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17-0

CHAPTER

Capital Budgeting for


the Levered Firm

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17-1

Prospectus
Recall that there are three questions in corporate
finance.
The first regards what long-term investments the firm
should make (the capital budgeting question).
The second regards the use of debt (the capital structure
question).
This chapter considers the nexus of these questions.

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17-2

Chapter Outline
17.1 Adjusted Present Value Approach
17.2 Flows to Equity Approach
17.3 Weighted Average Cost of Capital Method
17.4 A Comparison of the APV, FTE, and WACC Approaches
17.5 Capital Budgeting When the Discount Rate Must Be Estimated
17.6 APV Example
17.7 Beta and Leverage
17.8 Summary and Conclusions

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17-3

17.1 Adjusted Present Value Approach

APV = NPV + NPVF


The value of a project to the firm can be thought
of as the value of the project to an unlevered firm
(NPV) plus the present value of the financing side
effects (NPVF):
There are four side effects of financing:
The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing

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17-4

APV Example
Consider a project of the Pearson Company, the timing and size of
the incremental after-tax cash flows for an all-equity firm are:

–$1,000 $125 $250 $375 $500

0 1 2 3 4

The unlevered cost of equity is r0 = 10%:


$125 $250 $375 $500
NPV10%  $1,000    
(1.10) (1.10) (1.10) (1.10) 4
2 3

NPV10%  $56.50
The project would be rejected by an all-equity firm: NPV < 0.
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17-5

APV Example (continued)


Now, imagine that the firm finances the project with
$600 of debt at rB = 8%.
Pearson’s tax rate is 40%, so they have an interest tax
shield worth TCBrB = .40×$600×.08 = $19.20 each year.
The net present value of the project under leverage is:
APV = NPV + NPV debt tax shield
4
$19.20
APV  $56.50   t
t 1 (1 . 08)
APV  $56.50  63.59  $7.09
So, Pearson should accept the project with debt.
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17-6

APV Example (continued)


Note that there are two ways to calculate the NPV of the
loan. Previously, we calculated the PV of the interest tax
shields. Now, let’s calculate the actual NPV of the loan:
4
$600  .08  (1  .4) $600
NPVloan  $600   t
 4
t 1 (1 . 08) (1 . 08)
NPVloan  $63.59
APV = NPV + NPVF
APV  $56.50  63.59  $7.09
Which is the same answer as before.
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17-7

17.2 Flows to Equity Approach


Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, rS.
There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows
Step Two: Calculate rS.
Step Three: Valuation of the levered cash flows at rS.

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17-8

Step One: Levered Cash Flows for Pearson


Since the firm is using $600 of debt, the equity holders only have
to come up with $400 of the initial $1,000.
Thus, CF0 = –$400
Each period, the equity holders must pay interest expense. The
after-tax cost of the interest is B×rB×(1 – TC) = $600×.08×(1 – .40)
= $28.80
CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600
CF2 = $250 – 28.80
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4
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Step Two: Calculate rS for Pearson


B
rS  r0  (1  TC )( r0  rB )
S
B B
To calculate the debt to equity ratio, , start with
S V
4
$125 $250 $375 $500 19.20
PV   2
 3
 4
 t
(1.10) (1.10) (1.10) (1.10) t 1 (1.08)

P V = $943.50 + $63.59 = $1,007.09


B = $600 when V = $1,007.09 so S = $407.09.
$600
rS  .10  (1  .40)(.10  .08)  11.77%
$407.09
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Step Three: Valuation for Pearson


Discount the cash flows to equity holders at rS =
11.77%
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

$96.20 $221.20 $346.20 $128.80


PV  $400    
(1.1177) (1.1177) (1.1177) (1.1177) 4
2 3

PV  $28.56

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17-11

17.3 WACC Method for Pearson


S B
rW ACC  rS  rB (1  TC )
SB SB
To find the value of the project, discount the unlevered
cash flows at the weighted average cost of capital.
Suppose Pearson’s target debt to equity ratio is 1.50
B 1.5S  B
1.50 
S
B 1 .5 S 1.5 S
   0.60  1  0.60  0.40
S  B S  1. 5 S 2. 5 SB
rW ACC  (0.40)  (11.77%)  (0.60)  (8%)  (1  .40)
rW ACC  7.58%
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Valuation for Pearson using WACC


To find the value of the project, discount the
unlevered cash flows at the weighted average cost
of capital
$125 $250 $375 $500
NPV  $1,000    
(1.0758) (1.0758) 2 (1.0758) 3 (1.0758) 4

NPV7.58% = $6.68

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17-13

17.4 A Comparison of the APV, FTE,


and WACC Approaches
All three approaches attempt the same
task:valuation in the presence of debt financing.
Guidelines:
Use WACC or FTE if the firm’s target debt-to-value
ratio applies to the project over the life of the project.
Use the APV if the project’s level of debt is known
over the life of the project.
In the real world, the WACC is the most widely
used by far.
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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 effects Yes No No

Which approach is best?


Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is constant
WACC is by far the most common
FTE is a reasonable choice for a highly levered firm
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17-15

17.5 Capital Budgeting When the


Discount Rate Must Be Estimated
A scale-enhancing project is one where the project is
similar to those of the existing firm.
In the real world, executives would make the
assumption that the business risk of the non-scale-
enhancing project would be about equal to the business
risk of firms already in the business.
No exact formula exists for this. Some executives might
select a discount rate slightly higher on the assumption
that the new project is somewhat riskier since it is a new
entrant.
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17-16

17.6 APV Example:


Worldwide Trousers, Inc. is considering replacing a $5
million piece of equipment. The initial expense will be
depreciated straight-line to zero salvage value over 5
years; the pretax salvage value in year 5 will be
$500,000. The project will generate pretax savings of
$1,500,000 per year, and not change the risk level of
the firm. The firm can obtain a 5-year $3,000,000 loan
at 12.5% to partially finance the project. If the project
were financed with all equity, the cost of capital would
be 18%. The corporate tax rate is 34%, and the risk-free
rate is 4%. The project will require a $100,000
investment in net working capital. Calculate the APV.
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17-17

17.6 APV Example: Cost


Let’s work our way through the four terms in this equation:
APV = –Cost + PV unlevered + PV depreciation + PV interest
project tax shield tax shield

The 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.
NWC is riskless, so we discount it at rf. Salvage value should
have the same risk as the rest of the firm’s assets, so we use r0.
100,000 500,000  (1  .34)
Cost  $5.1m  
(1  r f ) 5
(1  r0 ) 5
 $4,873,561.25
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17-18

17.6 APV Example: PV unlevered project


Turning our attention to the second term,

APV = –$4,873,561.25 + PV unlevered + PV depreciation + PV interest


project tax shield tax shield

PV unlevered is the present value of the unlevered cash flows


project discounted at the unlevered cost of capital, 18%.

5
UCFt 5
$1.5m  (1  .34)
PVunlevered  
project t 1 (1  ro ) t
t 1 (1. 18) t

PVunlevered  $3,095,899
project

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17-19

17.6 APV Example: PV depreciation tax shield

Turning our attention to the third term,

APV = –$4,873,561.25 + $3,095,899 + PV depreciation + PV interest


tax shield tax shield

PV depreciation is the is the present value of the tax savings due to


tax shield depreciation discounted at the risk free rate: rf = 4%

PV depreciation   D  TC
5

tax shield t 1
t
(1  rf )
5
$1m  .34
 t
$1,513,619
t 1 (1.04)

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17-20

17.6 APV Example: PV interest tax shield


Turning our attention to the last term,

APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + PV interest


tax shield

PV interest is the present value of the tax savings due to interest


tax shield expense discounted at the firm’s debt rate: rD = 12.5%

TC  rD  $3m 5 0.34  0.125  $3m


5
PV interest   
tax shield t 1 (1  rD ) t
t 1 (1 .125) t

5
127,500
PV interest   t
 453,972.46
tax shield t 1 (1.125)

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17-21

17.6 APV Example: Adding it all up


Let’s add the four terms in this equation:

APV = –Cost + PV unlevered + PV depreciation + PV interest


project tax shield tax shield

APV = –$4,873,561.25 + $3,095,899 + $1,513,619 + $453,972.46

APV = $189,930

Since the project has a positive APV, it looks like a go.

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17-22

17.7 Beta and Leverage


Recall that an asset beta would be of the form:

Cov(UCF , Market)
β Asset 
σ 2Market

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17.7 Beta and Leverage: No Corp.Taxes


In a world without corporate taxes, and with riskless corporate
debt, (bDebt = 0) it can be shown that the relationship between the
beta of the unlevered firm and the beta of levered equity is:
Equity
β Asset   β Equity
Asset
In a world without corporate taxes, and with risky corporate
debt, it can be shown that the relationship between the beta of
the unlevered firm and the beta of levered equity is:

Debt Equity
β Asset   β Debt   β Equity
Asset Asset

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17.7 Beta and Leverage: with Corp. Taxes

In a world with corporate taxes, and riskless debt,


it can be shown that the relationship between the
beta of the unlevered firm and the beta of levered
equity is:  Debt 
β Equity  1   (1  TC ) β Unlevered firm
 Equity 

 Debt 
Since 1   (1  TC )  must be more than 1 for a
 Equity 
levered firm, it follows that bEquity > bUnlevered firm.

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17-25

17.7 Beta and Leverage:


with Corp. Taxes
If the beta of the debt is non-zero, then:
B
β Equity  β Unlevered firm  (1  TC )(β Unlevered firm  β Debt ) 
SL

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17.8 Summary and Conclusions


1. The APV formula can be written as:
Additional

UCFt Initial
APV    effects of 
t 1 (1  r0 )
t
investment
debt
2. The FTE formula can be written as:

LCFt  Initial Amount 
FTE      
t 1 (1  rS )
t
 investment borrowed 

3. The WACC formula can be written as



UCFt Initial
NPVW ACC  
t 1 (1  rW ACC )
t
investment
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17.8 Summary and Conclusions


4. Use the WACC or FTE if the firm's target debt
to value ratio applies to the project over its life.
 WACC is the most commonly used by far.
 FTE has appeal for a firm deeply in debt.
5 The APV method is used if the level of debt is
known over the project’s life.
 The APV method is frequently used for special
situations like interest subsidies, LBOs, and leases.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.
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17-28

Example: Hamilos Worldwide


Hamilos Worldwide is considering a $5 million expansion of
their existing business. The initial expense will be
depreciated straight-line over 5 years to zero salvage value;
the pretax salvage value in year 5 will be $500,000. The
project will generate pretax gross earnings of $1,500,000 per
year, and not change the risk level of the firm. Hamilos can
obtain a 5-year 12.5% loan to partially finance the project.
Flotation costs are 1% of the proceeds. If undertaken, this
project should maintain a target D/E ratio of 1.50. If the
project were financed with all equity, the cost of capital
would be 18%. The corporate tax rate is 30%, and the risk-
free rate is 6%. The project will require a $100,000
investment in net working capital.
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17-29

Hamilos Worldwide Using WACC


a) Using the WACC methodology, comment on the
desirability of this project.
S D
rW ACC  rs  rD (1  TC )
V V
D
rs  r0  (r0  rD )(1  TC )
E
3
rs  18%  (18%  12.5%)(1  0.30)
2
2 3
rW ACC   23.775%   12.5%  (1  .30)
5 5
rW ACC  14.76%
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17-30

Hamilos Worldwide Using WACC


a) Using the WACC methodology, comment on the
desirability of this project.
NPVW ACC  $5,100,000 
5
$500,000  (1  0.30)  1,000,000

t 1 (1 .1476 ) t

$100,000  $500,000  (1  .30)



(1.1476) 5

 $322,677.06
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Hamilos Worldwide Using APV


b) Using the APV methodology, comment on the
desirability of this project.
First some preliminaries: The firm wants to finance the project
such that the debt-equity ratio = 1.5.
This implies a debt-to-value ratio of 3/5:
D 3 3
 D E
E 2 2
3 3
E E
D 2 2 3 2 3
    
DE 3 5 5
EE E 2 5
2 2
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Hamilos Worldwide Using APV

So, let’s find PV unlevered and borrow 3/5 of that value.


project

STEP ONE:

PV unlevered = PV unlevered + PV depreciation + PV interest – PV flotation


project project tax shield tax shield costs

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Hamilos Worldwide Using APV

PV levered = PV unlevered + PV depreciation + PV interest – PV flotation


project project tax shield tax shield costs

5 UCFt
PV unlevered =
project
S (1 + r )
t=1 0
t

5 D×TC
PV depreciation = S
tax shield t = 1
(1 + rf)t

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Hamilos Worldwide Using APV


PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs

3 Recall that the


D= × PV unlevered
5 dollar amount of
project
debt depends on
5
TC×rD×D the PV levered.
PV interest =
tax shield
S
t=1 (1 + rD)t
project

3
TC×rD× × PV unlevered
5 5
S
project
PV interest =
tax shield t=1 (1 + rD)t
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Hamilos Worldwide Using APV


PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs
3
D= × PV unlevered
We need to borrow D* such that:
5 project
3
D ×(1 – .01) = × PV unlevered
*
5 project
1 3
*
D = × × PV unlevered
0.99 5 project

Our pre-tax flotation costs are one percent of D*


* 0.01 3
0.01×D = × × PV unlevered
0.99 5 project
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A digression on floatation costs

Oh by the way, flotation costs are deductible.

So the present value of the after-tax flotation costs are

0.013
PV flotation = – (1 – TC) × × × PV unlevered
costs 0.99 5 project

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Hamilos Worldwide Using APV


PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs

5 D×TC
S
5 UCFt
= S (1 + r )
t=1 0
t +
t=1
(1 + rf)t

3
TC×rD× × PV unlevered
5 5
S
project
+
t=1 (1 + rD)t
3 0.01
– (1 – TC) × × × PV unlevered
0.99 5 project
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Hamilos Worldwide Using APV


PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs

3
TC  rD   PVlevered
5
UCFt 5
D  TC 5 5  0.01 3
  
project
PVlevered  (1  TC )      PVlevered
t 1 (1  ro ) t 1 (1  r f ) (1  rD ) t
t t
project t 1  .99  5 project

5
1,500,000  (.70) 5 $1,000,000  .30
PVlevered  t

project t 1 (1.18) t 1 (1.06) t

3
 0.30  0.125  PVlevered
5 5  0.01 3

project
 (.70)      PVlevered
t 1 (1.125) t  .99  5 project

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Hamilos Worldwide Using APV


PV levered = PV unlevered + PV depreciation + PV interest – PV flotation
project project tax shield tax shield costs

PVlevered= $3,283,529.57 + $1,263,709.14 +


project
0.08011× PVlevered – 0.00424 × PVlevered
project project

PVlevered – 0.08011× PVlevered + 0.00424× PVlevered = $4,547,238.71


project project project

$4,547,238.71 $4,547,238.71
PVlevered = = = $4,920,563.66
project 1 – 0.08011 + 0.00424 0.92413
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Hamilos Worldwide Using APV

APV 
$100,000 500,000  (1  .30)
 $5,100,000  5
 5
 $4,920,563.66
(1.06) (1.18)

APV  48,277.71

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Hamilos Worldwide Using FTE


c) Using the FTE methodology, comment on the
desirability of this project.
Since the bondholders are financing $2,952,338.20, the
shareholders only have to pony up
$2,047,661.80 = $5,100,000 – $2,952,338

Thus the year-zero levered cash flow is $2,047,661.80 + after-tax


flotation costs
 .01   3 
LCF0  $2,147,662  (1  .30)       $4,920,563.66 
 .99   5 
= –$2,147,662 –$20,875.11
LCF0 = –$2,168,536.92
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Hamilos Worldwide Using FTE


LCF0 = –$2,168,536.92
The LCF for years one through 4 is

$1,091,670.41 =
= [$1.5m – $1m – .125×$2,952,338.20 ] ×(1 – .30) + $1,000,000

The LCF for year 5 is

–$1,410,667.79 = $1,091,670.41 – $2,952,338.20 + $100,000 +


$500,000(1 – .30)

The NPV at rs = 23.775% is –$18,759.67


McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
17-43

Summary Hamilos Worldwide


Using WACC
NPV = –$322,677.06
Using APV
NPV = $48,277.71
Using FTE
NPV = –$18,759.67
Should we accept or reject the project?
If the dollar amount of debt is known over the project’s life, (in
this example the amount of debt would be $2,952,338.20) then
the APV method is appropriate and the firm would accept the
project.
Otherwise, the firm should reject the project.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

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