Mcgraw-Hill/Irwin Corporate Finance, 7/E: © 2005 The Mcgraw-Hill Companies, Inc. All Rights Reserved
Mcgraw-Hill/Irwin Corporate Finance, 7/E: © 2005 The Mcgraw-Hill Companies, Inc. All Rights Reserved
Mcgraw-Hill/Irwin Corporate Finance, 7/E: © 2005 The Mcgraw-Hill Companies, Inc. All Rights Reserved
CHAPTER
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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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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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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:
0 1 2 3 4
NPV10% $56.50
The project would be rejected by an all-equity firm: NPV < 0.
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0 1 2 3 4
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0 1 2 3 4
PV $28.56
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NPV7.58% = $6.68
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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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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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5
127,500
PV interest t
453,972.46
tax shield t 1 (1.125)
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APV = $189,930
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Cov(UCF , Market)
β Asset
σ 2Market
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Debt Equity
β Asset β Debt β Equity
Asset Asset
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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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$322,677.06
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STEP ONE:
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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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3
TC×rD× × PV unlevered
5 5
S
project
PV interest =
tax shield t=1 (1 + rD)t
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0.013
PV flotation = – (1 – TC) × × × PV unlevered
costs 0.99 5 project
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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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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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$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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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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$1,091,670.41 =
= [$1.5m – $1m – .125×$2,952,338.20 ] ×(1 – .30) + $1,000,000
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