Chapter 19

FINANCING AND VALUATION

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER OVERVIEW
In finance, we assume there is a separation
between investment and financing decisions. As a
general rule this is correct.
But there are times when financing a project
changes the risk profile of the firm (through
changes in leverage) and hence WACC. So we
have to take into account the impact of financing on
valuation.
There are two ways to do this:
1. Adjust the discount rate

2. Adjust the NPV

19-2
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Capital Project Adjustments
Adjust the discount rate - Modify discount rate
to reflect the risk due to the project (i.e. capital
structure, bankruptcy risk, other factors)
Adjusted present value - Assume the firm is
financed entirely by equity, make adjustments to
the net present value based on financing costs
and other issues

19-3
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL

After tax WACC (recap):

D E
WACC rD (1 TC ) rE
V V

Where V=D+E
We know this already

19-4
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Example: Sangria Corporation has marginal tax rate
of 35%. Cost of equity is 12.4%, pretax cost of debt is
6%. Given the following book and market-value
balance sheets, what is tax-adjusted WACC?

19-5
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Example, Continued
Debt ratio = (D/V) = 500/1,250 = .4, or 40%
Equity ratio = (E/V) = 750/1,250 = .6, or 60%

WACC .06 (1 .35)(.40) .124(.60)

.090
9.0%

19-6
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Application of WACC:
Sangria wants to invest in a machine with
cash flows of $1.731 million per year pre-
tax. What is the value of the machine,
given initial investment of $12.5 million?

19-7
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Assuming perpetual cash flows:
C1
NPV C0
rg
1.125
12.5
.09
0

NPV of the machine =0.

Zero NPV means ROE is exactly equal to cost of
equity, rE 19-8
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Assuming the project is a mini-firm, its
market value balance sheet is as follows:

19-9
19-1 AFTER-TAX WEIGHTED-AVERAGE
COST OF CAPITAL
Example, Continued

After tax interest rD (1 TC ) D .06 (1 .35) 5 .195

Expected equity income C rD (1 TC ) D 1.125 .195 0.93

expected equity income

Expected equity return rE
equity val ue
0.93
.124, or 12.4%
7.5

19-10
19-2 VALUING BUSINESSES
Business value is usually computed as
discounted value of free cash flows (FCF) to a
valuation horizon
The method is similar to evaluating a stock using
DDM
First, calculate (A) the total PV of annual FCFs
during the non-constant growth period, until the
growth rate become constant. At this point
calculate (B) the terminal value (or horizon value)
using the constant growth model and find its PV.
Then add (A) and (B) together.
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19-2 VALUING BUSINESSES

FCF1 FCF2 FCFH PVH

PV ...
(1 r ) (1 r )
1 2
(1 r ) H
(1 r ) H

A = PV (free cash flows) B = PV (horizon value)

Where PVh = FCFh-1/(WACC-g)

In this case, r = WACC

19-12
TABLE 19.1A FREE-CASH-FLOW PROJECTIONS,
RIO CORPORATION ($ MILLIONS), PAGE 485/6

Read page 485 for explanation of the numbers.

19-13
TABLE 19.1B FREE-CASH-FLOW PROJECTIONS,
RIO CORPORATION ($ MILLIONS)

Here various assumptions associated with the estimation of FCF and the firm values
are explicitly shown.

19-14
19-2 VALUING BUSINESSES

Example: Rio Corporation

Free cash flow = profit after tax + depreciation
changes in fixed assets changes in working
capital
FCF1 = 8.7 + 9.9 (109.6 95) (11.6 11.1) =
$3.5 million
Work similarly for FCF2, FCF3, ..., FCFh, and PVh
3.5 3.2 3.4 5.9 6.1 6.0
PV(FCF)
1.09 1.09 1.09 1.09 1.09 1.096
2 3 4 5

20.3
19-15
19-2 VALUING BUSINESSES
Example, Continued

FCFH 1 6.8
Horizon va lue PVH 113.4
WACC g .09 .03
1
PV(horizon value) 113.4 $67.6
1.096

PV(busines s) PV(FCF) PV(horizon value)

20.3 67.6
$87.9 million
This is the value of the firm. To obtain value of equity, subtract debt.
19-16
19-3 USING WACC IN PRACTICE

What should be included in debt?

Theoretically, all debt including the
following:
Long-term debt
Short-term debt
Current liabilities (however, short-term liabilities
are usually netted out to obtain net current assets)

19-17
19-3 USING WACC IN PRACTICE

After-Tax WACC if more than two sources

of capital:
Preferred stock and other forms of financing
must be included in formula

D P E
WACC (1 TC ) rD rP rE
V V V

19-18
19-3 USING WACC IN PRACTICE

Example, Continued
Calculate WACC for Sangria Corporation given
preferred stock is $25 million of total equity and
yields 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%
19-19
19-3 ADJUSTING WACC WHEN CAPITAL
STRUCTURE CHANGES (PERMANENTLY)
Determining costs of each financing type:
Cost of equity from market data, may be
using DDM or CAPM
Cost of debt set by market
Preferred stock often has preset dividend
rate
Then calculate the market value weights

19-20
19-3 ADJUSTING WACC WHEN CAPITAL
STRUCTURE CHANGES (PERMANENTLY)
Example, debt ratio D/V changes from 0.4 to
0.2, what is the effect on WACC?
Step 1: calculate r at current debt (unlevering,
without tax, this is MM model)
r .06(.4) .124(.6) .0984
Step 2: calculate re using the new D/V, 20%:
rE .0984 (.0984 .06)(.25) .108
Step 3: Calculate new WACC (assume debt
stays at 6%).
WACC .06(1 .35)(.2) .108(.8) .0942 9.42%
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FIGURE 19.1 WACC, SANGRIA CORPORATION

19-22
19-4 ADJUSTED PRESENT VALUE

Thus far we adjust the financing impact by

adjusting the discount rate, i.e. we modify
to reflect capital structure, bankruptcy risk,
other factors.
Another way to adjust for financing impact
is by adjusting the present value. Assume
all-equity-financed firm, then adjust value
based for financing side effects and other
costs/benefits of the project to obtain the
adjusted present value (APV).
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19-4 ADJUSTED PRESENT VALUE

APV = Base Case NPV + PV Impact

Base case: All-equity-financed firm NPV
PV impact: All costs and benefits directly
resulting from project
For example: PV tax shield may be in the
form of a subsidy from the government.
Flotation cost is an example of cost
associated with financing a project.

19-24
19-4 ADJUSTED PRESENT VALUE

Example 1
Project A has $150,000 NPV. Firm must issue
stock to finance project, with $200,000
brokerage cost
Project NPV = 150,000
Stock issue cost = 200,000
Adjusted NPV = 150,000-200,000 = 50,000
Do not invest in Project A

19-25
19-4 ADJUSTED PRESENT VALUE

Example 2
Project B has $20,000 NPV. Firm can issue
debt at 8% to finance project. New debt has PV
tax shield of $60,000. Assume Project B is the
only option.
Project NPV = 20,000
Stock issue cost = 60,000
Adjusted NPV = -20,000+60,000 = 40,000
Invest in Project B

19-26
TABLE 19.2 RIO CORPORATION APV ($ MILLIONS)

19-27
19-4 ADJUSTED PRESENT VALUE

Example 3
Rio Corporation APV

APV Base case NPV PV(interes t tax shields)

84.3 5.0 $89.3 million

19-28