Net Present Value:

C is the corporate tax rate, currently 35% when

considering only federal taxes.

WACC is an appropriate and straightforward method to

use if the firm undertaking the project or acquisition
intends to maintain a fixed target debt-to-value ratio
afterwards.
WACC Decreases As D/E Increases

Investments= Initial Capital Expenditures (year 0

only)+ Required Ongoing Capital Expenditures
(upgrades to machines etc.) + Change in Net
Working Capital- Terminal Value (year T only)
CFT = EBIATT + depreciationT - investmentsT
Continuation Value as of time T = [CFT*(1+g)]/(rg)

rmrfmarket risk premium

APV is an appropriate and straightforward method to

use if the debt used to finance the project is fixed and
perpetual, or if you at least have a projected schedule
of interest payments that will result from any debt
used to finance the project.

Levering/Unlevering w/ Taxes: D fixed

= business risk + financial risk

Financial risk is the risk that equity-holders must bear
in the presence of higher-priority debt (not bankruptcy
risk)

rE is the return that equity investors

require they company to achieve on the
firms stock if they are to continue holding
it. This is the cost of equity finance.
rD is the return that creditors have to
receive to lend the firm money. This is
effectively the rate at which the firm can
borrow. It will be higher than the risk free
rate because the pledge by the firm to repay
the debt is risky (since the firm might
default).
E is the market value of equity. D is
technically the market value of debt, but in
practice the book value of debt is used and
this is usually not too far off the mark.
(E+D) is referred to as the total
capitalization of the firm. Critically, all of
these are expected values after the project
has been undertaken.
In practice, [E/(E+D)] and [D/(E+D)] are
thought of together as the target capital
structure of the firm after it has undertaken
the project. These values are often given or

Example: Sangrias Use of WACC

WACC=.124x.6+.06x(1-.35)x.4=9%
Sangriaconsidersinvesting$12.5mina
perpetual crushing machine
CF of $1.731m before tax for perpetuity
FCF = $1.125m after tax
Project has same risk as Sangrias other
operations and it is financed with the same
debt and equity ratios (E = $7.5m and D =
$5m)
NPV=-$12.5m+$1.125m/9%=0 Project just
exactly breaks even
Example: APV of Sangrias Crusher

Remember, we consider investing $12.5m in

crusher, generating after tax cash flow of
$1.125m
: rD = 6%, rE = 12.4%, D/D+E = 40%, and
tC = 35%
First, calculate NPV as if investment is all
equity financed
r = 12.4% x 60% + 6% x 40% = 9.84%
A
NPV
= -$12.5m + $1.125m/9.84% = ALL E

When debt is fixed and perpetual and the

appropriate discount rate for the stream of
payments from debt is rD, present value of
the debt tax shield will equal CD
Present value of option today:

1. The Mechanics of Valuing Equity:

Consider a single period problem where the
riskless interest rate is zero, and there are no
taxes. A firm consists of a machine that will
produce cash flows of $210 if the economy is
good and $80 if the economy is bad. The good
and bad states occur with equal probability
and the covariance of these states with the
market portfolio is zero. Initially, the firm has
100 shares outstanding and debt with a face
value of $50 due at the end of the period.
What is the share price of the firm?
Answer: Since the covariance of the states
with the market portfolio is zero, the
appropriate discount rate with which to
discount the cash flows is in this case the risk
free rate. The expected payoff to equity is .
5($210-$50) +.5($80-$50)=$95, so the price
per share is $95/100 = $.95.
Takeaway points from this exercise:
Equity is a residual claim and it is priced
accordingly.
The riskless rate can be used to discount cash
flows from a risky project if and only if the risk
of the cash flows has zero covariance with the
market.
2. Modigliani-Miller Practice Question:
Executive Chalk is financed solely by common
stock and has outstanding 25m shares with a
market price of $10 per share. It now
announces that it intends to issue $160m old
debt and to use the proceeds to buy back
common stock. (from Brealey, Myers, and
Allen.)
Answer: This is a classical example of a
recapitalization that we need to solve using
the two equations two unknowns approach.
The first equation gives the new value of
equity and the second equation determines
the number of shares we can repurchase.
Initially, the total value of the firm is the value
of its equity of $250m. After the
recapitalization the firm has $160m of debt,
and the value of the equity will be only $90m.
If we repurchase R shares, the new share price
becomes P = $90m / 25m - R
The number of shares we can repurchase is
given as P x R = $160m.Solving these
equations yields, P = $10 and R = 16m, and
the answers to the questions are:
The share price remains at $10
The company can repurchase 16m shares
The total value of the firm remains $250m (this
is where we use MM)
After the recap, the D/E ratio is 1.78
Nobody gains or loses. The share price remains
constant so the equity holders neither win nor
lose. The debt is issued at fair value, so the
debt holders neither win nor lose.
3. Modigliani-Miller Practice Question:
Executive Cheese has issued debt with a
market value of $100m and has outstanding
15m shares with a market price of $10 a share.
It now announces that it intends to issue a
further $60m of debt and use the proceeds to
buy back common stock. Debtholders, seeing

apparent. For example, if a firm wants to do

an acquisition and the CEO says that the
combined firm intends to maintain a capital
structure of 30% debt, 70% equity, then [D/
(E+D)] for this formula should be 30% and
[E/(E+D)] should be 70%. It is most
appropriate to use WACC when the firm is
aiming for a specific capital structure after
undertaking the project.

$120m after the recap. If we repurchase R

shares, the new share price becomes P =
$120m / 15m R.
The number of shares we can repurchase is
given as P x R = $60m.Solving these equations
yields, P = $12 and R = 5m. The answers to the
questions are then:
The share price increases to $12
The company can repurchase 5m shares
The total value of the firm remains $250m
After the recap, the D/E ratio is 1.08
The shareholders gain, the old debt holders
lose, and the new debt holders neither gain nor
lose. Since the old debt becomes more risky, its
value decreases, and this hurts the old debt
holders. Since the total value of the company
remains unchanged, the equity holders gain
what the debt holders lose, and this is reflected
in the increase in the share price from $10 to
$12. Intuitively, when the debt holders get more
risk, the equity holders hold less risk, and this
increases the present value of the debt. The
new debt holders anticipate this, and they will
only lend the money if they are adequately
compensated, so their rate of return already
incorporates the risk of the new debt, and their
claim is worth $60m borrowed.
Takeaway points from Modigliani-Miller
exercises above:
To determine the effects of a recapitalization,
we must solve for the future share price, using
the two equations with two unknowns.
If the increase in the total value of the equity
matches the number of new shares issued (or
the decrease in the value of the equity matches
the number of shares repurchased), then the
share price remains unchanged. In this case the
equity holders are equally well off. If the value
of the equity increases more than the number
of shares (i.e., because we are making the debt
more risky), the share price will increase and
the equity holders will gain.
New debt holders are always equally well off.
They anticipate the future risk of the debt, and
will only lend at an interest rate that reflects
this risk.
4. Misconceptions about Financial Policy
and Valuation
As the firm borrows more and debt becomes
risky, both stockholders and bondholders
demand a higher rate of return. Thus, by
reducing the debt ratio, we can reduce both the
cost of debt and the cost of equity, making
everybody better off.
Answer: This argument is incorrect. In order to
reduce the debt ratio, the firm will have to buy
back debt, which requires a lower return than
equity. The firm will therefore replace debt with
equity, which requires a higher return. The
required rate of return on the remaining debt
will go
down (or at worst stay the same), as will the
required rate of return on (the now safer) equity.
But the amount by which these go down is
offset by the higher weight on the riskier equity.
The weighted average of the required rate on
the debt and that on the equity will continue to
be the required rate on the assets.
Moderate borrowing does not significantly
affect the probability of financial distress or
bankruptcy. Consequently moderate borrowing
will not increase the expected rate of return
demanded by shareholders.
Answer: The required rate of return (the terms

$1.067m
ValueofDebtTaxShield
Each period, interest payment is 6% of $5m
= $.3m
Tax reduction is $.3m x 35% = $.105m
PV(DTS) = $.105m / 9.84% = $1.067m
APV = -$1.067m + $1.067m = 0

1.) Two firms have the exact same cash flows and
those cash flows have identical covariance with the
market. In an MM world, they must have the same
APV.
SOLUTION: True. APV = NPV_all equity firm +
PV(DTS). For NPV_all equity firm, discount rate is
equal to rA. And, all firms with same cash flow
profile and same rAs have same NPV. Also since tax
rate is zero in MM world => PV(DTS) is zero.
Therefore, APV is the same for all firms with same
cash flow profile and identical covariance with the
market.
2.) Does Not Exist Corp (DNEC) is a firm operating
in a Modigliani-Miller world. As DNECs leverage
increases, the empirical data show that both its
required return on equity (rE) and required return
on debt (rD) increase. Therefore, as leverage
increases, DNECs value decreases.
SOLUTION False. MM Proposition states that a
firms value is independent of its capital structure,
and so the required return on assets is
independent of financial structure. Even if rE and
rD increase, the weightings on these factors adjust
to maintain the same rA . The graphs in Class 3
explicitly show this.
3) As discussed in the article "A Real World Way to
Manage Real Options", to compute possible values
of the option at each stage in the decision tree, you
have to begin taking optimal decisions from the
present moment in time.
SOLUTIONFalse. You need to start from the furthest
moment in time (the last node).
4) Michael Milken in the article "Why Capital
Structure Matters" believes that capital structure is
relevant because there is symmetric information
about firms between the management and the
market
SOLUTION False. He believes management knows
more than the market and therefore signals its
information to the market through capital
structure.
5.) You are trying to estimate cost of capital for a
project taken by Firm X. Assume there are no
taxes. Based on business risk of Firm X's project
you identify three comparables -- Firm a, Firm b
and Firm c. The data tells you that the equity beta
E_a = 0.90, E_b = 1.00 and E_c = 1.10 and the
market value of Debt/(Debt+Equity) ratio of the
three firms are 25%, 35% and 50% for firms a, b
and c respectively. If the D_a = D_b =D_c=0,
the asset beta for Firm X's project is 1.00.
SOLUTION False. The asset beta for Firm A is
0.90*(1-25%)+0 = 0.675. Similarly the asset beta
for Firm B is 0.65 and Firm C is 0.55. The asset
beta for Firm X should be picked to be average
across comparables (to reduce idiosyncratic noise
in the estimates -- based on law of large numbers).
Doing so gives Asset beta for Firm X's project =
0.625
II. Hello I am a Mac and I am a PC
You own Apple iPhone Inc. and are standing at t=0.
You make cash flow projections on a project that
will destroy Microsoft (called "Destroy PC") which
has a PV of $1000 mill and a NPV of - $5mill.
Unfortunately, as is, DP is a project that you do not
want to take. Fortunately, if you did invest in the
DP project, Facebook Inc. -- who hates Microsoft
more than Apple Inc does -- has offered to purchase
the DP project at the end of two years for $600mill.
Over this year, the project may increase in value by
20% or decline in value by 50%. The risk-free rate
is 10%.
How large is the PV of the option to sell to
Facebook at t=2? Should Apple do the Destroy PC
project if you included this option to sell to
Facebook at t=2? (25 points)
SOLUTION:Step 1: Go to the last node and assume
all information is available. In this case the node is
at t=2. Step 2: Make optimal decision at this node

the extra risk, mark the value of the existing

debt down to $70m. (from Brealey, Myers, and
Allen.)
Answer: Again, this is a classical example of a
recapitalization solve using the two-equations
Two unknowns approach. Initially, the total
value of the firm is the value of its equity of
$150m plus the value of its debt of $100m, for
a total value of $250m. After the
recapitalization, the value of the old debt is
marked down to $70, and the total value of the
firms (new plus old) debt is $130m. Since the
value of the company is unchanged (MM), the
value of the equity must be
=0Od=45.5.PV = 1/(1+rF) [ Ou (rF - d) / (u - d) +
Od (u - rF) / (u - d) ] = 5.9
Thus with the PV of this option the project has a
total value of NPV = -5 + PV of option = 0.9 >0.
Thus Apple should take the Destroy PC project.
III. There are two firms, Lever and Unlever with
identical cash flows from the operating side of the
business. The time today is t=0. Lever has equity
and debt in its capital structure with debt requiring
a payment of $50 at t=1. Unlever has only equity
in its capital structure. The states of the world at
time 1 that are possible based on cash flows that
are generated are summarized as below:

You are an investor and are consider forming

two portfolios.
Portfolio 1 = Buy 33% of Levers equity and Buy
66% of Lever's debt and Portfolio 2 = Buy 33%
of Unlevers equity and Buy 33% of Levers
debt.
(a) What are the payoffs of Portfolio 1 and
Portfolio 2 in each of the states? (10 points) To
get at the payoffs of the two portfolios it
is easier if we first figure out what debt
and equity is worth in Lever and Unlever
in each of the states. (1) State
S1:Cashflows = 5 Lever: This firm has both
Debt and Equity Debt gets the first stab at
these cash flows => D
= 5. Note that the
_Lever
Lever firm enters into bankruptcy Equity gets
the residual cash flows => E
= 0. Why?
_Lever
Debt holders have been promised $50 but the
cash of only $5 was generated. Therefore Debt
holders get whatever the firm is worth, while
Equity holders get zero (Since nothing is left
after paying the debt holders).
Unlever: This firm has only EquityEquity gets all
the cash flows => E
= 5.
_Unlever
Portfolio 1 = (1/3)* E
+ (2/3)*
_Lever
D
= (1/3)*0+(2/3)*5= 10/3 Portfolio
_Lever
2 = (1/3)* E
+(1/3)* D
_Unlever
_Lever
=(1/3)*5 + (1/3)*5 = 10/3 (2) State
S2:Cashflows = 300Lever: This firm has both
Debt and Equity
Debt gets the first stab at these cash flows =>
D
= 50.
_Lever
Equity gets the residual cash flows => E
_Lever
= 250. Why? Debt holders have been promised
$50 but the cash of $300 was generated.
Unlever: This firm has only EquityEquity gets all
the cash flows => E
= 300Portfolio 1
_Unlever
= (1/3)* E
+ (2/3)* D
=
_Lever
_Lever
(1/3)*250+(2/3)*50= 350/3 Portfolio 2 =
(1/3)* E
+(1/3)* D
_Unlever
_Lever
=(1/3)*300 + (1/3)*50 = 350/3
(b) How do the values of two portfolios compare
at t=0? What principle did you use to make this
comparison and what can you say about value
of lever relative to value of unlever? The two
portfolios have identical payoffs state by state
at t=1 (i.e., in each of S and S ). Then any
1
2
investor standing at t=0 must value these
portfolios the same. Therefore the values of
these portfolios at t=0 must be equal. The
principle we use to make this claim is that if the

using all the available information

required rate of return and expected rate of
payoffs of two portfolios are same state by
return will be used interchangeably in this
state, then the values of these portfolios muse
course) depends on the systematic risk of the
be same at t=0 due to no arbitrage.
claim. When a firm borrows even a little
Value of Portfolio 1 = Value of Portfolio 2
amount, the volatility of the equity increases,
(1/3)* E
+ (2/3)* D
= (1/3)*
_Lever
_Lever
and so does the systematic risk of the equity.
E
+(1/3)* D
This is why even a little debt will increase the
_Unlever
_Lever
There are two nodes to consider at t=2 Focus on
rate of return required of the equity.
Equity
=
Rearranging,
gives
us:
_Unlever
the top node from t=2 to t=1 Ou =0
Furthermore, note that this argument does not
Equity
+Debt
This follows if we note that the PV of the project in
depend on there being any risk of bankruptcy at
_Lever
_Lever
the higher state is 1440> the amount Facebook
all (i.e., debt can be risk free). Note that the
Or, V
=V
_Unlever
_Lever
will pay =600. Therefore the option to sell to
required rate of return on debt may be invariant
facebook is not exercised in this state and
Note:
to the debt ratio at relatively low levels of debt,
therefore has zero value.
Value of Lever: V
=
and will only rise if the debt itself becomes
_Lever
At the intermediate state the PV of project is
risky, i.e. if there is a risk of bankruptcy. In
Equity
+Debt
Value of Unlever:
600>= the amount facebook will pay. Therefore
_Lever
_Lever
problem 2 above, debt became risky after the
the option payoff is 0. Use the general real option
V
= Equity
(c) Where did
new issue because there was a state of the
_Unlever
_Unlever
(arbitrage pricing) formula to discount and get the
world where creditors did not receive the face
PV of the option in top node at t=1. PV = 1/(1+rF) [
you use the assumption "Bankruptcy is not
value of their bonds.
Ou (rF - d) / (u - d) + Od (u - rF) / (u - d) ] = 0
costly" in your calculations?Did not account for
Takeaway points from this exercise:
where, u = 20%, d = -50% and rF = 10%Focus on
any losses that the firm might incur when the
the bottom node from t=2 to t=1 Ou =0 (follows
The essence of the Modigliani-Miller theorem
firm is unable to meet its debt obligation and
from the logic above) Od=350.
is that you cannot increase the overall value of
therefore has to declare bankruptcy. (eg., in
Use
the
general
real
option
(arbitrage
pricing)
the firm by repackaging the firm's cash flows,
state S )
1
formula
to
discount
and
get
the
PV
of
the
option
in
i.e. by distributing them differently across debt
bottom
node
at
t=1.
and equity.
PV = 1/(1+rF)
If there are no tax benefits of debt, bankruptcy costs,
or other [ Ou (rF - d) / (u - d) + Od (u - rF) / (u - d) ] = 45.5Step 3:
Use the general real option (arbitrage pricing) formula to discount and
violations of the MM assumptions, then the weighted average of
get the PV of the option at t=0. Ou
the required rate on the debt and that on the equity will continue
to be the required rate on the assets, no matter what the firm does
to its capital structure.