Asset Pricing and Corporate Finance II PDF

Asset Pricing and Corporate Finance II Capital Budgeting and Valuation with Leverage Philipp Krüger Lecture objectives Familiarize yourself with three methods of including the value of the interest tax shields in the capital budgeting decision. How to use t...

Asset Pricing and Corporate Finance II Capital Budgeting and Valuation with Leverage Philipp Krüger Lecture objectives Familiarize yourself with three methods of including the value of the interest tax shields in the capital budgeting decision. How to use the WACC method? What is the principle of the APV method? Learning the principle of the flow-to-equity method. How to adjust valuation for imprefections? 2 Overview The WACC method The Adjusted Present Value (APV) method The Flow-to-Equity method Project based costs of capital Other effects of financing 3 Overview In this section we discuss the three main methods for capital budgeting with leverage and market imperfections. To illustrate the methods, we make the following simplifying assumptions: – The project has average risk – The firm’s debt-equity ratio is constant – Corporate taxes are the only market imperfection (other imperfections are not relevant at the level of debt chosen) We will also consider situations in which we relax these assumptions. 4 The WACC method The WACC method takes the interest tax shield into account by using the after-tax cost of capital as the discount rate. We assume that the firm maintains a constant debt-equity ratio over time. Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, by discounting its future free cash flow using the WACC. FCF1 FCF2 FCF3 V0L = + + + 1 + rwacc (1 + rwacc ) 2 (1 + rwacc ) 3 5 The WACC method Example: Assume Avco is considering introducing a new line of packaging, the RFX series. – Avco expects the technology used in these products to become obsolete after four years. However, the marketing group expects annual sales of $60 million per year over the next four years for this product line. – Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively, per year. – Developing the product will require upfront R&D and marketing expenses of $6.67 million, together with a $24 million investment in equipment. The equipment will be obsolete in four years and will be depreciated via the straight-line method over that period. – Avco expects no net working capital requirements for the project. – Avco pays a corporate tax rate of 40%. 6 The WACC method 7 The WACC method Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the RFX project. Thus, Avco’s WACC is E D 300 300 rwacc = rE + rD (1 −  c ) = (10%) + (6%)(1 − 0.40) E + D E + D 600 600 = 6.8% 8 The WACC method The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows. 18 18 18 18 V0 L = + 2 + 3 + 4 = $61.25 million 1.068 1.068 1.068 1.068 The NPV of the project is 61.25 – 28 = $33.25 million. 9 The WACC method Summary of the WACC method: 1. Determine the free cash flow of the investment. 2. Compute the weighted average cost of capital. 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC. The WACC can be used throughout the firm as the company- wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio. 10 The WACC method By undertaking the RFX project, Avco adds new assets to the firm with initial market value $61.25 million. Therefore, to maintain its debt-to-value ratio, Avco must add $30.625 million in new debt. Avco can add this debt either by reducing cash or by borrowing and increasing debt. Assume Avco decides to spend its $20 million in cash and borrow an additional $10.625 million. Because only $28 million is required to fund the project, Avco will pay the remaining $2.625 million to shareholders through a dividend (or share repurchase). 11 The WACC method The market value of Avco’s equity increases by $30.625 million. Adding the dividend of $2.625 million, the shareholders’ total gain is $33.25 million. – Which is exactly the NPV calculated for the RFX project 12 The WACC method What happens over the life of the project? Debt Capacity: – The amount of debt at a particular date that is required to maintain the firm’s target debt-to-value ratio – The debt capacity at date t is calculated as: Dt = d  Vt L Where d is the firm’s target debt-to-value ratio and VLt is the levered continuation value on date t. 13 The WACC method 14 The APV method The adjusted present value method (APV) is an alterative valuation method in which we determine the levered value of an investment by first calculating its unlevered value, which is its value without any leverage, and then adding the value of the interest tax shield. V L = APV = V U + PV (Interest Tax Shield) The first step in the APV method is to calculate the value of the free cash flows using the project’s cost of capital if it were financed without leverage. 15 The APV method What is the project’s unlevered cost of capital? The cost of capital of a firm, were it unlevered: for a firm that maintains a target leverage ratio, it can be estimated as the weighted average cost of capital computed without taking into account taxes (pre-tax WACC). E D rU = rE + rD = Pretax WACC E + D E + D We value the interest tax shield separately. 16 The APV method The firm’s unlevered cost of capital equals its pretax WACC because it represents investors’ required return for holding the entire firm (equity and debt). This argument relies on the assumption that the overall risk of the firm is independent of the choice of leverage. For Avco, its unlevered cost of capital and the project value without leverage are calculated as: rU = 0.50  10.0% + 0.50  6.0% = 8.0% 18 18 18 18 V U = + 2 + 3 + 4 = $59.62 million 1.08 1.08 1.08 1.08 17 The APV method The value of $59.62 million is the value of the unlevered project and does not include the value of the tax shield provided by the interest payments on debt. 18 The APV method The next step is to find the present value of the interest tax shield. When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at the project’s unlevered cost of capital. 0.73 0.57 0.39 0.20 PV (interest tax shield) = + 2 + 3 + 4 = $1.63 million 1.08 1.08 1.08 1.08 V L = V U + PV (interest tax shield) = 59.62 + 1.63 = $61.25 million 19 The APV method Summary of the APV method: 1. Determine the investment’s value without leverage. 2. Determine the present value of the interest tax shield. a. Determine the expected interest tax shield. b. Discount the interest tax shield. 3. Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage. 20 The Flow-to-Equity method In the Flow-to-Equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders after taking into account all payments to and from debt holders. The cash flows to equity holders are then discounted using the equity cost of capital. The free cash flow to equity holders is the cash flow that remains after adjusting for interest payments, debt issuance and debt repayments. 21 The Flow-to-Equity method 22 The Flow-to-Equity method Note two changes in the calculation of the free cash flows. – Interest expenses are deducted before taxes. – The proceeds from the firm’s net borrowing activity are added in. These proceeds are positive when the firm issues debt and are negative when the firm reduces its debt by repaying principal. Net Borrowing at Date t = Dt − Dt − 1 The FCFE can also be calculated, using the free cash flow, as FCFE = FCF − (1 −  c )  (Interest Payments) + (Net Borrowing) After-tax interest expense 23 The Flow-to-Equity method Because the FCFE represent payments to equity holders, they should be discounted at the project’s equity cost of capital. – Given that the risk and leverage of the RFX project are the same as for Avco overall, we can use Avco’s equity cost of capital of 10.0% to discount the project’s FCFE. 9.98 9.76 9.52 9.27 NPV (FCFE ) = 2.62 + + 2 + 3 + 4 = $33.25 million 1.10 1.10 1.10 1.10 24 The Flow-to-Equity method Summary of the Flow-to-equity method: 1. Determine the free cash flow to equity of the investment. 2. Determine the equity cost of capital. 3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital. 25 Project based costs of capital In the real world, a specific project may have different market risk than the average project for the firm. In addition, different projects may vary in the amount of leverage they will support. Suppose Avco launches a new plastics manufacturing division that faces different market risks than its main packaging business. – The unlevered cost of capital for the plastics division can be estimated by looking at other single-division plastics firms that have similar business risks. 26 Project based costs of capital Assume two firms are comparable to the plastics division and have the following characteristics: Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital for each competitor can be estimated by calculating their pretax WACC. Competitor 1: rU = 0.60  12.0% + 0.40  6.0% = 9.6% Competitor 2: rU = 0.75  10.7% + 0.25  5.5% = 9.4% 27 Project based costs of capital With the unlevered cost of capital in hand (9.5%) we can use the APV approach. To use WACC or FTE method we need to estimate the project’s equity cost of capital, which depends on the incremental debt the company will take on as a result of the project. A project’s equity cost of capital may differ from the firm’s equity cost of capital if the project uses a target leverage ratio that is different than the firm’s. The project’s equity cost of capital can be calculated as: D rE = rU + (rU − rD ) E 28 Project based costs of capital Now assume that Avco plans to maintain an equal mix of debt and equity financing as it expands into plastics manufacturing, and it expects its borrowing cost to be 6%. – Given the unlevered cost of capital estimate of 9.5%, the plastics division’s equity cost of capital is estimated to be: 0.50 rE = 9.5% + (9.5% − 6%) = 13.0% 0.50 The division’s WACC is: rWACC = 0.50  13.0% + 0.50  6.0%  (1 − 0.40) = 8.3% 29 Project based costs of capital An alternative method for computing the division’s WACC is: rwacc = rwacc u − d c rD rwacc = 9.5% − 0.50  0.40  6% = 8.3% 30 Project based costs of capital 31 Project based costs of capital Solution (1) Lumber and milling: rE=12.7% rD=6 % D/(D+E)=0.4 (2) GPS inventory system: - risk similar to that of other technology firms - comparable firms: rU=15% - Hasco plans to finance the project with 10 % of debt (constant debt to value ratio of 10 %): D/(D+E)=10%=1/(1+9) - rD=6% Corporate tax rate τc=0.35 32 Project based costs of capital (1) Lumber and milling: - Equity cost of capital: use current rE=12.7% - WACC: rWACC=0.4*6%*0.65+0.6*12.7%=9.2 % - Unlevered cost of capital: rU=0.4*6%+0.6*12.7%=10% (2) GPS inventory system: - Equity cost of capital: rE=rU+D/E (rU-rD)=15% + 1/9(15%- 6%)=16% - WACC: rWACC=rU-τcdrD=15%-0.35*1/10*6%=14.8% - Unlevered cost of capital: use that of comparable firms (rU=15%) → Costs of capital are quite different across divisions because of differences in (i) business risk and (ii) leverage 33 Project based costs of capital Determining the incremental leverage of a project: To determine the equity or weighted average cost of capital for a project, the incremental financing that results if the firm takes on the project needs to be calculated. In other words, what is the change in the firm’s total debt (net of cash) with the project versus without the project. 34 Other effects of financing So far we have only considered taxes in the valuation methods. We can adjust our valuation to account for imperfections such as issuance costs, security mispricing, and financial distress costs. For instance, when a firm raises capital by issuing securities, the banks that provide the loan or underwrite the sale of the securities charge fees. These fees should be included as part of the project’s required investment, reducing the NPV of the project. 35 Other effects of financing 36 Other effects of financing If management believes that the securities they are issuing are priced differently than their true value, the NPV of the transaction should be included in the value of the project. – The NPV of the transaction is the difference between the actual money raised and the true value of the securities sold. If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for existing shareholders. It should be deducted from the project NPV in addition to other issuance costs. 37 Other effects of financing 38 Other effects of financing 39 Other effects of financing Financial distress and agency costs also impact the cost of capital. – For example, financial distress costs tend to increase the sensitivity of the firm’s value to market risk, raising the unlevered cost of capital for highly levered firms. The free cash flow estimates for a project should be adjusted to include expected financial distress and agency costs. In addition, because these costs also affect the systematic risk of the cash flows, the unlevered cost of capital will no longer be independent of the firm’s leverage. 40 Other effects of financing 41