Chapter 20 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Financing and Valuation

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

20- 2

Topics Covered

After Tax WACCValuing BusinessesUsing WACC in PracticeAdjusted Present ValueYour Questions Answered

20- 3

Capital Project Adjustments

1. Adjust the Discount Rate Modify the discount rate to reflect capital

structure, bankruptcy risk, and other factors.

2. Adjust the Present Value Assume an all equity financed firm and then

make adjustments to value based on financing.

20- 4

After Tax WACC

V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula

20- 5

After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

20- 6

After Tax WACC

Example - Sangria Corporation - continued

Balance Sheet (Book Value, millions)Assets 1,000 500 Debt

500 EquityTotal assets 1,000 1,000 Total liabilities

Balance Sheet (Book Value, millions)Assets 1,000 500 Debt

500 EquityTotal assets 1,000 1,000 Total liabilities

20- 7

After Tax WACC

Example - Sangria Corporation - continued

Balance Sheet (Market Value, millions)Assets 1,250 500 Debt

750 EquityTotal assets 1,250 1,250 Total liabilities

Balance Sheet (Market Value, millions)Assets 1,250 500 Debt

750 EquityTotal assets 1,250 1,250 Total liabilities

20- 8

After Tax WACC

Example - Sangria Corporation - continued

V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 500/1,250 = .4 or 40%

Equity ratio = (E/V) = 750/1,250 = .6 or 60%

20- 9

After Tax WACC

Example - Sangria Corporation - continued

V

Er

V

DTcrWACC ED )1(

%0.9

090.

60.124.40.)35.1(06.

WACC

20- 10

After Tax WACCExample - Sangria Corporation - continued

The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax.

Given an initial investment of $12.5 million, what is the value of the machine?

20- 11

After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million

Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million

20- 12

After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

009.

125.15.12

10

gr

CCNPV

009.

125.15.12

10

gr

CCNPV

20- 13

After Tax WACCExample - Sangria Corporation – continued

Perpetual Crusher project

Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt

7.5 EquityTotal assets 12.5 12.5 Total liabilities

Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt

7.5 EquityTotal assets 12.5 12.5 Total liabilities

20- 14

After Tax WACCExample - Sangria Corporation – continued

Perpetual Crusher project

93.0195.125.1)1(incomeequity Expected

195.5)35.1(06.)1(interestAfter tax

DTrC

DTr

CD

CD

93.0195.125.1)1(incomeequity Expected

195.5)35.1(06.)1(interestAfter tax

DTrC

DTr

CD

CD

20- 15

After Tax WACCExample - Sangria Corporation – continued

Perpetual Crusher project

12.4%or 124.5.7

93.0

ueequity val

incomeequity expectedreturnequity Expected

Er

12.4%or 124.5.7

93.0

ueequity val

incomeequity expectedreturnequity Expected

Er

20- 16

Capital Budgeting

Valuing a Business or ProjectThe value of a business or Project is usually

computed as the discounted value of FCF out to a valuation horizon (H).

The valuation horizon is sometimes called the terminal value.

HH

HH

wacc

PV

wacc

FCF

wacc

FCF

wacc

FCFPV

)1()1(...

)1()1( 22

11

HH

HH

wacc

PV

wacc

FCF

wacc

FCF

wacc

FCFPV

)1()1(...

)1()1( 22

11

20- 17

Capital Budgeting

Valuing a Business or Project

HH

HH

r

PV

r

FCF

r

FCF

r

FCFPV

)1()1(...

)1()1( 22

11

PV (free cash flows) PV (horizon value)

In this case r = waccIn this case r = wacc

20- 18

Valuing a Business

Latest year0 1 2 3 4 5 6 7

1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.72 Cost of goods sold 63.1 66.2 71.3 76.3 79.9 83.1 87 90.23 EBITDA (1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.54 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.15 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.46 Tax 6 4.7 4.8 5.2 5.2 5.4 5.4 5.47 Profit after tax (5-6) 11.2 8.7 9 9.6 9.7 10 10.1 108 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 16.2 15.99 Investment in working capital 1 0.5 0.8 0.9 0.5 0.6 0.6 0.4

10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8

PV Free cash flow, years 1-6 20.3 113.4 (Horizon value in year 6)PV Horizon value 67.6PV of company 87.9

Forecast

Example: Rio Corporation

20- 19

Valuing a Business

Assumptions

Sales growth (percent) 6.7 7 7 7 4 4 4 375.5 74 74.5 74.5 75 75 75.5 7613.3 13 13 13 13 13 13 1379.2 79 79 79 79 79 79 79

5 14 14 14 14 14 14 14

Tax rate, percent 35%WACC 9%Long term growth forecast 3%

Fixed assets and working capital

Gross fixed assets 95 109.6 125.1 141.8 156.8 172.4 188.6 204.5Less accumulated depreciation 29 38.9 49.5 60.8 72.6 84.9 97.6 110.7Net fixed assets 66 70.7 75.6 80.9 84.2 87.5 91 93.8Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1Working capital 11.1 11.6 12.4 13.3 13.9 14.4 15 15.4

Example: Rio Corporation – continued - assumptions

20- 20

Valuing a Business

Example: Rio Corporation – continued

FCF = Profit after tax + depreciation + investment in fixed assets

+ investment in working capital

FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = $3.5 million

20- 21

Valuing a Business

Example: Rio Corporation – continued

6.3

1.1

23.

1.1

20.

1.1

39.1

1.1

15.1

1.1

96.

1.1

.80-PV(FCF) 65432

6.3

1.1

23.

1.1

20.

1.1

39.1

1.1

15.1

1.1

96.

1.1

.80-PV(FCF) 65432

20- 22

Valuing a Business

Example: Rio Corporation – continued

6.67$3.1131.09

1 value)PV(horizon

3.11303.09.

8.6 PV Value Horizon

6

1H

gwacc

FCFH

6.67$3.1131.09

1 value)PV(horizon

3.11303.09.

8.6 PV Value Horizon

6

1H

gwacc

FCFH

20- 23

Valuing a Business

million $87.9

6.673.02

value)PV(horizonPV(FCF)s)PV(busines

million $87.9

6.673.02

value)PV(horizonPV(FCF)s)PV(busines

Example: Rio Corporation – continued

20- 24

WACC vs. Flow to Equity

– If you discount at WACC, cash flows have to

be projected just as you would for a capital

investment project. Do not deduct interest.

Calculate taxes as if the company were all-

equity financed. The value of interest tax

shields is picked up in the WACC formula.

20- 25

WACC vs. Flow to Equity

– The company's cash flows will probably not be forecasted

to infinity. Financial managers usually forecast to a

medium-term horizon -- ten years, say -- and add a

terminal value to the cash flows in the horizon year. The

terminal value is the present value at the horizon of post-

horizon flows. Estimating the terminal value requires

careful attention, because it often accounts for the

majority of the value of the company.

20- 26

WACC vs. Flow to Equity

– Discounting at WACC values the assets and

operations of the company. If the object is to

value the company's equity, that is, its common

stock, don't forget to subtract the value of the

company's outstanding debt.

20- 27

Tricks of the Trade

What should be included with debt?

– Long-term debt?

– Short-term debt?

– Cash (netted off?)

– Receivables?

– Deferred tax?

20- 28

After Tax WACC

Preferred stock and other forms of financing must be included in the formula

EPD r

V

Er

V

Pr

V

DTcWACC )1(

20- 29

After Tax WACC

Balance Sheet (Market Value, millions)Assets 125 50 Debt

25 Preferred Equity50 Common Equity

Total assets 125 125 Total liabilities

%04.11

1104.

146.125

5010.

125

2508.

125

50)35.1(

WACC

Example - Sangria Corporation - continuedCalculate WACC given preferred stock is $25 mil of total equity and yields 10%.

20- 30

Tricks of the Trade

How are costs of financing determined?– Return on equity can be derived from market data

– Cost of debt is set by the market given the specific rating of a firm’s debt

– Preferred stock often has a preset dividend rate

20- 31

WACC & Debt Ratios

Example continued: Sangria and the Perpetual Crusher project at 20% D/V

Step 1 – r at current debt of 40%

Step 2 – D/V changes to 20%

Step 3 – New WACC

0984.)6(.124.)4(.06. r

108.)25)(.06.0984(.0984. Er

0942.)8(.108.)2)(.35.1(06. WACC

20- 32

Adjusted Present Value

APV = Base Case NPV

+ PV Impact

Base Case = All equity finance firm NPVPV Impact = all costs/benefits directly

resulting from project

20- 33

Adjusted Present Value

example:

Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.

20- 34

Adjusted Present Value

example:Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.

Project NPV = 150,000Stock issue cost = -200,000Adjusted NPV- 50,000

don’t do the project

20- 35

Adjusted Present Value

example:

Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.

20- 36

Adjusted Present Value

example:Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.

Project NPV = - 20,000Stock issue cost = 60,000Adjusted NPV 40,000

do the project

20- 37

Adjusted Present Value

Latest year0 1 2 3 4 5 6 7

10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8

PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6Base-case PV of company 84.3

Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97

PV Interest tax shields 5

APV 89.3

Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%

After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79

ForecastLatest year

0 1 2 3 4 5 6 7

10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8

PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6Base-case PV of company 84.3

Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97

PV Interest tax shields 5

APV 89.3

Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%

After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79

Forecast

Example – Rio Corporation APV

20- 38

Adjusted Present Value

million

APV

3.89$0.53.84

shields)st tax PV(Intere NPV case Base

million

APV

3.89$0.53.84

shields)st tax PV(Intere NPV case Base

Example – Rio Corporation APV - continued