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# Chap019 (1)

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### Chap019 (1)

1. 1. Principles of Chapter 19 Corporate Finance Tenth Edition Financing and Valuation Slides by Matthew WillMcGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
3. 3. 19-3 Capital Project Adjustments1. Adjust the Discount Rate  Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors.1. Adjust the Present Value  Assume an all equity financed firm and then make adjustments to value based on financing.
4. 4. 19-4 After Tax WACC Tax Adjusted Formula D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V
5. 5. 19-5 After Tax WACCExample - Sangria CorporationThe firm has a marginal tax rate of 35%. The cost ofequity 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?
6. 6. 19-6 After Tax WACCExample - Sangria Corporation - continued Balance Sheet (Book Value, millions) Assets 1,000 500 Debt 500 Equity Total assets 1,000 1,000 Total liabilities
7. 7. 19-7 After Tax WACCExample - Sangria Corporation - continued Balance Sheet (Market Value, millions) Assets 1,250 500 Debt 750 Equity Total assets 1,250 1,250 Total liabilities
8. 8. 19-8 After Tax WACCExample - SangriaCorporation - continuedDebt ratio = (D/V) = 500/1,250 = .4 or 40%Equity ratio = (E/V) = 750/1,250 = .6 or 60% D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V
9. 9. 19-9 After Tax WACCExample - Sangria Corporation - continued D  E WACC = rD × (1 − Tc) ×   +  rE ×  V   V WACC = .06 × (1 − .35)( .40) + .124( .60) = .090 = 9 .0 %
10. 10. 19-10 After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetualcrushing machine with cash flows of \$1.731million per year pre-tax.Given an initial investment of \$12.5 million,what is the value of the machine?
11. 11. 19-11 After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine withcash flows of \$1.731 million per year pre-tax. Given an initial investmentof \$12.5 million, what is the value of the machine? Cash Flows Pretax cash flow 1.731 Tax @ 35% 0.606 After-tax cash flow \$1.125 million
12. 12. 19-12 After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine withcash flows of \$1.731 million per year pre-tax. Given an initial investmentof \$12.5 million, what is the value of the machine? C1 NPV = C0 + r−g 1.125 = −12.5 + .09 =0
13. 13. 19-13 After Tax WACCExample - Sangria Corporation – continued Perpetual Crusher project Balance Sheet - Perpetual Crusher (Market Value, millions) Assets 12.5 5.0 Debt 7.5 Equity Total assets 12.5 12.5 Total liabilities
14. 14. 19-14 After Tax WACCExample - Sangria Corporation – continued Perpetual Crusher projectAfter tax interest = rD (1 − TC ) D = .06 × (1 − .35) × 5 = .195Expected equity income = C − rD (1 − TC ) D = 1.125 − .195 = 0.93
15. 15. 19-15 After Tax WACCExample - Sangria Corporation – continued Perpetual Crusher project expected equity incomeExpected equity return = rE = equity value 0.93 = = .124 or 12.4% 7.5
16. 16. 19-16 Capital BudgetingV
17. 17. 19-17 Capital BudgetingValuing a Business or Project FCF1 FCF2 FCFH PVHPV = + + ... + + (1 + r ) (1 + r ) 1 2 (1 + r ) H (1 + r ) H PV (free cash flows) PV (horizon value) In this case rr = wacc In this case = wacc
18. 18. 19-18 Valuing a BusinessExample: 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 0.410 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
19. 19. 19-19 Valuing a BusinessExample: Rio Corporation – continued - assumptionsAssumptionsSales 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 14Tax rate, percent 35%WACC 9%Long term growth forecast 3%Fixed assets and working capitalGross 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
20. 20. 19-20 Valuing a BusinessExample: Rio Corporation – continuedFCF = Profit after tax + depreciation + investment in fixed assets + investment in working capitalFCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = \$3.5million
21. 21. 19-21 Valuing a BusinessExample: Rio Corporation – continued 3.5 3.2 3.4 5 .9 6.1 6.0PV(FCF) = + + + + + 1.09 (1.09 ) 2 (1.09) (1.09) (1.09) (1.09) 3 4 5 6 = 20.3
22. 22. 19-22 Valuing a BusinessExample: Rio Corporation – continued FCFH +1  6.8 Horizon Value = PVH = =  = 113.4 wacc − g  .09 − .03  1PV(horizon value) = ×113.4 = \$67.6 (1.09) 6
23. 23. 19-23 Valuing a BusinessExample: Rio Corporation – continuedPV(business) = PV(FCF) + PV(horizon value) = 20.3 + 67.6 = \$87.9 million
24. 24. 19-24WACC 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.
25. 25. 19-25 WACC vs. Flow to Equity– The companys 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.
26. 26. 19-26WACC vs. Flow to Equity– Discounting at WACC values the assets and operations of the company. If the object is to value the companys equity, that is, its common stock, dont forget to subtract the value of the companys outstanding debt.
27. 27. 19-27 Tricks of the Trade What should be included with debt? – Long-term debt? – Short-term debt? – Cash (netted off?) – Receivables? – Deferred tax?
28. 28. 19-28 After Tax WACC  Preferred stock and other forms of financing must be included in the formula D  P  E WACC = (1 − Tc) × rD  +  × rP  +  × rE  V  V  V 
29. 29. 19-29 After Tax WACCExample - Sangria Corporation - continuedCalculate WACC given preferred stock is \$25 mil of total equity andyields 10%. Balance Sheet (Market Value, millions) Assets 125 50 Debt 25 Preferred Equity 50 Common Equity Total assets 125 125 Total liabilities  50   25   50  WACC = (1 − .35) × .08  +  × .10  +  × .146   125   125   125  = .1104 = 11.04%
30. 30. 19-30 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
31. 31. 19-31 WACC & Debt Ratios Example continued: Sangria and the Perpetual Crusher project at 20% D/VStep 1 – r at current debt of 40% r = .06(.4) + .124(.6) = .0984Step 2 – D/V changes to 20% rE = .0984 + (.0984 − .06)(.25) = .108Step 3 – New WACC WACC = .06(1 − .35)(.2) + .108(.8) = .0942
32. 32. 19-32 After Tax WACCExample - Sangria Corporation - continued
33. 33. 19-33Investment & Financing Interaction Adjusted Present Value vs. Adjusted Discount Rate
34. 34. 19-34 Investment & Financing InteractionAdjusted Cost of Capital(alternative to WACC)M&M Formula --> ADR = r (1 - Tc L )L = Debt / Valuer = Cost of equity @ all equityTc = Corp Tax Ratealternative to WACC (almost same results)
35. 35. 19-35 Investment & Financing InteractionAdjusted Cost of Capital(alternative to WACC) Miles and Ezzell  1 +r A  WACC = r − LrDTc  1+ r    D 
36. 36. 19-36 Capital Project Adjustments1. WACC2. Adjust the Discount Rate  Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors.1. Adjust the Present Value  Assume an all equity financed firm and then make adjustments to value based on financing.
37. 37. 19-37 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
38. 38. 19-38 Adjusted Present Valueexample: 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.
39. 39. 19-39 Adjusted Present Valueexample: 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 - 50,000don’t do the project
40. 40. 19-40 Adjusted Present Valueexample: 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.
41. 41. 19-41 Adjusted Present Valueexample: 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 40,000do the project
42. 42. 19-42 Adjusted Present ValueExample – Rio Corporation APV Latest year Forecast 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 19.7 Pv Horizon value 64.6 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
43. 43. 19-43 Adjusted Present ValueExample – Rio Corporation APV - continuedAPV = Base case NPV + PV(Intere st tax shields) = 84.3 + 5.0 = \$89.3million