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- 1. ByArpit amarCorporate Finance – 2011Georg Simon Ohm University of applied Science, Nuremberg
- 2. Introduction Finance manager Takes two decision Investment or capital Financing decision budgeting decision Where to invest or How to raise money orpurchase of real assets sale of financial assets
- 3. Investment decision Finance manager Explores good investment projects Analyse NPV (net The difference present value) between Projects value and its cost Assumes all cost of financing is equity financed Takes opportunity cost of capital as And calculates discount rate NPV
- 4. Financing decision When Investment project is financed with equity capital as well as debt capital Then this will represent the capital structure of the firm Equity capital requires The return should be more return to be paid to then the opportunity cost ofshareholders or investors capitalDebt capital requires fixed Interest is tax-deductible interest to be paid to the expense, so we calculate after creditors tax cost of debt The weighted average of cost of debt and cost of equity taken together is called weighted average of capital (WACC)
- 5. WACC Analyse the cost of raising the equity and debt capitalTakes the weighted And value’s project average of cost WACC = Rd( 1-Tc) D/V + RE E/V Rd = cost of debt Re = cost of equity D= market value of debt E= market value of equity Tc = corporate tax rateThe formula of WACC works for average projects, wherebusiness risk from equity and debt ratio remains constantThe managers use WACC to discount future cash flows but when equity and debt ratios are expected to change , then WACC may not give exact results
- 6. Calculating Sangria’s WACC Sangria is a U.S.-based company whose products aim to promote happy , low stress lifestyles. The book value and market value are : Book values , $million Market values , $millionAssets $1000 $500 Debt Assets $1250 $500 Debtvalue value $500 Equity $750 Equity $1000 $1000 $1000 $1250 In market values : the value of debt In book value : the value of debt remains same and value of equity and equity are equal changes from $ 500 to $750 The given cost of debt is 6%.This The given cost of equity is 12.4%.represent interest paid on existing This represent the expected rate of and on new borrowing debt return demanded by investors
- 7. Sangria’s WACC Taking market Debt ratio = 500/1250 = .4 values for thecalculation of debt and equity ratios Equity ratio = 750/1250 = .6The market share price changes from $5 to $7.5.This is the current market price and when it is multiplied by number of its outstanding shares , then it increases the equity capital and changes equity ratio in overall capital structure. Sangria is constantly profitable and pays taxes at the marginal rate of 35% Therefore: Cost of debt (rd) = .06 Cost of equity (re)= 0.124 The company’s after- tax WACC is: Marginal tax rate (Tc) = .35 WACC= .06*(1-.35)*.4 +.124*.6 =.090 OR 9% Debt ratio (d/v) = .4 Equity ratio (e/v) = .6
- 8. Using Sangria’s WAAC for the valuation of projectSuppose there is an investment in the firm of $12.5 million in perpetual crushing machine. The machinenever depreciates and generates a cash flow of $1.731 million per year pre-tax. And overall the project is average risk If the risk involved in project is average then we use WACC as a discount rate NPV= Initial investment + cash flow / that is 9% discount rate of WACC Pre tax cash flow = $1.731 million NPV= -12.5 + 1.125 / .09 Tax at 35% of $1.731 million = .606 NPV = 0 After tax cash flow (c) = $1.125 million When NPV is zero then the project is barely acceptable as an investment. This states that return from investing $12.5 million in project generates the cash flow of $1.125 million which is equals to Sangria’s WACC OF 9%. That is: cash flow / investment =1.125/12.5*100 =9% Therefore return on investment is equal to cost
- 9. Assumptions about WACC•WACC formula uses after tax cost of debt thereby capturing the value of interest shield•The formula works for average projects where business risk and debt ratios are expectedto be constant•When business risk and debt ratios are not constant or expected change ,then use ofWACC is not exactly correct.•Pre tax cash flows are converted into after tax cash flows as if the project were all equityfinanced.•The project cash flow’s are then discounted by WACC in order to capture the effect fromtax shield•When NPV is zero then project is barely acceptable stating that the cost of capital andreturn from investment are equal
- 10. WACC and financial crisis Cost of capital assumes risk free rate of return but in practice its not risk free Cost of equity capital Cost of debt capital Return investors expects Interest to be paid by company High cost of equity capital makes High Cost of debt capital creates it compulsory for company to pay inflation , increase investors risk premium rate of return which expectations to cover this inflation has to be more than its beta rate Need to analyse good investment Incapacity to pay back huge debt projects. may lead to defaults and so credit Zero NPV or low NPV projects may institution will not lend more not be able pay high returns to money, investors loose faith and shareholders. may invest in government bonds, Share price and valuation of there will be refinancing problems company may get affected
- 11. Valuing BusinessesWhen valuing a business as a whole is necessary: • Mergers & Acquisition • Selling of a business unit • Going PublicWACC can be used to value businesses that are financed by debt & equityAssumption: constant debt ratio FCF1 FCF2 FCFH PVH PV = + + ×××+ + 1+ WACC ( 1+ WACC ) 2 ( 1+ WACC ) ( 1+ WACC ) H H Present Value (free cash flow) Present value (horizon value)
- 12. Valuing BusinessesExample: Valuing Rio CorporationInput data: • Rio Corporation is a similar corporation like Sangria • Same line of business like Sangria (Assumption: same proportion of debt like Sangria) ⇒ Sangrias WACC can be used – 9%Goal: Calculating the present value of Rio CorporationSteps to do: 1. Calculation of free cash flows (FCF) 2. Estimating horizon value 3. Calculation of present value
- 13. Valuing BusinessesExample: Valuing Rio Corporation Latest year Forecast 0 1 2 3 4 5 6 7 1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.7 2 Cost of goods sold 63.1 66.2 71.3 76.3 79.9 83.1 87 90.2 3 EBITDA (1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.5 4 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1 5 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.4 6 Tax 6 4.7 4.8 5.2 5.2 5.4 5.4 5.4 7 Profit after tax (5-6) 11.2 8.7 9 9.6 9.7 10 10.1 10 8 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 16.2 15.9 9 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 67.6 PV of company 87.9
- 14. Valuing BusinessesExample: Valuing Rio Corporation Assumptions Sales growth (percent) 6,7 7 7 7 4 4 4 3 75,5 74 74,5 74,5 75 75 75,5 76 13,3 13 13 13 13 13 13 13 79,2 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 95 109,6 125,1 141,8 156,8 172,4 188,6 204,5 Less accumulated depreciation 29 38,9 49,5 60,8 72,6 84,9 97,6 110,7 Net fixed assets 66 70,7 75,6 80,9 84,2 87,5 91 93,8 Depreciation 3,3 9,9 10,6 11,3 11,8 12,3 12,7 13,1 Working capital 11,1 11,6 12,4 13,3 13,9 14,4 15 15,4
- 15. Valuing BusinessesExample: Valuing Rio CorporationDetermination of free cash flows:FCF = profit after tax + depreciation – investment in fixed assets – - investment in working capitalFCF1= 8,7 + 9,9 – (109,6 - 95,0) – (11,6 -11,1) = 3,5 (million $)FCF2 = …Calculation of PV (FCF) 3.5 3.2 3.4 5 .9 6 .1 6.0PV(FCF) = + + + + + 1.09 (1.09) 2 (1.09 ) 3 (1.09) 4 (1.09 ) 5 (1.09 ) 6 = 20.3
- 16. Valuing BusinessesExample: Valuing Rio CorporationDetermination of horizon value:•Long run growth rate: 3% FCFH +1 6.8 Horizon Value = PVH = = = 113.4 wacc − g .09 − .03 1 PV(horizon value) = ×113.4 = $67.6 (1.09) 6 PV(business) = PV(FCF) + PV(horizon value) = 20.3 + 67.6 = $87.9 millionValue of equity = PV(business) – value of debt = 87,9 – 36,0 = $51,9 million
- 17. Valuing BusinessesTricks of the TradeMore than two sources of financing: D P E WACC = (1 − Tc) × rD + × rP + × rE V V V
- 18. Valuing BusinessesTricks of the TradeWhat about short term debt? • Leaving short term debt out of calculation is an error • No serious error if debt is only temporary or compensated by holdings of cash and marketable securitiesWhat about other current liabilities? • Usually "netted out" (Net working capital = current assets – current liabilities) • Net working capital is entered on the left hand side of balance sheet
- 19. Valuing BusinessesTricks of the TradeHow are the costs of financing calculated? • Interrest rate for equity can be retrieved by looking at the stock market (typical demand by investors) • Getting borrowing rate and D/V and E/V is not difficult • Convertible, junk debt,
- 20. Valuing BusinessesImpact of the Euro Crisis on valuing businesses• Inflation leads to increasing interest rates• WACC is increasing with increasing interest rates D P E WACC = (1 − Tc ) × rD + × rP + × rE V V V •Present value decreases with increasing WACC FCF1 FCF2 FCFH PVH PV = + + ×××+ + 1+ WACC ( 1+ WACC ) 2 ( 1+ WACC ) ( 1+ WACC ) H H•Key interest rate may increase higher interest rates (like mentioned above)•Influence of rating agencies•Influence of currency exchange rates Increase / decrease of FCF
- 21. APV -Adjusted present valueEstimating the firm or project base case value assuming it is all equity financed andthen adjust this base case value to account for the financing side effects . APV = Base Case NPV + sum of PV Impact Base Case = All equity finance firm NPV PV Impact = all costs/benefits directly resulting from project PV impact : Interest rate tax shields (plus) Issuing cost of securities ( minus) Financing packages subsidized ( plus)
- 22. APV- Base caseExample : Sangria Perpetual crusher project Cost of capital r = 9.84% Investment = $ 12.5 million Project cash flow = $ 1.125 million (perpetual).Base –case NPV= -12.5 + 1.125 = -$1.067 million .0984Project is not worthwhile with all equity financing.
- 23. APV-PV (interest tax shield)Condition I The project support with debt of $ 5 million 6% borrowing rate rD =.06 35 % tax rate ( Tc=.35)Annual tax shield = .35 X.06 X 5 = .0105 or $ 105,000. Tax shields are constantly rebalanced with debt and with discount rater =9.84% PV ( interest tax shields, debt rebalanced) = $ 105, 000 = $ 1.067 million .0984APV = sum of base –case value and PV( interest tax shield)APV = -1.067 million + 1.067 million = 0
- 24. APV-PV (interest tax shield)Condition IISuppose sangria plans to keep project debt fixed at $5 millionThe risk of tax shield is the same of the risk o the debt and we discount at the rate of 6% rate on debt.PV( tax shields, debt fixed) = – 105,000 = $ 1.75 million. .06APV = -1.067 + 1.75 =$ .683 millionNow the project is more attractive with fixed debt , the interest tax shields are safe and therefore worth more .( if perpetual crusher project fails , the $ 5 million of fixed debt may end up as a burden on sangria’s other asset)
- 25. APV -Other financial side effects Suppose finance by issuing debt and equity $ 7.5 million equity with issue cost of 7% = $ 525.000 $ 5 million of debt issue cost of 2% = $ 100,000 Assume debt s fixed once is issued and tax shield worth $1.75 million APV = -1.067+ 1.75- 0.525 -0.100 = 0.58 millionNote : other financial side affects Leasing ( plus) with base case NPV subsidies loan from government ( plus)
- 26. APV for businessRio corporation APV valuation Latest year Forecast 0 1 2 3 4 5 6 710 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8 PV Free cash flow, years 1-6 19.7 Pv Horizon value 64.6 horizon value 6 year 113.4 Base-case PV of company 84.3 Debt 51 50 49 48 47 46 45 3.06 3 2.94 2.88 2.82 2.76 1.07 1.05 1.03 1.01 0.99 0.97 PV Interest tax shields 5 APV 89.3 Tax rate, percent 35% Opportunity cost of capital 9.84% WACC (To discount horizon value to year 6) 9% Lomg term growth forecast 3% Interest rate (years 1-6) 6% After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79
- 27. APV for businessOpportunity cost of capital= 9.84%APV = base –case NPV + PV ( interest tax shields)If the debt levels are taken as fixed and tax shield discounted by 6% borrowing rate =$ 84.3 + 5.0 = $ 89.3 million.There is an increase of $1.4 million from NPV , this increase is higher early debt levels. APV explore financial strategies with out looking the fixed debt ratio or having to calculate the WACC for every scenario. APV useful when debt for a project is tied to book value or has to repaid on fixed schedule. Leverage buyouts( LBO) – generating cash by selling assets , shaving cost and improving profit margins APV works fine for LBOs but for WACC can’t use the discount rate to evaluate an LBOs because its debt ratio will not be constant.
- 28. APV for international investments Custom tailored project financing, special contracts with suppliers, customers and governments. When debt ratio will not be constant , turn to APVExample1- In project ,if the competing supplier offers low interest rate project loans or lease of the plant in their bids, then NPVs of this loans or lease should be included in project analysis2- A manufacture agrees a guarantee to provide in minimum price this value is also addition to project APV –if the market price varies3- if the government impose cost or restriction such as the investors should park their part of incoming money in non interest bearing accounts e.g 2 years, then this period calculate the cost of this requirement and subtract it from APV.
- 29. Thank you

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