CAPITAL BUDGETING

WITH LEVERAGE

Introduction

Discuss three approaches to valuing a risky project

that uses debt and equity financing.
Initial Assumptions

The project has average risk.

For

convenience the betas or costs of capital used will be for

the existing firm rather than being project specific.

The firms debt-equity ratio is constant.

This

simplifies the application in that we dont need to worry

about changing costs of capital and fixes the adjustment of our
risk measure for leverage.

Corporate taxes are the only imperfection.

No

agency, bankruptcy or issuance costs to quantify.

The Weighted Average Cost

of Capital Method

rwacc

E
D

rE
rD (1 c )
E D
E D

Because the WACC incorporates the tax

savings from debt, we can compute the
levered value (V for enterprise value, L for
leverage) of an investment, by discounting its
future
expected
freeFCF
cash flow using
FCFthe
FCF1
L
3
2
V

L
0
WACC.
2
3
1 rwacc
(1 rwacc )
(1 rwacc )

Valuing a Project with WACC

Ralph Inc. is considering introducing a

new type of chew toy for dogs.

Ralph expects the toys to become obsolete

after five years when it will be discovered
that chew toys only encourage dogs to eat
shoes. However, the marketing group
expects annual sales of $40 million for the
first year, increasing by $10 million per
year for the following four years.

Manufacturing costs and operating

expenses (excluding depreciation) are
expected to be 40% of sales and $7 million,
respectively, each year.

Valuing a Project with WACC

Developing the product will require upfront R&D

and marketing expenses of $8 million. The fixed
assets necessary to produce the product will
require an additional investment of $20 million.
The

equipment will be obsolete once production

ceases and (for simplicity) will be depreciated via
the straight-line method over the five year period.

Ralph expects no incremental net working

capital requirements for the project.

Ralph has a target of 60% Equity financing.

Ralph pays a corporate tax rate of 35%.

Expected Future Free Cash

Flow

Market Value Balance

Sheet

The firm is currently at its target

leverage:

Equity to Net Debt plus Equity ratio is:

$510.00/($510.00 + $390.00 - $50.00) =
60.0%

Valuing a Project with WACC

Ralph intends to maintain a similar (net)

debt-equity ratio for the foreseeable
future, including any financing related to
the project. Thus, Ralphs WACC is:
E
D
rE
rD (1 c )
E D
E D
510
340

(12%)
(5%)(1 0.35)
850
850
8.5%

rwacc

Valuing a Project with WACC

The value of the project, including the tax

shield from debt, is calculated as the present
value of its future free cash flows discounted
at the WACC.
L
0

12.45
16.35
20.25
24.15 28.05

+
2
3
4
1.085
1.085
1.085
1.085 1.0855
$77.30 million

The

NPV (value added) of the project is $52.10

million

$77.30 million $25.20 million = $52.10 million

It is important to remember the difference between value

and value added.

Summary of the WACC

Method
1.

Determine the free cash flow of the investment.

2.

Compute the weighted average cost of capital.

3.

4.

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
companywide cost of capital for new investments
that are of comparable risk to the rest of the firm
and that will not alter the firms debt-equity ratio.

Implementing a Constant DebtEquity Ratio

By undertaking the project, Ralph adds

new assets to the firm with an initial
market value $77.30 million.

Therefore, to maintain the target debt-tovalue ratio, Ralph must add $30.92 million
in new debt.
40%

$77.30 = $30.92
60% $77.30 = $46.38 (compare to $52.10)

Implementing a Constant Debt-Equity

Ratio

Ralph can add (net) debt in this amount

either by reducing cash and/or by
borrowing and increasing actual debt.

Suppose Ralph decides to spend $25.20 million

(cover the negative FCF in year 0) in cash to
initiate the project.

This increases net debt by $25.20 million

New Market Value Balance

Sheet

We need an increase in net debt of

$30.92.
Spend $25.20 million on the project and
pay a $5.72 million dividend so $30.92
million in cash goes out (this further
increases net debt and reduces equity
by the required amount).

Implementing a Constant Debt-Equity

Ratio

The market value of Ralphs equity increases by

$46.38 million.

$556.38 $510.00 = $46.38 (60% of $77.30)

Adding the dividend of $5.72 million into the mix,

the shareholders total gain is $52.10 million.

$46.38 + 5.72 = $52.10

Which is exactly the NPV calculated for the project

Alternatively: without the dividend the equity

increased by the projects NPV of $52.10 = $562.10 $510.00. This is too large an increase in equity, given
the increase in debt of $25.20, if Ralph is to maintain
60% equity.

Implementing a Constant Debt-Equity

Ratio

Debt Capacity

The amount of debt at a particular date

that is required to maintain the firms
target debt-to-value ratio

The debt capacity at date t is calculated as:

Dt d Vt L

Where

d is the firms target debt-to-value ratio

and VLt is the projects levered continuation
value on date t.

Implementing a Constant Debt-Equity

Ratio

Debt Capacity

Vt

VLt calculated as:

L

FCFt 1

Value of FCF in year t 2 and beyond

}
L
Vt 1

1 rwacc

Debt Capacity

In order to maintain the target financing,

the amount of new debt must fall over
the life of the project.
This is true because the value of the
project depends upon the future cash
flow at each point in time. Since the
project ends, value decreases. Since
value decreases, debt must also
decrease.

The Adjusted Present Value Method

Adjusted Present Value (APV)

A valuation method to determine the

levered value
of an investment by first calculating its
unlevered
value and then adding the value of the
interest
shield
and
any costs
APV
V U tax
PV
(Interest
Taxdeducting
Shield)
that arise from other market imperfections

VL

PV (Financial Distress, Agency, and Issuance Costs)

The Unlevered Value of the

Project

The first step in the APV method is to

calculate the value of the free cash flows
using the projects cost of capital if it
were financed without leverage.

The Unlevered Value of the Project

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 (recall the picture) as the
weighted average cost of capital computed
without taking into account taxes (pre-tax WACC).

rU

E
D

rE
rD Pretax WACC
E D
E D

This

is, strictly speaking, only true for firms that adjust

their debt to maintain a target leverage ratio.

The Unlevered Value of the Project

For Ralph, the unlevered cost of capital

is calculated as:
rU 0.60 12.0% 0.40 5.0%

9.2%
The projects value without leverage is
then calculated as:
V

12.45
16.35
20.25
24.15
28.05

+
2
3
4
1.092
1.092
1.092
1.092
1.0925
$75.71 million

Valuing the Interest Tax

Shield

The value of $75.71 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.

Interest paid in year t rD Dt 1

The

interest tax shield is equal to the interest

paid multiplied by the corporate tax rate.

Interest Tax Shield

From the debt capacity calculation we

can find the interest associated with the
project if the financing is kept at the
target.

Valuing the Interest Tax Shield

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 projects cash flows, so
they should be discounted at the projects
unlevered cost
of capital.
0.54
0.50
0.43
0.32
0.18

PV (interest tax shield)

1.092
1.092
$1.59 million

1.092

1.092

1.0925

Valuing the Project with Leverage

The total value of the project with

leverage is the sum of the value of the
interest tax shield and the value of the
unlevered
V L project.
V U PV (interest tax shield)
75.71 1.59 $77.30 million

The NPV of the project is $52.10 million

$77.30

million $25.20 million = $52.10 million

This is exactly the same value found using the

WACC approach.

Summary of the APV

Method
1.

2.

3.

Determine the investments value

without leverage.
Determine the present value of the interest
tax shield.
a.

Determine the expected interest tax shield.

b.

Discount the interest tax shield.

Add the unlevered value to the present

value of the interest tax shield to determine
the value of the investment with leverage.

Summary of the APV Method

The APV method has some advantages.

It can be easier to apply than the WACC

method when the firm does not maintain a
constant debt-equity ratio.

The APV approach also explicitly values

market imperfections and therefore allows
managers to measure their contribution to
value.

The Flow-to-Equity Method

Flow-to-Equity

A valuation method that calculates the free

cash flow available to equity holders taking
into account all payments to and from debt
holders.
Free

Cash Flow to Equity (FCFE), the free cash

flow that remains after adjusting for interest
payments, debt issuance and debt repayments

The cash flows to equity holders are then

discounted using the equity cost of capital.

Free Cash Flow to Equity

Valuing the Equity Cash

Flows

Because the FCFE represent payments to equity

holders, they should be discounted at the
projects equity cost of capital.

Given that the risk and leverage of the project are the
same as for Ralph Inc. overall, we can use Ralphs
equity cost of capital of 12.0% to discount the projects
FCFE.
9.09
11.31
13.43
15.46 17.37

+
2
3
4
1.12
1.12
1.12
1.12
1.125
$52.10 million

NPV (FCFE ) 5.72

The value of the projects FCFE represents the gain to

shareholders from the project and it is identical to the
NPV computed using the WACC and APV methods. (The
debt is sold at a fair price.)

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 will may

also vary in the amount of leverage they
will support.

Estimating the Unlevered Cost of Capital

Suppose the project Ralph launches

faces different market risks than its main
business.

The unlevered cost of capital for the new

project can be estimated by looking at
publicly traded, pure play firms that have
similar business risks.

Estimating the Unlevered Cost of Capital

Assume two firms are comparable to the

chew toy project in terms of basic
business risk and have the following
observable
characteristics:
Firm
Equity Beta
Debt Beta
Debt-toValue Ratio
Firm A

1.7

0.05

40%

Firm B

1.9

0.10

50%

Estimating the Unlevered Cost

of Capital using Betas

We now find their unlevered or asset

betas:
E
D
0.6
0.4



1.7
0.05 1.04
A
U

A
E

A
D

E D
E D
0.6 0.4
0.6 0.4
EB
DB
0.5
0.5
B
B
B
U B

1.9

0.1 1.0
E
D
B
B
B
E D
E D
0.5 0.5
0.5 0.5

An average of these unlevered betas is

1.02.
Note,
unlevered beta of 1.02 gives an
rU ran
f U ( RP ) 4% 1.02(6%) 10.12%
unlevered cost of equity capital of:

Project Leverage
and the Equity Cost of Capital

Now assume that Ralph plans to maintain a 20%

debt to value ratio for its chew toy project, and it
expects its borrowing cost to be 4%.
We now relever the unlevered beta estimate of
1.02 and using the SML we find the cost of levered
equity:
D
0.2
E U ( U D ) 1.02
(1.02 0.0) 1.275
E
0.8
rE rf E ( RP ) 4% 1.275(6%) 11.65%
A cost of debt capital of 4% is consistent with the
low leverage chosen and a debt beta of 0.

Project Leverage and the

Weighted Average Cost of Capital

With a 20% debt to value ratio, a cost of

equity capital of 11.65%, and a cost of
debt capital of 4% we can now estimate
the WACC for the project.
rWACC

0.8
0.2

11.65%
4%(1 0.35) 9.84
0.8 0.2
0.8 0.2

An Alternate Approach
From the observable (or measurable)
data we can get estimates of the cost of
equity capital and the cost of debt
capital:
Firm A:
rE 4% 1.7 6% 14.2%

rD 4% 0.05 6% 4.3%

rE 4%
Firm
B: 1.9 6% 15.4%
rD 4% 0.1 6% 4.6%

An Alternate Approach

Recall the relation between the levered cost of

equity capital and the unlevered cost of equity
capital:
D

rE rU

(rU rD )

Rearranging this we find:

In other words, the unlevered cost of equity

capital equals the pre-tax WACC

E
D
rU
rE
rD pre-tax WACC
ED
ED

Estimating the Unlevered Cost of Capital

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.
Firm
A: rU 0.60 14.2% 0.40 4.3% 10.24%

Firm B: rU 0.50 15.4% 0.50 4.6% 10.0%

Based on these comparable firms, we

estimate an unlevered cost of capital for
the project that is approximately
10.12%.

Project Leverage
and the Equity Cost of Capital

Ralph plans to maintain a 20% debt to

value ratio for its chew toy project, and it
expects its borrowing cost to be 4%.

Given the unlevered cost of capital

estimate of 10.12%, the chew toy divisions
equity cost of capital is estimated to be:

rE

0.20
10.12%
(10.12% 4%)
0.80
11.65%

Project Leverage and the

Weighted Average Cost of Capital

The divisions WACC can now be

rWACC 0.80 to
11.65%
estimated
be: 0.20 4.0% (1 0.35)
9.84%

An alternative method for calculating the

chew toy divisions WACC is:

rWACC rU d c rD

10.12% 0.20 0.35 4%

9.84%