcapital17.4 A Comparison of the APV,FTE,andWACCApproachesAllthreeapproachesattemptthesametask:valuationinthepresenceofdebtfinancing.Guidelines:UseWACCorFTEifthefirmstargetdebt-to-valueratioappliestotheprojectoverthelifeoftheproject.UsetheAPViftheprojectslevelofdebtisknownoverthe
11、lifeoftheproject.Intherealworld,theWACCisthemostwidelyusedbyfar.Summary:APV,FTE,andWACCAPVWACC FTEInitialInvestment AllAllEquityPortionCashFlowsUCFUCFLCFDiscountRatesr0 rWACCrSPVoffinancingeffectsYesNo NoWhichapproachisbest?UseAPVwhenthelevelofdebtisconstantUseWACCandFTEwhenthedebtratioisconstant17.
12、5 Capital Budgeting When theDiscountRateMustBeEstimatedAscale-enhancingprojectisonewheretheprojectissimilartothoseoftheexistingfirm.Intherealworld,executiveswouldmaketheassumptionthatthebusinessriskofthenon-scale-enhancingprojectwouldbeaboutequaltothebusinessriskoffirmsalreadyinthebusiness.Noexactfo
13、rmulaexistsforthis.Someexecutivesmightselectadiscountrateslightlyhigherontheassumptionthatthenewprojectissomewhatriskiersinceitisanewentrant.17.6APVExample:WorldwideTrousers,Inc.isconsideringa$5millionexpansionoftheirexistingbusiness.Theinitialexpensewillbedepreciatedstraight-lineover5yearstozerosal
14、vagevalue;thepretaxsalvagevalueinyear5willbe$500,000.Theprojectwillgeneratepretaxearningsof$1,500,000peryear,andnotchangetherisklevelofthefirm.Thefirmcanobtaina5-year$3,000,000loanat12.5%topartiallyfinancetheproject.Iftheprojectwerefinancedwithallequity,thecostofcapitalwouldbe18%.Thecorporatetaxrate
15、is34%,andtherisk-freerateis4%.Theprojectwillrequirea$100,000investmentinnetworkingcapital.CalculatetheAPV.17.6APVExample:CostThe cost of the project is not$5,000,000.We must include the round trip in and out of net working capital and the after-tax salvage value.Lets work our way through the four te
16、rms in this equation:NWC is riskless,so we discount it at rf.Salvage value should have the same risk as the rest of the firms assets,so we use r0.17.6APVExample:PV unlevered projectThe PV unlevered project is the present value of the unlevered cash flows discounted at the unlevered cost of capital,1
17、8%.Turning our attention to the second term,17.6APVExample:PV depreciation tax shieldThe PV depreciation tax shield is the present value of the tax savings due to depreciation discounted at the risk free rate,at rf=4%Turning our attention to the third term,17.6APVExample:PV interest tax shieldThe PV
18、 interest tax shield is the present value of the tax savings due to interest expense discounted at the firms debt rate,at rD=12.5%Turning our attention to the last term,17.6APVExample:AddingitallupSince the project has a positive APV,it looks like a go.Lets add the four terms in this equation:17.7Be
19、taandLeverageRecallthatanassetbetawouldbeoftheform:17.7BetaandLeverage:NoCorp.TaxesInaworldwithoutcorporatetaxes,andwithrisklesscorporatedebt,itcanbeshownthattherelationshipbetweenthebetaoftheunleveredfirmandthebetaofleveredequityis:In a world without corporate taxes,and with risky corporate debt,it
20、 can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:17.7BetaandLeverage:withCorp.TaxesInaworldwithcorporatetaxes,andrisklessdebt,itcanbeshownthattherelationshipbetweenthebetaoftheunleveredfirmandthebetaofleveredequityis:Since must be more than
21、 1 for a levered firm,it follows that17.7BetaandLeverage:withCorp.TaxesIfthebetaofthedebtisnon-zero,then:17.8SummaryandConclusions1.TheAPVformulacanbewrittenas:2.TheFTEformulacanbewrittenas:3.TheWACCformulacanbewrittenas17.8SummaryandConclusions4UsetheWACCorFTEifthefirmstargetdebttovalueratioappliestotheprojectoveritslife.5TheAPVmethodisusedifthelevelofdebtisknownovertheprojectslife.6Thebetaoftheequityofthefirmispositivelyrelatedtotheleverageofthefirm.