Asset Pricing and Corporate Finance II
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Questions and Answers

What is the estimated equity cost of capital for Avco's plastics division?

  • 9.5%
  • 13.0% (correct)
  • 15.0%
  • 12.7%

    • What is the WACC for the plastics division according to the given calculations?

  • 10.0%
  • 14.8%
  • 8.3% (correct)
  • 6.0%

    • In the GPS inventory system scenario, what is the calculated equity cost of capital?

  • 14.0%
  • 15.0%
  • 12.7%
  • 16.0% (correct)

    • What factors contribute to the differences in costs of capital across different divisions?

    <p>Business risk and leverage.</p> Signup and view all the answers

    What is the main purpose of the WACC method in capital budgeting?

    <p>To incorporate the after-tax cost of capital as the discount rate</p> Signup and view all the answers

    What key assumption is made when using the WACC method?

    <p>The project has average risk</p> Signup and view all the answers

    What does the Adjusted Present Value (APV) method primarily focus on?

    <p>Considering the impact of interest tax shields separately</p> Signup and view all the answers

    Which method highlights the cash flow available to equity holders after debt payments?

    <p>Flow-to-Equity method</p> Signup and view all the answers

    In the WACC method, what must be true about the firm's debt-equity ratio?

    <p>It must remain constant over time</p> Signup and view all the answers

    What is the role of interest tax shield in capital budgeting decisions?

    <p>To reduce the overall tax burden on the firm</p> Signup and view all the answers

    When capital budgeting for a project with leverage, what is considered an imperfection in the market?

    <p>Corporate taxes</p> Signup and view all the answers

    What method is used to calculate the depreciation of the equipment?

    <p>Straight-line method</p> Signup and view all the answers

    What is the expected WACC for Avco as calculated?

    <p>6.8%</p> Signup and view all the answers

    How much new debt must Avco add to maintain its debt-to-value ratio after the RFX project?

    <p>$30.625 million</p> Signup and view all the answers

    What is the NPV of the RFX project?

    <p>$33.25 million</p> Signup and view all the answers

    What is the purpose of computing the value of the investment using the WACC?

    <p>To assess the tax benefit of leverage</p> Signup and view all the answers

    By undertaking the RFX project, how much does the market value of Avco's equity increase?

    <p>$30.625 million</p> Signup and view all the answers

    What will Avco do with the $2.625 million that remains after funding the RFX project?

    <p>Pay it to shareholders as a dividend or share repurchase</p> Signup and view all the answers

    Which of the following is a step in the WACC method summarized?

    <p>Compute the weighted average cost of capital</p> Signup and view all the answers

    Which tax rate is applied in the calculation of WACC for Avco?

    <p>40%</p> Signup and view all the answers

    What is the present value of the interest tax shield when calculated using the APV method?

    <p>$1.63 million</p> Signup and view all the answers

    Which calculation is required to determine the investment's value without leverage in the APV method?

    <p>Estimating future cash flows</p> Signup and view all the answers

    What does the Flow-to-Equity method calculate?

    <p>Cash flow available to equity holders</p> Signup and view all the answers

    In the Flow-to-Equity method, what adjustment is made to the cash flows regarding interest?

    <p>Interest expenses are deducted before taxes</p> Signup and view all the answers

    How is net borrowing at date t calculated?

    <p>$D_t - D_{t-1}$</p> Signup and view all the answers

    What is the final step in the APV method?

    <p>Adding unlevered value to the present value of the interest tax shield</p> Signup and view all the answers

    What should the cash flows to equity holders be discounted at in the Flow-to-Equity method?

    <p>The equity cost of capital</p> Signup and view all the answers

    What effect does net borrowing have on the calculation of free cash flow to equity holders?

    <p>It is added or subtracted depending on debt activity</p> Signup and view all the answers

    What represents the cash flow available to equity holders after accounting for all payments to debt holders?

    <p>Free Cash Flow to Equity (FCFE)</p> Signup and view all the answers

    What is the purpose of calculating the free cash flow to equity in the Flow-to-Equity method?

    <p>To assess the project’s profitability from the perspective of equity holders.</p> Signup and view all the answers

    How is NPV calculated in the provided example?

    <p>By discounting free cash flows to equity using a cost of capital.</p> Signup and view all the answers

    What factors can cause the equity cost of capital for a project to differ from the firm's overall equity cost of capital?

    <p>The project’s market risk and target leverage ratio.</p> Signup and view all the answers

    What is the unlevered cost of capital for Competitor 1, based on the provided information?

    <p>9.6%</p> Signup and view all the answers

    What does the term 'project-based costs of capital' refer to?

    <p>Costs that are influenced by the specific market risks and leverage of an individual project.</p> Signup and view all the answers

    Which method can be used to estimate the unlevered cost of capital for a new business division?

    <p>Comparison with similar firms that operate in the same market.</p> Signup and view all the answers

    In the Flow-to-Equity method, which of the following is NOT a step in the process?

    <p>Calculate the project’s internal rate of return.</p> Signup and view all the answers

    What impact does leverage have on the equity cost of capital for a specific project?

    <p>Higher leverage tends to increase the equity cost of capital due to more risk.</p> Signup and view all the answers

    What is the formula for calculating Competitor 2's unlevered cost of capital?

    <p>0.75 x 10.7% + 0.25 x 5.5%</p> Signup and view all the answers

    What is a key consideration when using the WACC or FTE method for project evaluation?

    <p>The incremental debt associated with the new project.</p> Signup and view all the answers

    Study Notes

    Asset Pricing and Corporate Finance II - Capital Budgeting and Valuation with Leverage

    • Lecture Objectives:
      • Familiarization with three methods for incorporating interest tax shields in capital budgeting decisions.
      • Understanding the WACC method.
      • Understanding the Adjusted Present Value (APV) method.
      • Understanding the Flow-to-Equity method.
      • Adjusting valuation for imperfections.

    Overview

    • Methods:
      • WACC method
      • Adjusted Present Value (APV) method
      • Flow-to-Equity method
    • Simplifying Assumptions:
      • Constant average project risk
      • Constant debt-to-equity ratio
      • Corporate taxes are the only market imperfection

    The WACC Method

    • Discount Rate: The after-tax cost of capital is used as the discount rate.
    • Constant Debt-Equity Ratio: Assumes a consistent debt-to-equity ratio over time.
    • Levered Value Calculation: Future free cash flows are discounted using the WACC to compute the levered value of an investment.

    The WACC Method - Example (Avco)

    • Product: New packaging line (RFX series).
    • Technology: Technology is obsolete after four years.
    • Sales: $60 million per year for four years.
    • Costs: Manufacturing ($25 million), Operating Expenses ($9 million), R&D/Marketing ($6.67 million), Equipment ($24 million).
    • Depreciation: Straight-line method over four years.
    • Working Capital: No net working capital requirements.
    • Tax Rate: 40%

    The WACC Method - Incremental Earnings Forecast

    • Data: Financial data for each year (0 to 4) for revenue, costs, EBIT, income tax, net income, and free cash flow.

    The WACC Method - Avco's WACC Calculation

    • Data: Avco's balance sheet data (cash, existing assets, total assets, debt, equity, total liabilities and equity).
    • Debt cost of capital: 6%
    • Equity cost of capital: 10%
    • WACC: 6.8%

    The WACC Method - Project Valuation

    • NPV: The project's present value is $61.25 million, and the NPV of the project is $33.25 million.

    The WACC Method - Summary

    • Steps: Determine free cash flow, compute WACC, compute levered investment value using WACC.
    • Use in Firm: Used as a company-wide cost of capital for comparable risk investments, maintaining a consistent debt-to-equity ratio.

    The APV Method

    • Valuation: Determines the levered value of an investment by calculating the unlevered value (without leverage) and adding the value of the interest tax shield.
      • VL = APV = VU + PV(Interest Tax Shield)
    • Unlevered Cost of Capital: The project's cost of capital if there was no leverage.

    The APV Method - Avco Example

    • Unlevered Cost of Capital: 8%.
    • Unlevered Project Value (VU): $59.62 million
    • Interest Tax Shield Calculation: The present value of the interest tax shield is calculated.
    • Levered Project Value (VL): $61.25 million

    The APV Method - Summary

    • Steps: Determine unlevered investment value, calculate the present value of the interest tax shield, add unlevered value to the present value of the interest tax shield to determine the levered investment value.

    The Flow-to-Equity Method

    • Valuation: Calculates the free cash flow available to equity-holders after considering payments to and from debt holders. Free cash flow to equity is adjusted for interest payments, debt issuance, and debt repayments.

    The Flow-to-Equity Method - Incremental Earnings Forecast

    • Data: Financial data to estimate free cash flow to equity (FCFE) for each year (0 to 4), including sales, operating expenses, depreciation, interest expense, pretax income, net income, plus depreciation, less capital expenditure, less changes in working capital, plus net borrowing, to get FCFE.

    The Flow-to-Equity Method - Project Valuation

    • Project NPV: The sum of discounted FCFE for the four years, discounted with Avco's equity cost of capital (10%), which yields a $33.25 million NPV.

    The Flow-to-Equity Method - Summary

    • Steps: Determine the free cash flow to equity, calculate the equity cost of capital, compute equity value by discounting the free cash flow, using the equity cost of capital.

    Project-Based Costs of Capital

    • Varying Project Risk: Projects may have differing market risk than the average firm project.
    • Varying Leverage: Projects may have different leverage than the average firm project.
    • Estimating Unlevered Cost of Capital: Estimating unlevered costs of capital for projects using comparable firms with similar business risk.

    Project-Based Costs of Capital - Avco Example

    • Plastics Division: Avco is considering initiating a plastics division that requires a different cost of capital.
    • Approximation of Unlevered Cost of Capital Use data from comparable firms or use a 9.5% unlevered cost of capital.
    • Estimating the Equity Cost of Capital: This equity cost of capital can be computed considering the projects level of future leverage vs firm average level of leverage.
    • Divison WACC: Calculated considering the debt portion and equity (in the case of the example 0.5 / 0.5).

    Other Effects of Financing

    • Taxes: Only taxes are considered, which impacts valuation.
    • Imperfections: Issuance costs, security mispricing, financial distress costs need to be considered for a more thorough valuation.
    • Transaction Costs: Fees charged by banks for loans or underwriting must be calculated as part of the project's investment.
    • Security Mispricing: If management believes securities are mispriced, the difference needs to be reflected in the project valuation.
    • Equity Issues: Reduced price received at equity issues impacts project valuation.
    • Financial Distress: Distress costs impact firm value, increasing sensitivity to market risk. This must be included in the cost of capital, which in turn must be included in the financial valuation model
    • Agency Costs: Agency costs impact the calculation of financial distress costs.

    Specific Example (Gap Expansion Loan)

    • Loan Amount: $100 million
    • Interest Rate: 6% vs 5%
    • Loan Term: 5 years, all principal repaid in year 5.

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    Asset Pricing and Corporate Finance II PDF

    Description

    Test your understanding of capital budgeting and valuation methods, including WACC, APV, and Flow-to-Equity. Dive into how interest tax shields impact corporate finance decisions and valuation under market imperfections.

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