Corporate Finance: Capital Budgeting For The Levered Firm

17-1
Chapter Seventeen
Capital Budgeting
forFinance
the
Corporate
Ross Westerfield Jaffe
Levered Firm
17
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
17-2
Prospectus
Recall that there are three questions in corporate
finance.
The first regards what long-term investments the
firm should make (the capital budgeting question).
The second regards the use of debt (the capital
structure question).
This chapter is the nexus of these questions.
McGraw-Hill Ryerson
17-3
Chapter Outline
17.1 Adjusted Present Value Approach
17.2 Flows to Equity Approach
17.3 Weighted Average Cost of Capital Method
17.4 A Comparison of the APV, FTE, and WACC
Approaches
17.5 Capital Budgeting for Projects that are Not ScaleEnhancing
17.6 APV Example
17.7 Beta and Leverage
17.8 Summary and Conclusions
McGraw-Hill Ryerson
17-4
17.1 Adjusted Present Value Approach

APV NPV NPVF
The value of a project to the firm can be thought of as the
value of the project to an unlevered firm (NPV) plus the
present value of the financing side effects (NPVF):
There are four side effects of financing:
The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing
McGraw-Hill Ryerson
17-5
APV Example
Consider a project of the Pearson Company, the timing and
size of the incremental after-tax cash flows for an allequity firm are:
-$1,000
0
$125
$250
$375
$500
The unlevered cost of equity is r0 = 10%:
NPV10%
NPV10%
$125
$250
$375
$500
$1,000
2
3
(1.10) (1.10) (1.10) (1.10) 4
$56.50
The project would be rejected by an all-equity firm: NPV < 0.

McGraw-Hill Ryerson
17-6
APV Example (continued)

Now, imagine that the firm finances the project with
$600 of debt at rB = 8%.
Pearsons tax rate is 40%, so they have an interest
tax shield worth TCBrB = .40$600.08 = $19.20
each year.
The net present value of the project under leverage is:
APV NPV NPVF

4
$19.20
APV $56.50
t
(
1
.
08
)
t 1
APV $56.50 63.59 $7.09

So, Pearson should accept the project with debt.
McGraw-Hill Ryerson
17-7
APV Example (continued)

Note that there are two ways to calculate the NPV
of the loan. Previously, we calculated the PV of the
interest tax shields. Now, lets calculate the actual
NPV of the loan: 4
$600 .08 (1 .4) $600
NPVloan $600
t
4
(
1
.
08
)
(
1
.
08
)
t 1
NPVloan $63.59
APV NPV NPVF
APV $56.50 63.59 $7.09

Which is the same answer as before.
McGraw-Hill Ryerson
17-8
17.2 Flows to Equity Approach

Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, rS.
There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows
Step Two: Calculate rS.
Step Three: Valuation of the levered cash flows at rS.
McGraw-Hill Ryerson
17-9
Step One: Levered Cash Flows for Pearson

Since the firm is using $600 of debt, the equity holders only have to
come up with $400 of the initial $1,000.
Thus, CF0 = -$400
Each period, the equity holders must pay interest expense. The after-tax
cost of the interest is BrB(1-TC) = $600.08(1-.40) = $28.80
CF3 = $375 -28.80

CF2 = $250 -28.80
CF1 = $125-28.80
-$400
0
McGraw-Hill Ryerson
CF4 = $500 -28.80 -600
$96.20
$221.20
$346.20
-$128.80
17-10
Step Two: Calculate rS for Pearson

B
rS r0 (1 TC )(r0 rB )
S
To calculate the debt-to-equity ratio, B/S, start with the debt
to value ratio. Note that the value of the project is
4
$125
$250
$375
$500
19.20
PV
2
3
4
t
(1.10) (1.10) (1.10) (1.10)
(
1
.
08
)
t 1
PV $943.50 63.59 $1,007.09

B = $600 when V = $1,007.09 so S = $407.09.
$600
rS .10
(1 .40)(.10 .08) 11.77%
$407.09
McGraw-Hill Ryerson
17-11
Step Three: Valuation for Pearson

Discount the cash flows to equity holders at rS = 11.77%
-$400
0
$96.20
1
$221.20
2
$346.20
3
-$128.80
4
$96.20
$221.20
$346.20
$128.80
PV $400
2
3
(1.1177 ) (1.1177 ) (1.1177 ) (1.1177 ) 4
PV $28.56
McGraw-Hill Ryerson
17-12
17.3 WACC Method for Pearson

rWACC
S
B
rS
rB (1 TC )
SB
SB
To find the value of the project, discount the unlevered cash

flows at the weighted average cost of capital.
Suppose Pearson Inc. target debt to equity ratio is 1.50.
B
1.5S B
1.50
S
B
1 .5 S
1 .5
S
0.60
1 0.60 0.40
S B S 1 .5 S 2 .5
SB
rWACC (0.40) (11.77%) (0.60) (8%) (1 .40)
rWACC 7.58%
McGraw-Hill Ryerson
17-13
Valuation for Pearson using WACC

To find the value of the project, discount the
unlevered cash flows at the weighted average cost
of capital
$125
$250
$375
$500
NPV $1,000
2
3
(1.0758) (1.0758) (1.0758) (1.0758) 4
NPV6.88% $6.68
McGraw-Hill Ryerson
17-14
17.4 A Comparison of the APV, FTE, and

WACC Approaches
All three approaches attempt the same task:
valuation in the presence of debt financing.
Guidelines:
Use WACC or FTE if the firms target debt-to-value ratio
applies to the project over the life of the project.
Use the APV if the projects level of debt is known over
the life of the project.
In the real world, the WACC is the most widely used

approach by far.
McGraw-Hill Ryerson
17-15
Summary: APV, FTE, and WACC

Initial Investment
Cash Flows
Discount Rates
APV
WACC FTE
All
UCF
r0
All
UCF
rWACC
Equity Portion
LCF
rS
No
No
PV of financing effects Yes
Which approach is best?

Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is constant
McGraw-Hill Ryerson
17-16
17.5 Capital Budgeting for Projects that

are Not Scale-Enhancing
A scale-enhancing project is one where the project
is similar to those of the existing firm.
In the real world, executives would make the
assumption that the business risk of the non-scaleenhancing project would be about equal to the
business risk of firms already in the business.
No exact formula exists for this. Some executives
might select a discount rate slightly higher on the
assumption that the new project is somewhat riskier
since it is a new entrant.
McGraw-Hill Ryerson
17-17
17.5 Capital Budgeting for Projects that are

Not Scale-Enhancing: An example
World-Wide Enterprises (WWE) is planning to enter into a
new line of business (widget industry)
American Widgets (AW) is a firm in the widget industry.
WWE has a D/E of 1/3, AW has a D/E of 2/3.
Borrowing rate for WWE is10 %
Borrowing rate for AW is 8 %
Given: Market risk premium = 8.5 %, Rf = 8%, Tc= 40%
What is the appropriate discount rate for WWE to use for its
widget venture?
McGraw-Hill Ryerson
17-18
17.5 Capital Budgeting for Projects that are

Not Scale-Enhancing: An example
A four step procedure to calculate discount rates:
1. Determining AWs cost of Equity Capital (rs)

2. Determining AWs Hypothetical All-Equity Cost of
Capital. (r0)
3. Determining rs for WWEs Widget Venture
4. Determining rWACC for WWEs Widget Venture.
McGraw-Hill Ryerson
17-19
STEP 1:Determining AWs cost of Equity

Capital (rs)
r R ( R R )
s
r 8% 1.5 8.5 %
s
r 20.75 %
s
McGraw-Hill Ryerson
17-20
STEP 2 :Determining AWs Hypothetical AllEquity Cost of Capital. (r0)
B
rS r0
(1 TC )( r0 rB )
S
2
0.2075 r (0.6)(r 0.12)
3
0
r 0.1825
0
McGraw-Hill Ryerson
17-21
STEP 3 :Determining rs for WWEs Widget

Venture
Assuming that the business risk of WWE and AW
are the same,
B
rS r0
(1 TC )( r0 rB )
S
1
r 0.1825 (0.6)(0.1825 0.10)
3
s
r 0.199
s
NOTE : rs (WWE) < rs (AW)

McGraw-Hill Ryerson
because D/E (WWE) < D/E (AW)

17-22
STEP 4: Determining rWACC for WWEs Widget

Venture.
rWACC
WACC
WACC
S
B
rS
rB (1 TC )
SB
SB
3
1
0.199 0.10(0.6)
4
4
0.16425 16.425%
McGraw-Hill Ryerson
17-23
17.6 APV Example:
Worldwide Trousers, Inc. is considering a $5 million expansion of

their existing business.
The initial expense will be depreciated straight-line over five
years to zero salvage value
The pretax salvage value in year 5 will be $500,000.
The project will generate pretax earnings of $1,500,000 per year,
and not change the risk level of the firm.
The firm can obtain a five-year $3,000,000 loan at 12.5% to
partially finance the project.
If the project were financed with all equity, the cost of capital
would be 18%. The corporate tax rate is 34%, and the risk-free
rate is 4%.
The project will require a $100,000 investment in net working
capital.
Calculate the APV.
McGraw-Hill Ryerson
17-24
17.6 APV Example: Cost

Lets work our way through the four terms in this equation:
APV Cost PVunlevered PVdepreciation PV interest

project
tax shield
tax shield
The cost of the project is not $5,000,000.

We must include the round trip in and out of net working
capital and the after-tax salvage value.
NWC is riskless, so
we discount it at rf.
Salvage value should Cost $5.1m 100,000 500,000(1 .34)
5
5
(
1
r
)
(
1
r
)
have the same risk as
f
0
the rest of the firms $4,873.561.25
assets, so we use r0.
McGraw-Hill Ryerson
17-25
17.6 APV Example: PV unlevered project

Turning our attention to the second term,
APV $4,873.561.25 PVunlevered PVdepreciation PV interest

project
tax shield
tax shield
The PV unlevered project is the present value of the unlevered cash

flows discounted at the unlevered cost of capital, 18%.
PVunlevered
project
5
UCFt
$1.5m (1 .34)
t
t
(
1
r
)
(
1
.
18
)
t 1
t 1
o
5
PVunlevered $3,095,899
project
McGraw-Hill Ryerson
17-26
17.6 APV Example: PV depreciation tax shield

Turning our attention to the third term,
APV $4,873.561.25 $3,095,899 PVdepreciation PV interest

tax shield
tax shield
The PV depreciation tax shield is the present value of the tax savings
due to depreciation discounted at the risk free rate, at rf = 4%
PVdepreciation
tax shield
D TC
t
(
1
r
)
t 1
f
5
$1m .34
$1,513,619
t
t 1 (1.04)
5
McGraw-Hill Ryerson
17-27
17.6 APV Example: PV interest tax shield

Turning our attention to the last term,
APV $4,873.561.25 $3,095,899 $1,513,619 PV interest

tax shield
The PV interest tax shield is the present value of the tax savings due
to interest expense discounted at the firms debt rate, at rD =
12.5%
5
5
TC rD $3m
0.34 0.125 $3m
PV interest
t
t
(
1
r
)
(
1
.
125
)
t 1
t 1
D
tax shield
PV interest
tax shield
McGraw-Hill Ryerson
127,500
453,972.46
t
t 1 (1.125)
17-28
17.6 APV Example: Adding it all up

Lets add the four terms in this equation:
APV $4,873.561.25 3,095,899 1,513,619 453,972.46

APV $189,930
Since the project has a positive APV, it looks like a go.
McGraw-Hill Ryerson
17-29
17.7 Beta and Leverage

Recall that an asset beta would be of the form:
Asset
McGraw-Hill Ryerson
Cov(UCF , Market )
2Market
17-30
17.7 Beta and Leverage: No Corp.Taxes

In a world without corporate taxes, and with riskless
corporate debt, it can be shown that the relationship
between the beta of the unlevered firm and the beta of
levered equity is:
Asset
Equity
Equity
Asset
In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship

between the beta of the unlevered firm and the beta of
levered equity is:
Asset
McGraw-Hill Ryerson
Debt
Equity
Debt
Equity
Asset
Asset
17-31
17.7 Beta and Leverage: with Corp. Taxes

In a world with corporate taxes, and riskless debt, it can
be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:
Equity
Since
Debt
1
(1 TC ) Unlevered firm
Equity
Debt
1
(1 TC )
Equity
must be more than 1 for a
levered firm, it follows that

McGraw-Hill Ryerson
Equity Unlevered firm

17-32
17.7 Beta and Leverage: with Corp. Taxes

If the beta of the debt is non-zero, then:
Equity
McGraw-Hill Ryerson
B
Unlevered firm (1 TC )( Unlevered firm Debt )
SL
17-33
17.8 Summary and Conclusions

1. The APV formula can be written as:
Additional
Initial
UCFt
APV
effects of
t
investment
t 1 (1 r0 )
debt
2. The FTE formula can be written as:

Amount
Initial
LCFt
APV

t
t 1 (1 rS )
investment borrowed
3. The WACC formula can be written as

Initial
UCFt
t
investment
t 1 (1 rWACC )
McGraw-Hill Ryerson
17-34
17.8 Summary and Conclusions (cont.)
4 Use the WACC or FTE if the firm's target debt to

value ratio applies to the project over its life.
5 The APV method is used if the level of debt is
known over the projects life.
6 The beta of the equity of the firm is positively
related to the leverage of the firm.
McGraw-Hill Ryerson
17-35
Appendix 17-A:The APV approach to

Valuing Leveraged Buyouts (LBOs)
An LBO is the acquisition by a small group of investors of a
public or private company financed primarily with debt.
In an LBO, the equity investors are expected to pay off
outstanding principal according to a specific timetable.
The owners know that the firms debt-to-equity ratio will fall
and can forecast the dollar amount of debt needed to finance
future operations.
Under these circumstances, the APV approach is more
practical than the WACC approach because the capital
structure is changing.
McGraw-Hill Ryerson
17-36
The APV Approach to Valuing LBOs:

The RJR Nabisco Buyout
In 1988, the CEO of the firm announced a bid of $75 per
share to take the firm private in a management buyout.
Another bid of $90 per share by Kohlberg Kravis and
Roberts (KKR) was followed.
At the end, KKR emerged from the bidding process with an
offer of $109 a share, totalling $25 billion.
We use the APV technique to analyze KKRs winning
strategy.
McGraw-Hill Ryerson
17-37
The RJR Nabisco Buyout (cont.)

KKR planned a significant increase in leverage with
accompanying tax benefits.
The firm issued almost $24 billion of new debt to complete
the buyout with annual interest costs of $3 billion.
4 Steps for RJR LBO valuation
Step1: Calculating the PV of UCF for 1989-93:
PV
1988
PV
1988
$5.404 $4.311 $2.173 $2.336 $2.536
(1.14) (1.14) (1.14) (1.14) (1.14)

2
$12.224 billion
McGraw-Hill Ryerson
17-38

Step1: Calculating the PV of UCF beyond 1993:
Assume :UCF grow at 3 % after 1993
PV
1993
PV
1988
$2.536(1.03)
$23.746 billion
0.14 0.03
$23.746 billion
$12.333 billion
(1.14)
5
TOTAL UNLEVERED VALUE = 12.224 +12.333 = $24.557 b
McGraw-Hill Ryerson
17-39

Step3: Calculating the PV of interest tax shields 1989-93:
Given: average cost of debt (pretax) = 13.5 %
$1.151 $1.021 $1.058 $1.120 $1.184

PV
$3.877 b
(1.135) (1.135) (1.135) (1.135) (1.135)
1988
Step4: Calculating the PV of interest tax shields beyond 1993:

Assume: debt/assets ratio will be maintained at 25 %.
The WACC method will be appropriate to find terminal value.
McGraw-Hill Ryerson
17-40

1
r 0.14 (1 0.34)(0.14 0.135) 0.141
3
s
WACC
3
1
(0.141) 0.135(1 0.34) 0.128 12.8%
4
4
PV
1993
McGraw-Hill Ryerson
$2.536(1.03)
$26.654 billion
0.128 0.03
17-41

We know that: VL= VU + PVTS
PVTS = VL (1993)-VU(1993)
VL (1993)(from Step4) and Vu (1993)(from Step1)
PVTS = $26.654 23.746 = $2.908 billion
$2.908 billion
PV
$1.544 billion
(1.135)
1988
Total value of interest tax shields = 1.544 + 3.877 (from Step3)

= $5.421
McGraw-Hill Ryerson
17-42
Total value of RJR = Total unlevered value +

Total value of interest tax shields
= $24.557 (Step1) + 5.421 (Step 4)
= $29.978 billion
McGraw-Hill Ryerson

Corporate Finance: Capital Budgeting For The Levered Firm

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17-1

2003 McGrawHill Ryerson Limited

2003 McGrawHill Ryerson Limited

2003 McGrawHill Ryerson Limited

17.1 Adjusted Present Value Approach

2003 McGrawHill Ryerson Limited

The unlevered cost of equity is r0 = 10%:

The project would be rejected by an all-equity firm: NPV < 0.

2003 McGrawHill Ryerson Limited

APV Example (continued)

APV NPV NPVF

APV $56.50 63.59 $7.09

2003 McGrawHill Ryerson Limited

APV Example (continued)

APV $56.50 63.59 $7.09

2003 McGrawHill Ryerson Limited

17.2 Flows to Equity Approach

2003 McGrawHill Ryerson Limited

Step One: Levered Cash Flows for Pearson

CF3 = $375 -28.80

CF4 = $500 -28.80 -600

2003 McGrawHill Ryerson Limited

Step Two: Calculate rS for Pearson

PV $943.50 63.59 $1,007.09

2003 McGrawHill Ryerson Limited

Step Three: Valuation for Pearson

2003 McGrawHill Ryerson Limited

17.3 WACC Method for Pearson

To find the value of the project, discount the unlevered cash

2003 McGrawHill Ryerson Limited

Valuation for Pearson using WACC

2003 McGrawHill Ryerson Limited

17.4 A Comparison of the APV, FTE, and

In the real world, the WACC is the most widely used

2003 McGrawHill Ryerson Limited

Summary: APV, FTE, and WACC

PV of financing effects Yes

Which approach is best?

2003 McGrawHill Ryerson Limited

17.5 Capital Budgeting for Projects that

2003 McGrawHill Ryerson Limited

17.5 Capital Budgeting for Projects that are

2003 McGrawHill Ryerson Limited

17.5 Capital Budgeting for Projects that are

A four step procedure to calculate discount rates:

1. Determining AWs cost of Equity Capital (rs)

2003 McGrawHill Ryerson Limited

STEP 1:Determining AWs cost of Equity

2003 McGrawHill Ryerson Limited

STEP 2 :Determining AWs Hypothetical AllEquity Cost of Capital. (r0)

2003 McGrawHill Ryerson Limited

STEP 3 :Determining rs for WWEs Widget

NOTE : rs (WWE) < rs (AW)

because D/E (WWE) < D/E (AW)

STEP 4: Determining rWACC for WWEs Widget

2003 McGrawHill Ryerson Limited

17.6 APV Example:

Worldwide Trousers, Inc. is considering a $5 million expansion of

2003 McGrawHill Ryerson Limited

17.6 APV Example: Cost

APV Cost PVunlevered PVdepreciation PV interest

The cost of the project is not $5,000,000.

2003 McGrawHill Ryerson Limited