capital budgeting for the levered firm_lesson8
TRANSCRIPT
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Capital budgeting for a levered rm
Capital budgeting decisions for a leveredrm
Three methods can be used to value a rmas a whole or a project when leverage isemployed:
The adjusted present value method (APV
The !ow"to"e#uity method ($T%
The weighted average cost of capitalmethod (&ACC
Although they loo' dierent) they providethe same value estimates
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The adjusted present value (APV)
APV*+PV,+PV$APV*adjusted present value of a project for alevered rm
+PV*net present value of a project for an
unlevered rm+PV$*net present value of the nancing sideeect (additional eects of debt
Additional eects of debt: ta- eects)nancial distress costs) !otation costs)interest subsidies.
/t can be rewritten as:investmentinitialdebteffectsaddit
r
UCFAPV
tt
u
t ...)1(1
++
=
=
0C$ * the project after"ta- C$s to stoc'holders of anunlevered rm
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The adjusted present value (APV)
%-. A project of the 1inger.Co. of which:C$s*233)3334 each year in perpetuity
Costs*567 of the sales
/nitial investment*852)3334
Tc*987 ru*637ebt*;6boo' valueratio*;>8
/f both the project and the rm are nanced
with only e#uity:Sales 500,000$Costs (360,000$)
Operating Income 140,000$
Corporate tax (34%) (4,600$)
!C" #,400$
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The adjusted present value (APV)
/n perpetuity and considering only the ta-subsidy as nancing side eect:
DTIr
UCFAPV c
u
+= 0
$#1,#5.#,16&34.0000,450.0
400,#=+=APV
+PV*";9)333
The project should be rejected by an e#uity"rm? however) it is accepted by a levereged
rm@
PV of the Ta-shield
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Flow-to-euit! (FT")
$T% method consists in discounting the C$sfrom the project to shareholders of the leveredrm at the cost of e#uity capital:
/n perpetuity:
)..()1(1
borrowedamountinvestmentinitialr
LCFNPV
t te
t
+
=
=
C$ * the project after"ta- C$s to stoc'holders of a leveredrm
)( 0 DIr
LCFNPV
e
=
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Flow-to-euit! (FT")
$rom the previous e-ample) assume an interestrate of ;37 on debt.
C$ can be also calculated from 0C$:
Sales 500,000$
Costs (360,000$)
Interest (10%) (1,6.#5$)
Income a'ter interest 1,3.05$
Corporate tax (34%) (43,30.0$)
C" 4,06.5$
$5.06,4$5.#,16&10.0&)34.01($400,#
)1(
)1(
=
=
=
LCFDrTUCF
DrTLCFUCF
dC
dC
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Flow-to-euit! (FT")
Calculate the discount rate re.
The value of the project according to $T%approach:
3
1)10.00.0)(34.01(0.0.0
))()(1(
+=
+=E
DrrTrr ducue
$#1%,#)5.##,16000,45(.0
%5.06%,%4
)( 0
==
=
NPV
DI
r
LCFNPV
e
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#eighted-average $ost of $apital(#ACC)
&ACC method consists in discounting the unleveredC$s at the r&ACC:
/n perpetuity:
$rom the previous e-ample:
)1(
.)1(1
cDEWACC
tt
WACC
t
TrDE
Dr
DE
Er
investmentinitialr
UCFNPV
+
++
=
+
=
=
0Ir
UCFNPV
WACC
=
13.0)34.01(&10.0&4
1.0&
4
3=+=WACCr
$#1,#000,4513.0
400,#==NPV
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#hi$h approa$h to use%
/f the rmBs target >V ratio applies to theproject over its life) use &ACC or $T%.
oth reand r&ACCwill remain constant
/f the projectBs level of debt is 'nown over the
life of a project) use APV.&ACC is the most widely used method) followedby $T%
APV is preferred in leveraged buyouts (Ds
because it is 'nown the schedule of debtreduction in the future and ta- shields can beeasily calculated. Also when !otation costs andinterest subsidies are involved) APV is preferred.
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&is$ount rates
APV)$T%)&ACC employ respectively ru) reandr&ACCas discount rates
%-. $irm A has a >V ratio*;>8 (or >% ratio*;>9./t e-pects to borrow at ;37. /t has just one
competitor) rm ) nanced with 837 of e#uityand
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&is$ount rates
$T% needs re. /f you have previously estimated
ru from reof ) you can calculate refor rm A:
1$5.0
6.0
4.0%)1$)(40.01(%5.$0
))()(1(
=
+=
+=
u
uu
ducue
r
rr
E
DrrTrr
3
1%)10%$5.1)(40.01(%$5.1%#.1# +=
refor rm A (;=.=7 is less than refor rm
(63.527) because rm has a higher >% ratio@
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&is$ount rates
&ACC needs r&ACC.
%45.16)4.01(1.04
1
%#.1#4
3
)1(
=+=
+
++
=
WACC
cDEWACC
r
TrDE
Dr
DE
Er
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&ividend Poli$!
A dividend is a cash distribution of earnings toshareholders
ividend policy can provide information toshareholders concerning rm performance.
The decision to pay dividends has to beapproved by the board of directors
ierent types of dividends:
Cash dividends
1toc' dividends
1toc' split
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&ividend Poli$!
Cash dividendCompanies can pay regular cash dividends (e-.8times a year and sometimes e-tra cash dividends.
Dthers may decide not to pay dividends.
1toc' dividend
A distribution of additional shares of stoc' tostoc'holders on a pro"rata basis (on the basis of the7 of shares held and without any cost for the
shareholders
/t increases the number of shares outstanding giventhe same value of the rm) thereby reducing thevalue of each share.
1toc' price was
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