Chapter 19 Principles of Corporate Finance Eighth Edition Financing and Valuation Slides by Matthew...

Chapter 19

Principles of

Corporate FinanceEighth Edition

Financing and Valuation

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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MT480

Unit 8 Seminar

Chapter 19


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Topics Covered

After Tax WACCValuing BusinessesUsing WACC in PracticeAdjusted Present ValueYour Questions Answered


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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.


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After Tax WACC

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Er

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DTcrWACC ED )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 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?


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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



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After Tax WACC


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


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



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After Tax WACC


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

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

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After Tax 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 $1.731 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 $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


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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?

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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


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93.0195.125.1)1(incomeequity Expected

195.5)35.1(06.)1(interestAfter tax

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12.4%or 124.5.7

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incomeequity expectedreturnequity Expected

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12.4%or 124.5.7

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incomeequity expectedreturnequity Expected

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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.


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– 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.


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– 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.


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Tricks of the Trade

What should be included with debt?

– Long-term debt?

– Short-term debt?

– Cash (netted off?)

– Receivables?

– Deferred tax?


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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


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Chapter 19 Practice Question 1

Table 19.3 shows a book balance sheet for the Wishing Well Motel chain. The company’s long-term debt is secured by its real estate assets, but it also uses short-term bank financing. It pays 10 percent interest on the bank debt and 9 percent interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The expected return on Wishing Well’s common stock is 18 percent. Calculate Wishing Well’s WACC. Assume that the book and market values of Wishing Well’s debt are the same. The marginal tax rate is 35 percent.


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If the bank debt is treated as permanent financing, the capital structure proportions are:

Bank debt (rD = 10 percent) $280 9.4%

Long-term debt (rD = 9 percent) 1800 60.4

Equity (rE = 18 percent, 90 x 10 million shares) 900 30.2

$2980 100.0%

WACC* = [0.10x(1 - 0.35)x0.094] + [0.09x(1 - 0.35)x0.604] + [0.18x0.302] = 0.096 = 9.6%


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Suppose Wishing Well is evaluating a new motel and resort on a romantic site in Madison County, Wisconsin. Explain how you would forecast the after-tax cash flows for this project.

(Hints: How would you treat taxes? Interest expense? Changes in working capital?)


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Forecast after-tax incremental cash flows as explained in Section 6.1. Interest is not included; the forecasts assume an all-equity financed firm.


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To finance the Madison County project, Wishing Well will have to arrange an additional $80 million of long-term debt and make a $20 million equity issue. Underwriting fees, spreads, and other costs of this financing will total $4 million. How would you take this into account in valuing the proposed investment?


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Calculate APV by subtracting $4 million from base-case NPV.


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You are considering a five-year lease of office space for R&D personnel. Once signed, the lease cannot be canceled. It would commit your firm to six annual $100,000 payments, with the first payment due immediately. What is the present value of the lease if your company’s borrowing rate is 9 percent and its tax rate is 35 percent? Note: The lease payments would be tax-deductible.


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The after-tax cash flows are: 0.65 × $100,000 = $65,000 per year.

The after-tax discount rate is: 0.65 × 0.09 = 0.0585 = 5.85%

The present value of the lease is equal to the present value of a five-year annuity of $65,000 per year plus the immediate $65,000 payment:

$65,000 × [annuity factor, 5.85%, 5 years] + $65,000 =

($65,000 × 4.2296) + $65,000 = $339,924


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Questions

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