CAPITAL STRUCTUREVALUATION & CAPITAL BUDGETING

FEUI Program Studi Maksi – PPAK

Manajemen Keuangan

Kuliah II 13.04.2009

RWJ CH. 17Sugeng Purwanto Ph.D, FRM

Note: Submit a summary of Chapter 15&16.

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CAPITAL STRUCTURE AND FIRM VALUE

PV of tax shield

Zero leverage firm value

Leveraged firm value

PV of financial distress costsValueofthe firm(V = S + B)

Debt RatioB/S orB/V

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CAPITAL ASSET PRICING MODEL (CAPM)

“Common method to determine the cost of equity of risky assets”

ExpectedReturnE[R]

Β (Systematic Risk)

Security Market Line :”SML”E[Ri] = Rf + β (E[Rm] – Rf)

E[Ri] Expected return stock “I”E[Rm] Expected market returnRf Risk-free rate (T-Bill rate, SBI rate)β Systematic risk (non-diversiable risk, market tisk)E[Rm]-Rf Risk Premium

Rf

CAPITAL BUDGETINGReview

METHODS

(1) Pay back period (PBP)(2) Discounted pay back period (DPBP)(3) NPV (net present value)(4) IRR (internal rate of return)

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CAPITAL BUDGETING

3 APPROACHES:

(1) ADJUSTED PRESENT VALUE

(2) FLOW TO EQUITY (FTE)

(3) WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Note:All of the above approaches are using NPV method.

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ADJUSTED PRESENT VALUE APPROACH

APV = NPV + NPFVAPV = Adjusted Present ValueNPV = Value of the project to an unlevered firmNPVF = Net Present Value of the financing side effect

NPVAF Side Effects. There are 4 side effects (can be “+” or “-”:

1). The tax subsidy to debt (tax benefits from debt)2). The costs of issuing new securities3). The costs of financial distress4). Subsidies to debt financing

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TAX SUBSIDY (BENEFITS FROM TAX)Example I.A. APV APPROACH. FOR UNLEVERED FIRM

Consider a project of the P.B. Singer Co. with the following characteristics:Cash inflows: $500,000 per-year for the indefinite futureCash costs: 72% of salesInitial investment: $475,000TC (Corporate Tax): 34%R0 (the cost of capital for a project of an all-equity firm) : 20%

Calculate the Net Present value (NPV) of project!

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Answer: I.A.Cash inflows $500,000Cash costs = 72%x$500,000 -$360,000Operating income $140,000Corporate Tax: 34%x$140,000 -$47,600Unlevered Cash Flow (UCF) $92,400

Present Value of annuity of $92,400 with a discount rate R0 of 20% is:

PV = $92,400/20% = $462,000

NPV = PV – Initial Investment = $462,500 - $475,000 = - $13,000 Zero Debt B = 0 ---- NPVF = 0APV = NPV + NPVF APV = -$13,000 + 0 = -$13,000The project is not feasible! 8

Example continue: Example I.B. APV APPROACH FOR LEVERED FIRM

Now assume that the firm finances the project with US$126,229.50 in debt. So that the remaining investment of $475,000 - $126,229.50 = $348,770.50 is financed with equity.Evaluate the project feasibility!

Answer:APV = NPV + NPVF

= NPV + TC x B

APV = -$13,000 + 34% x $126,229.50= -$13,000 + $42,918= $29,918

The APV IS POSITIVE. THE PROJECT IS FEASIBLE. 9

Example II.Evaluate the project feasibility with FLOW TO EQUITY (FTE) Approach.

Answer:FTE Approach steps.

Step 1.Calculating Levered Cash Flow (LCF)

Step 2.Calculating the Discount Rate of Leverage Equity RsRs = R0 + B/S (1 – Tc) (R0 – RB)

Step 3.ValuationNPV = LCF/Rs

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Step 1. Calculating LCF

Cash Inflows $500,000Cash costs: 72% x $500,000 -$360,000Interest: 10% x $126,229.50 -$12,622.95Income after interest $127,377.05Corporate Tax: 34%x$127,377.05 -$43,377.20Levered Cash Flow (LCF) $84,068.85

Note:You can calculate LCF with a formula:LCF = UCF – (1 – Tc) x RB x B

UCF = Unlevered Cash Flow = $92,400RB = 10%B = $126,229.50

LCF = $92,400 – (1-34%)x10%x$126,229.50 = $84,068.,8511

Step 2. Calculating Discount Rate of Levered Equity Rs

Rs = R0 + B/S (1 – Tc) (R0 – RB)

Rs = 20% + 1/3 x (1-34%) (20% - 10%)= 22.2%

Note:Target Debt-to-Equity ratio is 1/3Target Debt-to-Value ratio is 1/4

B/S = 1/3 Debt-to-Equity ratio

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Step 3. VALUATION OF PROJECT

The Present Value of the project levered cash flow (LCF) is

PV = LCF/Rs

= $84,068.85/22.2%

= $378,688.50

Initial Investment $475,000Debt $126,299.50Equity = $475,000 - $126,299.50 = $348,770.50

NPV = PV – Equity Invested= $378,688.50 - $348,770.50= $29,918. ---- NPV Positive! The project is feasible!

The same result with APV approach. 13

Example III.Evaluate the project feasibility with WEIGHTED AVERAGE COST OF CAPITAL METHOD (WACC)

Answer:RWACC = S/(S+B) x Rs + B/(S+B) x RB (1 – Tc) S Equity

B DebtTc Corp

Tax∞ UCF

NPV = ∑ - Initial Investment

t=1 (1 + RWACC)t

UCF = UNLEVERED CASH FLOW

PERPETUITY OF UCF :

NPV = UCF/RWACC - Initial Investment

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Example III continue

RWACC = 3/4 x 22.2% + ¼ x 10% (1 – 34%)= 18.3%

PV of project = UCF/RWACC

= $92,400/ 18.3%

= $504,918

NPV = $504,918 - $475,000

= $29,918 NPV Positive, the project is feasible

The same result with APV Approach or FTE Approach.15

WHICH APPROACH TO BE USED?

Suggested guideline

USE WACC OR FTE IF THE FIRM’s TARGET DEBT-TO-EQUITY RATIO APPLIES TO THE PROJECT OVER ITS LIFE.

USE APV IF THE PROJECT’s LEVEL OF DEBT IS KNOWN OVER THE LIFE OF THE PROJECT.

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ESTIMATION OF DISCOUNT RATE

Procedure to calculate Discount Rate

Step 1. Determining of Cost of Equity Capital of industryRs = Rf + β (Rm – Rf) CAPM MethodTo find Rs

Step 2. Determining Cost of Capital if ALL EquityRs = R0 + B/S (1-Tc) (R0 – RB)To find R0

Step 3. Determining Rs for the firm evaluated

Step 4. Determining RWACC for the firm evaluated

DO EXERCISES!! Example 17.1 17

EXERCISES (AND/OR HOMEWORK)

RWJ Text Book page 496 – 500

Example 17.1Determination of Cost of capital.

Example 17.2APV Example.

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BETA AND LEVERAGE

The No-Tax Case

βEquity = βAsset [1 + Debt/equity]

The Corporate Tax Case

βEquity = [1 + (1-Tc)xDebt/Equity] βUnlevered firm

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Example 17.3.BETA AND LEVERAGE

C.F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is considered riskless. The corporate tax rate is 34%. Regression analysis indicates that the beta of the firm’s equity is 2. the risk-free rate is 10%, and the expected market premium is 8.5%. What would the project’s discount rate be in the hypothetical case that C.F.Lee Inc is all equity?

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Example 17.3.Answer

Beta of hypothetical all-equity firm.

βEquity = [1 + (1-Tc)xDebt/Equity] βUnlevered firm

Unlevered Beta:βUnlevered firm = βEquity / [1 + (1-Tc)xDebt/Equity]βUnlevered firm = 2/ [1 + (1-34%)x$100m/$200m] = 1.5

Discount Rate:Rs = R0 +β (Rm – Rf)Rs = 10% + 1.5 x 8.5% = 22.75% 21

Example 17.3.

The J.Lowers corp which currently manufacture staples is considering a $1 million investment in a project in the aircraft adhesive industry. The corporation estimates unlevered aftertax cash flows (UCF) of $300,000 per year into perpetuity from the project. The firm will finance the project with a debt-to-value ratio of 0.5 (or equivalently a debt-to-equity ratio of 1:1).The three competitors in this new industry are currently unlevered with betas of 1.2, 1.3, and 1.4. assuming a risk-free rate of 5%, a market risk premium of 9% and a corporate tax of 34%, what is the net present value of the oproject?

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Example 17.3. Answer1.Calculating the average unlevered beta in the industry.

Avg unlevered beta = (1.2 + 1.3 + 1.4)/3 = 1.3

2.Calculating the levered beta for J.lower’s new projectβEquity = [1 + (1-Tc) Debt/Equity] βUnlevered firm

= [1 + (1-34%) 1/1] = 2.16

3. Calculating the cost of levered equity for the projectRs = Rf + β (Rm – Rf) = 5% + 2.16x9% = 24.4%

4. Calculating the WACC for the projectRWACC = B/V RB (1-Tc) + S/V Rs

= 1/2x5% (1-34%)+1/2x24.4% = 13.9%

5. The project Val ue.NPV = UCF/RWACC – Initial Investment

= $300,000/13.9% - $1million = $1.16 million

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THE END