Chapter 19 Principles PrinciplesofCorporateFinance Tenth Edition Financing and Valuation Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies,

Chapter 19 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Tenth Edition

Financing and Valuation

Slides by

Matthew Will

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin


20- 2

McGraw Hill/Irwin

Topics Covered

After Tax WACCValuing BusinessesUsing WACC in PracticeAdjusted Present ValueYour Questions Answered


20- 3

McGraw Hill/Irwin

Capital Project Adjustments

1. Adjust the Discount Rate Modify the discount rate to reflect capital

structure, bankruptcy risk, and other factors.

2. Adjust the Present Value Assume an all equity financed firm and then

make adjustments to value based on financing.


20- 4

McGraw Hill/Irwin

After Tax WACC

V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula


20- 5

McGraw Hill/Irwin

After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?


20- 6

McGraw Hill/Irwin

After Tax WACC

Example - Sangria Corporation - continued

Balance Sheet (Book Value, millions)Assets 1,000 500 Debt

500 EquityTotal assets 1,000 1,000 Total liabilities

Balance Sheet (Book Value, millions)Assets 1,000 500 Debt



20- 7

McGraw Hill/Irwin

After Tax WACC


Balance Sheet (Market Value, millions)Assets 1,250 500 Debt


Balance Sheet (Market Value, millions)Assets 1,250 500 Debt



20- 8

McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 500/1,250 = .4 or 40%

Equity ratio = (E/V) = 750/1,250 = .6 or 60%


20- 9

McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

%0.9

090.

60.124.40.)35.1(06.

WACC


20- 10

McGraw Hill/Irwin

After Tax WACCExample - Sangria Corporation - continued

The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax.

Given an initial investment of $12.5 million, what is the value of the machine?


20- 11

McGraw Hill/Irwin

After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million

Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million


20- 12

McGraw Hill/Irwin

After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

009.

125.15.12

10

gr

CCNPV

009.

125.15.12

10

gr

CCNPV


20- 13

McGraw Hill/Irwin

After Tax WACCExample - Sangria Corporation – continued

Perpetual Crusher project

Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt

7.5 EquityTotal assets 12.5 12.5 Total liabilities

Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt

7.5 EquityTotal assets 12.5 12.5 Total liabilities


20- 14

McGraw Hill/Irwin



93.0195.125.1)1(incomeequity Expected

195.5)35.1(06.)1(interestAfter tax

DTrC

DTr

CD

CD

93.0195.125.1)1(incomeequity Expected

195.5)35.1(06.)1(interestAfter tax

DTrC

DTr

CD

CD


20- 15

McGraw Hill/Irwin



12.4%or 124.5.7

93.0

ueequity val

incomeequity expectedreturnequity Expected

Er

12.4%or 124.5.7

93.0

ueequity val

incomeequity expectedreturnequity Expected

Er


20- 16

McGraw Hill/Irwin

Capital Budgeting

Valuing a Business or Project

HH

HH

r

PV

r

FCF

r

FCF

r

FCFPV

)1()1(...

)1()1( 22

11

PV (free cash flows) PV (horizon value)

In this case r = waccIn this case r = wacc


20- 17

McGraw Hill/Irwin

WACC vs. Flow to Equity

– If you discount at WACC, cash flows have to

be projected just as you would for a capital

investment project. Do not deduct interest.

Calculate taxes as if the company were all-

equity financed. The value of interest tax

shields is picked up in the WACC formula.


20- 18

McGraw Hill/Irwin


– The company's cash flows will probably not be forecasted

to infinity. Financial managers usually forecast to a

medium-term horizon -- ten years, say -- and add a

terminal value to the cash flows in the horizon year. The

terminal value is the present value at the horizon of post-

horizon flows. Estimating the terminal value requires

careful attention, because it often accounts for the

majority of the value of the company.


20- 19

McGraw Hill/Irwin


– Discounting at WACC values the assets and

operations of the company. If the object is to

value the company's equity, that is, its common

stock, don't forget to subtract the value of the

company's outstanding debt.


20- 20

McGraw Hill/Irwin

Tricks of the Trade

What should be included with debt?

– Long-term debt?

– Short-term debt?

– Cash (netted off?)

– Receivables?

– Deferred tax?


20- 21

McGraw Hill/Irwin

After Tax WACC

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

EPD r

V

Er

V

Pr

V

DTcWACC )1(


20- 22

McGraw Hill/Irwin

Tricks of the Trade

How are costs of financing determined?– Return on equity can be derived from market data

– Cost of debt is set by the market given the specific rating of a firm’s debt

– Preferred stock often has a preset dividend rate

Documents

Chapter 19 Principles PrinciplesofCorporateFinance Tenth Edition Financing and Valuation Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies,