Corporate Finance, 4 DCF

Corporate Finance, 5 Stocks

Corporate Finance, 10 CAPM

Corporate Finance, 17 Levered Cap Budgeting

PV

(1  g )
C

(1  r ) t 0 (1  r )
C
PV
rg

C (1+g)2

EPS
 NPVGO
R

Beta of security Ei

In equilibrium, all portfolios including single securities must

lie on the security market
line, Finance,
SML.February 2008
LSF, Corporate

SML

RF  i ( E[ RM ]  RF )

The Tax Subsidy to Debt

The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing

There are four side effects of financing:

of the project to an unlevered firm (NPV) plus the present value

of the financing side effects (NPVF).

The value of a project to the firm can be thought of as the value

APV = NPV + NPVF

Adjusted Present Value Approach

RF

E[ Ri ]

The CAPM : the security market line

13

projects.
The value of a firm can be conceptualized as the sum of the value
of a firm that (perpetually) pays out 100% of its earnings as
dividends (so called cash cow) and the net present value of the
growth opportunities.

Growth opportunities are opportunities to invest in positive NPV

Growth opportunity model : NPVGO

C(1+g)

A growing stream of cash flows that lasts forever

Growing perpetuity

Expected return
of security E[Ri]

Corporate Finance, 4 DCF

Corporate Finance, 4 DCF
Corporate Finance, 12 Cost of capital
Corporate Finance, 17 Levered Cap Budgeting

BAPG, Corporate Finance, 2010

S+B

S
rS +

Equity + Debt

S+B

Equity + Debt

rB (1 TC)

rEquity +

Debt

B = bond

S = stock

= (EBIT - B RB) (1 tC)

LCF = UCF - B RB (1 tC)

Step One: Calculate the levered cash flow (LCFs)

Step Two: Calculate Rs
Step Three: Value the levered cash flow at Rs i.e., LCF / Rs

There are three steps in the FTE Approach:

the levered firm at the cost of levered equity capital, Rs:

Discount the cash flow from the project to the equity holders of

Flow to Equity: FTE-Approach

rDebt (1 TC)

14

10

Because interest expense is tax-deductible, we multiply the last

term by (1 TC).

rWACC =

rWACC =

Equity

The Weighted Average Cost of Capital WACC is given by:

The cost of capital with debt

Only add (subtract) cash flows from the same time period
You may use the time line
Specify a cash flow for each time period (even when it is $0)
If a constant cash flow starts in the future period t, compute
the NPV for the time t-1 first.

Some hints for computing NPV:

NPV = -C0 + C1/(1+r) + C2/(1+r)2 + .. + CT/(1+r)T

C 1 g

1 
r  g (1  r )

Net Present Value (NPV)

PV


t

C(1+g)T-1

C
1  g
1  g C


r  g 1  r 1  r t 0 1  r

C (1+g)2

C
C u (1  g ) T C u (1  g ) T 1


 ...
rg
(1  r ) T 1
(1  r ) T  2

C(1+g)

The formula for calculating NPV:

PV

A growing stream of cash flows with a fixed maturity

Growing annuity
Corporate Finance, 5 Stocks
Corporate Finance, 10 CAPM
Corporate Finance, 15 Capital structure
Corporate Finance, 17 Levered Cap Budgeting

P0

Case 1: zero growth

Case 2: constant growth
Case 3: differential growth

t 1

Divt

(1  R)
t

V xV y

Cov( x, y )

i 1

pi ( xi  x )( yi  y )

EBIT u (1  tC ) tC RB B

RU
RB

VU  tC B

Firm value increases with leverage due to the tax shield

Value of the project

RWACC

RWACC

NPV WACC

0.183

92400
 475 ,000
.183

15

29 ,918

UCF
 initial investment
RWACC

0.75 u 0.222  0.25 u 0.1 u (1  0.34)

S
B
RS 
RB (1  tC )
SB
SB

the weighted average cost of capital.

11

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

WACC approach

VL is the present value of the levered firm

VU is the present value of the unlevered firm
EBIT (1-tC) is the firm cash flow after corporate tax
tC is the corporate tax rate
RU is the required return to an all-equity firm (aftertax cost of capital).
RB is the interest rate (cost of debt)

VL

Proposition I (with corporate taxes)

(with taxes)

Value of the levered firm : MM Proposition I

p1 ( x1  x)2  p2 ( x2  x)2   pn ( xn  x)2

(wB B )  (wS S )  2(w B B )(wS S ) BS

V x2

p1x1  p2 x2   pn xn

Cov( x, y)

2
P

Vx

Expectation, standard deviation, variance,

covariance and correlation

Three scenarios for the valuation of stock

P1
1 R 1 R

Sources of payoffs:
Capital gain (tomorrows price)
Dividend
Div1
Value of a stock

Common stock
Corporate Finance, 5 Stocks
Corporate Finance, 10 CAPM
Corporate Finance, 15 Capital structure
Corporate Finance, 17 Levered Cap Budgeting

V 2 ( RM )

Cov ( Ri , RM )

B
S

B(1  tC )
S
S 
B
B(1  tC )  S
B(1  tC )  S

U  (1  tC )( U  B ) u

If the beta of the debt is non-zero, then:

16

12

Some of the increase in equity risk and return is offset by the

interest tax shield

Beta and Leverage: With Corporate Taxes

RB is the interest rate (cost of debt)

RS is the return on equity (cost of equity)
RU is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity

RS = RU + (B/S)(1-tC)(RU - RB)

Proposition II (with Corporate Taxes)

Expected return and leverage (with taxes) MM

Proposition II (with taxes)

Ei

the market portfolio (i.e., systematic risk).

Beta measures the responsiveness of a security to movements in

portfolio can be measured by its beta (E) value.

Researchers have shown that the risk of a security in a large

Risk when holding the market portfolio

Div T 1

Div1 (1  g1 )T R  g 2
1



R  g1 (1  R )T (1  R )T

Consolidating gives:

Case 3: differential growth