Capital structure and capital budgeting

Topics

First segment of the course: capital budgeting

Second segment of the course: capital structure (theory)

Chapter 18: Capital budgeting after accounting for capital structure considerations

The impact of leverage on capital budgeting

Tax shield

Issuance cost

Cost of financial distress

Financing specific subsidy

Here we incorporate these effects in the capital budgeting decision – emphasis on problem solving

Outline

APV, FTE, WACC as three approaches to the problem When do we use which:

APV when we know the $ value of debt

FTE or WACC when we know a D/E ratio

Other issues:

Quantifying the impact of leverage on risk

Scale enhancing projects vs. projects in a new industry

(revisited - Chapter 13)

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):

Four possible side effects of financing:

The Tax Subsidy to Debt

The Costs of Issuing New Securities

The Costs of Financial Distress

Subsidies to Debt Financing

APV Example

Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are:

-$1,000 $125

0

1

$250

2

$375

3

$500

4

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.

APV Example (continued)

Now, imagine that the firm finances the project with $600 of debt at rB = 8%.

Pearson’s 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.

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, let’s 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.

The APV approach

Find r0

Find unlevered cash flow

Use these to get NPV without debt

Find tax shield benefit of debt by either

Tax shield present value (easier calculation)

Debt present value (works better for some more complex situations) May need to add other effects of debt

APV = NPV + Effects of debt

Reminders

Proposition I (with Corporate Taxes)

The APV relation

VL = VU + TC B

Proposition II (with Corporate Taxes)

Calculation of rS and r0 rS = r0 + (B/S)×(1-TC)×(r0 - rB) rB is the interest rate (cost of debt) rS is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital)

B is the value of debt

S is the value of levered equity

Flow 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.

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 B×rB×(1-TC) = $600×.08×(1-.40) =

$28.80

CF3 = $375 -28.80

CF2 = $250 -28.80

CF1 = $125-28.80

-$400

0

$96.20

1

2

CF4 = $500 -28.80 -600

$221.20

3

$346.20

4

-$128.80

Step Two: Calculate rS for

Pearson

B rS r0

S

(1 TC )( r0 rB )

To calculate the debt-to-equity ratio, B/S, start with the