© the mcgraw-hill companies, inc., 2000 irwin/mcgraw hill 19- 1 topics covered after tax wacc ...

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19- 1

Topics Covered

After Tax WACC Tricks of the Trade Capital Structure and WACC Adjusted Present Value

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19- 2

Alternative Specifications

Tax-adjusted required rate

where t = marginal corporate tax rate

D/V = virtual debt ratio

r = rF + (rM – rF)

)1(*

V

Dtrr

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After Tax WACC

The tax benefit from interest expense deductibility must be included in the cost of funds.

This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.

ED r

V

Er

V

DWACC

ED r

V

Er

V

DWACC

Old Formula

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After Tax WACC

ED r

V

Er

V

DTcWACC )1(

Tax Adjusted Formula

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After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

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After Tax WACCExample - Sangria Corporation - continued

Balance Sheet (Book Value, millions)Assets 100 50 Debt

50 EquityTotal assets 100 100 Total liabilities

Balance Sheet (Book Value, millions)Assets 100 50 Debt

50 EquityTotal assets 100 100 Total liabilities

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After Tax WACCExample - Sangria Corporation - continued

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

75 EquityTotal assets 125 125 Total liabilities

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

75 EquityTotal assets 125 125 Total liabilities

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After Tax WACCExample - Sangria Corporation - continued

Debt ratio = (D/V) = 50/125 = .4 or 40%

Equity ratio = (E/V) = 75/125 = .6 or 60%

ED r

V

Er

V

DTcWACC )1(

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After Tax WACCExample - Sangria Corporation - continued

ED r

V

Er

V

DTcWACC )1(

%84.10

1084.

146.125

7508.

125

50)35.1(

WACC

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After Tax WACCExample - Sangria Corporation - continued

The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax.

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

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After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million

Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million

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After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

01084.

355.15.12

10

gr

CCNPV

01084.

355.15.12

10

gr

CCNPV

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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(

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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%.

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Adjusted Present Value

APV = Base Case NPV

+ PV Impact

Base Case = All equity finance firm NPV. PV Impact = all costs/benefits directly

resulting from project.

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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.

Adjusted Present Value

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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 = 150,000

Stock issue cost = -200,000

Adjusted NPV- 50,000

don’t do the project

Adjusted Present Value

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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.

Adjusted Present Value

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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 = - 20,000

Stock issue cost = 60,000

Adjusted NPV 40,000

do the project

Adjusted Present Value

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Topics Covered

Leveraged Buyouts Spin-offs and Restructuring Conglomerates Private Equity Partnership Control and Governance

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Definitions

Corporate control -- the power to make investment and financing decisions.

Corporate governance -- the role of the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions.

Financial architecture -- the financial organization of the business.

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Leveraged Buyouts

The difference between leveraged buyouts and ordinary acquisitions:

1. A large fraction of the purchase price is debt financed.

2. The LBO goes private, and its share is no longer trade on the open market.

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Leveraged Buyouts

The three main characteristics of LBOs:

1. High debt

2. Incentives

3. Private ownership

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Leveraged Buyouts

Acquirer Target Year Price ($bil)

KKR RJR Nabisco 1989 24.72$ KKR Beatrice 1986 6.25$ KKR Safeway 1986 4.24$ Thompson Co. Southland 1987 4.00$ AV Holdings Borg-Warner 1987 3.76$ Wing Holdings NWA, Inc. 1989 3.69$ KKR Owens-Illinois 1987 3.69$ TF Investments Hospital Corp of America 1989 3.69$ FH Acquisitions For Howard Corp. 1988 3.59$ Macy Acquisition Corp. RH Macy & Co 1986 3.50$ Bain Capital Sealy Corp. 1997 811.20$ Citicorp Venture Capital Neenah Corp. 1997 250.00$ Cyprus Group (w/mgmt) WESCO Distribution Inc. 1998 1,100.00$ Clayton, Dublier & Rice North Maerican Van Lines 1998 200.00$ Clayton, Dublier & Rice (w/mgmt) Dynatech Corp. 1998 762.90$ Kohlberg & Co. (w.mgmt) Helley Performance Products 1998 100.00$

10 Largest LBOs in 1980s and 1997/98 examples

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Private Equity Partnership

Investment PhaseInvestment Phase Payout PhasePayout Phase

General Partner put up 1% of capital

General Partner get carried interest in 20% of profits

Limited partners put in 99% of capital

Limited partners get investment

back, then 80% of profits

Investment in diversified portfolio of companies

Sale or IPO of companies

Partnership Partnership

Company 1Company 1

Company 2Company 2

Company NCompany N

Mgmt fees