Financing and Valuation

• Student Presentations• The After-Tax Weighted Average Cost of

Capital• Valuing Businesses• Using WACC in Practice• Adjusted Present Value

Capital Project Adjustments

• Adjust the Discount Rate• Modify the discount rate to reflect capital

structure, bankruptcy risk, and other factors.

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

make adjustments to value based on financing.

After Tax WACC

Tax Adjusted Formula

Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; Firm has 50% debt and 50% equity.

Calculate the after-tax weighted average cost of capital (WACC):

A) 7.1% B) 8.0% C) 9.05% D) None of the above

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?

After Tax WACCExample - Sangria Corporation - continued

After Tax WACC

Example - Sangria Corporation - continued

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

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

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?

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.

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125.15.12

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Example - Sangria Corporation – continuedPerpetual 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

Valuing a BusinessValuing a Business or Project• The 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(1 221

Given the following data, calculate the value of the firm:FCF1 = $7 million; FCF2 = $45 million; FCF3 = $55 million; FCF grows at a rate of 4% for year 4 and beyond. WACC = 10%,

A) $716.25 million B) $801.12 million C) $953.33 million D) None of the above

Valuing a BusinessExample: Rio Corporation

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

Valuing a BusinessExample: Rio Corporation – continued - assumptions

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

Valuing a BusinessExample: 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

Valuing a BusinessRio Corporation

6.67$3.113

1.09

1 value)PV(horizon

3.11303.09.

8.6PV ValueHorizon

6

1H

gWACC

FCFH

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.

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.

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, don't forget to subtract the

value of the company's outstanding debt.

Using WACC in Practice• Multiple sources of financing

– Weighted average of each element

• Short term debt– Generally can be ignored

• Other current liabilities• Costs of financing

– 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

WACC & Debt RatiosExample 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

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

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

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

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.

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

Adjusted Present Value

Adjusted Present ValueLatest 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

ForecastLatest 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

Forecast

Example – Rio Corporation APV

Adjusted Present ValueExample – Rio Corporation APV - continued

Next Class• Tuesday, April 17

– Management Compensation – Chapter 12