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S P R I N G 19 9 7 V O L U M E 10 . 1

Strategies (And How to Choose Between Them)

by Isik Inselbag and Howard Kaufold,

University of Pennsylvania

TWO DCF APPROACHES by Isik Inselbag and

Howard Kaufold,

FOR VALUING COMPANIES University of Pennsylvania*

UNDER ALTERNATIVE

FINANCING STRATEGIES

(AND HOW TO CHOOSE

BETWEEN THEM)

or decades now, finance theorists and shown that, if the firm maintains a constant ratio of debt

F practitioners have been debating the

validity of various approaches to valuing

to equity in market value terms, the weighted average

cost of capital method is an appropriate valuation

a levered corporation. The weighted technique regardless of the pattern or duration of the

average cost of capital (WACC) method, in which a firm’s cash flows. In this paper, we take this finding a

firm’s value is determined by its unlevered cash flows step further to show that the two valuation methods

discounted by WACC, appears to be the reigning give the same answer—again, regardless of the pattern

favorite among practitioners. The main challenger is and duration of the cash flows—for a much more

the Adjusted Present Value (APV) technique, which general set of financing strategies in which the debt/

values the firm as an all-equity entity plus any equity ratio is changing over time. As one example, we

incremental worth created by leverage.1 show the equivalence of the techniques for the case in

Authors of corporate finance papers and text- which a company commits to a schedule in which the

books seem to feel obligated to choose sides in this absolute dollar value of debt principal outstanding is

debate. Proponents of WACC argue that, although paid down over time.

there are problems with this approach when the We argue further that past confusion can prob-

firm’s capital structure is changing over time, it is ably be traced to assumptions the separate camps

easier to use because the expected equity returns in have implicitly made about the corporation’s finan-

this approach can be directly observed. Those who cial policy. While we will show the methods are

favor APV counter that the WACC method is correct equivalent under different financing strategies, our

only under restrictive assumptions about the firm’s analysis suggests that it is more practical to apply the

cash flows and financing mix. APV technique when the firm targets the dollar level

To our knowledge, there are only two studies— of debt outstanding in the future, and the WACC

one by one of the present writers—that have attempted approach when the firm instead intends to hold the

to reconcile the two views.2 Both of these studies have debt/value ratio fixed in the future.

*We wish to thank Jeffrey Jaffe and Saman Majd. Boston, 1978, pp. 153-160; and J. Miles and R. Ezzell, “The Weighted Average Cost

1. The Adjusted Present Value method was originally presented by Stewart of Capital, Perfect Capital Markets and Project Life: A Clarification,” Journal of

Myers in “Interactions of Corporate Financing and Investment Decisions— Financial and Quantitative Analysis, September 1980, pp. 719-730. For a compari-

Implications for Capital Budgeting,” Journal of Finance, March 1974, pp. 1-25. son of alternative approaches to valuing levered cash flows, see D. Chambers, R.

While we cast our argument in terms of valuing an entire firm, our findings are Harris, and J. Pringle, “Treatment of Financing Mix in Analyzing Investment

equally relevant in a capital budgeting context. The reader need only substitute the Opportunities,” Financial Management, Summer 1982, pp. 24-41. In contrast to the

marginal required return on assets and debt capacity appropriate to the project in findings presented below, they conclude that the various methods yield different

question. values. See footnote 7 for our explanation of their findings.

2. See I. Inselbag, “Project Evaluation and Weighted Average Cost of Capital,”

in Cees van Dam, editor, Trends in Financial Decision-Making, Martinus Nijhoff,

114

BANK OF AMERICA

JOURNAL OF

JOURNAL

APPLIEDOF

CORPORATE

APPLIED CORPORATE

FINANCE FINANCE

TABLE 1 Year 0 Year 1 Year 2 Year 3 Year 4

PROJECTED CASH FLOW

STATEMENT OF MEDIA, Sales 75,000 84,000 94,080 97,843

INC. ($000’s)

Cash Costs 45,000 50,400 56,448 58,706

Depreciation 10,000 11,200 12,544 13,046

Corporate tax 7,000 7,840 8,781 9,132

+Depreciation 10,000 11,200 12,544 13,046

Investments into:

Fixed Assets 100,000 10,000 11,200 12,544 13,046

Net Working Capital 7,500 900 1,008 376 391

valuation methods to appraise a hypothetical corpo-

ration under each of these financial policies. This A newspaper chain is planning to set up a new

process shows how the required return on equity division, Media, Inc., with projected cash flows as

and the weighted average cost of capital evolve presented in Table 1. The new operation would

under the separate policies. The result is a clearer require an initial investment in plant and equip-

understanding of the appropriate application of each ment of $100 million, plus an infusion of $7.5

of the valuation techniques. million of working capital (equal to 10% of ex-

To make these points, we invoke three as- pected first-year sales). Media’s sales are projected

sumptions that are standard in the related literature. to be $75 million during the first year of operation.

The required return on the firm’s assets is taken as Sales are expected to rise 12% per year over the

given and fixed over time. We also ignore costs of next two years, with growth stabilizing at a 4% rate

financial distress, since our objective is to clarify indefinitely thereafter. Management estimates that

the effect of the corporate tax subsidy of debt cash costs (cost of goods sold, general and admin-

financing per se in several popular valuation ap- istrative expenses, etc.) will constitute 60% of rev-

proaches. Finally, we finesse issues arising from the enue. New investments in plant and equipment

differential personal taxation of debt and equity will match depreciation each year, starting at 10%

returns to investors. of the initial $100 million asset cost and growing in

In the next section, we present the unlevered tandem with sales thereafter. The firm plans to

free cash flows for a hypothetical company used maintain working capital levels at 10% of the fol-

throughout the paper to illustrate the financing lowing year’s projected sales. With Media in the

strategies and resulting valuations. Then we com- 35% tax bracket, unlevered free cash flow (asset

pare the APV and WACC methods under the assump- cash flow) would approach $16 million in three

tion that the firm targets the absolute dollar value of years, and grow 4% per year thereafter.

debt outstanding. Next we present the same com- The all-equity value of a firm at any point in time

parison for the case in which the firm maintains a should equal the discounted value of future unlevered

constant debt/value blend. Finally, we discuss the free cash flows, which we will denote as Ci:

implications of our analysis for a third popular ∞ Ci

valuation approach that involves capitalizing the VU,t = ∑ i−t

(1)

firm’s flows to equity. i = t + 1 (1 + rA )

115

VOLUME 10 NUMBER 1 SPRING 1997

TABLE 2 Value as of time: Year 0 Year 1 Year 2 Year 3

ALL-EQUITY VALUE OF

MEDIA, INC. ($000’s) Unlevered Value 101,711 107,919 113,792 118,344

DEBT REPAYMENT

SCHEDULE OF TARGETED Debt Level 77,500 69,000 60,500 52,000 54,080

DEBT POLICY OF MEDIA,

INC. ($000’s)

where rA is the required return on the firm’s assets. value. In leveraged buyouts, for example, owners

In the example, with growth constant after year 3, the typically finance the newly acquired company with

current all-equity value of Media takes the form: unusually high debt amounts, and then gradually

pay down debt principal over the life of the transac-

VU,0 = C1/(1 + rA) + C2/(1 + rA)2 + C3/(1 + rA)2(rA – g). tion.3 At some point, the firm again achieves its

desired long-run debt/value ratio.

We will take the asset return as given in our Suppose, for example, that Media, Inc. arranges

analysis, and assume it is fixed at 18%. Applying this to borrow $77.5 million initially. The firm agrees to

discount rate to the free cash flows given in Table 1 repay $8.5 million of principal at the end of each of

implies that Media is worth approximately $102 the first three years of the contract, bringing debt

million in unlevered form: outstanding at the end of the third year to $52 million

(see Table 3). From that point on, Media will increase

VU,0 = 12.1/(1.18) + 13.6/(1.18)2 + 15.9/(1.18)2(.18 – .04). debt outstanding by 4% per year, in line with the

≅ $101.7 million. expected growth of operating cash flows. Because of

the firm’s highly levered position in the early years,

One can use equation (1) to trace the evolution we assume the borrowing rate is 11% initially, falling

of Media’s all-equity value through time. The result- to 9% once it re-achieves a stable capital structure

ing estimates are shown in Table 2. (after year 3).

Media’s value as a levered company depends on One can use either the APV or WACC method

the financing policy the firm pursues. We now to value a company choosing this type of financial

outline two plausible financing strategies, indicating policy. But, under these circumstances, we will show

how the APV and WACC methods can be applied in that the APV method is more direct.

either context. In the first case, Media chooses a

target for the absolute dollar value of its outstanding The APV Method

debt. In the second, the company instead chooses to

fix its market debt/value ratio over time. The APV method treats the value of a levered

firm at any point in time (VL,t) as its value as an all-

TARGETING THE DOLLAR VALUES OF equity entity (VU,t), plus the discounted value of the

DEBT OUTSTANDING interest tax shields from the debt its assets will

support (DVTSt):4

Many firms agree to financing contracts that

specify debt service payments and outstanding fu- VL,t = VU,t + DVTSt. (2)

ture debt levels over the life of the contract, as

opposed to adhering to a target capital structure by The principle is straightforward. The firm’s

fixing the firm’s debt as a constant proportion of firm unlevered value is determined by the operating

3. For a discussion of such an example, see I. Inselbag and H. Kaufold, “How assets if it is unable to service the debt (costs of financial distress). We ignore these

to Value Recapitalizations and Leveraged Buyouts,” Journal of Applied Corporate costs to focus on the tax effects of leverage.

Finance, Volume 2, Number 2, Summer 1989, pp. 87-96.

4. To be entirely true to Myers’ concept, we should also deduct from this value

any costs of having the debt outstanding, such as the costs of liquidating the firm’s

116

JOURNAL OF APPLIED CORPORATE FINANCE

Our analysis suggests that it is more practical to apply the APV technique when the

firm targets the dollar level of debt outstanding in the future, and the WACC

approach when the firm instead intends to hold the debt/value ratio fixed in

the future.

DEBT, EQUITY AND TOTAL

VALUE OF MEDIA, INC.: Unlevered value 101,711 107,919 113,792 118,344

DOLLAR VALUE OF DEBT Discounted value of tax shields 30,501 30,872 31,612 32,760

TARGETED ($000’s) Levered value 132,212 138,791 145,404 151,104

Value of debt 77,500 69,000 60,500 52,000

Value of equity 54,712 69,791 84,904 99,104

income generated by its assets (as illustrated in the given period is calculated as the discounted value of

projections presented above). The debt supported its projected unlevered free cash flows, discounted

by these operating cash flows increases levered by the weighted average cost of capital:

value because interest (unlike dividends) is deduct- C t +1 Ct +2

ible from the firm’s income for corporate tax pur- VL,t = + (4)

(1 rWACC,t ) (1 rWACC,t )(1 + rWACC,t +1 )

+ +

poses. As a result, for given operating income, the

after-tax amount available for payment to both Ct +3

+ + ....

bondholders and stockholders taken together in- (1 + rWACC,t )(1 + rWACC,t +1 )(1 + rWACC,t + 2 )

creases as more of the payout is in the form of interest

rather than dividends. The weighted average cost of capital for each

Under this financial policy, projected debt lev- period is the weighted average of the after-tax debt

els are “exogenous”—that is to say, they do not and equity required returns, weighted by the relative

depend on future firm performance, but are pre- size of each source of financing in the market value

determined by the schedule of debt service. As a capital structure of the firm:

result, the borrowing rate, rD, is the appropriate Dt E

discount rate for current and future interest tax shields: rWACC,t = rD,t (1 − T ) + rE,t t (5)

VL,t VL,t

rDDt rDDt+1 rDDt+2

DVTSt = T[ + 2 + + ...] (3) If the firm targets dollar future debt levels in

(1 + rD ) (1+ rD ) (1+ rD )3

absolute terms, the debt/value ratio changes over

where T is the corporate tax rate, and Di is the time, thus causing changes in both the required

outstanding debt balance at the end of year i. equity return and the weighted average cost of

In the Media example, the value of interest tax capital. To see how a company’s required equity

shields as of the beginning of the first year is: return is affected by changes in its debt/value ratio,

.11(77,500) .11(69,000) .11(60,500)

consider equation (6a), which shows how the firm’s

DVTS0 = T[ + 2 + + after-tax income stream (represented by its asset

(1.11) (1.11) (1.11)3

returns plus its annual tax savings) is divided among

.09(52,000) the bondholders and stockholders:

(1.11)3 (.09-.04)

≅ $30.5 million. VU,t (rA ) + DVTS t (rD ) = Dt (rD ) + E t (rE,t ) (6a)

The value of the company is easily calculated as On the left-hand side of the equation, the

$132.2 million, the sum of these tax shields and the unlevered value of the asset cash flows is VU, the all-

value of the all-equity company (see Table 2). Using equity value of the company. These assets generate

the fact that the levered value of the company is an annual expected return of rA, which is determined

equal to the sum of its debt and equity, VL,t = Dt + Et, by the riskiness of the operating cash flows. As we

the evolution of corporate value, debt and equity is have seen, this all-equity value is supplemented by

given in Table 4. the value of interest tax shields, DVTS. Given the

“exogenous,” or pre-determined, character of future

The Weighted Average Cost of Capital (WACC) debt levels and interest tax shields, this asset gener-

Method ates the return of rD, which is compatible with the

lower risk of these cash flows.

Under the WACC method, a widely used ap- As shown on the right-hand side of the equa-

proach to corporate valuation, the firm’s value in a tion, these two sources of after-tax income are shared

117

VOLUME 10 NUMBER 1 SPRING 1997

TABLE 5 For the Year: Year 0 Year 1 Year 2 Year 3 Year 4 ...

REQUIRED RETURN TO

EQUITY AND WEIGHTED Required equity return 24.0% 21.8% 20.4% 19.7% 19.7%

AVERAGE COST OF

CAPITAL MEDIA, INC.: Weighted average cost of capital 14.1% 14.5% 14.9% 15.0% 15.0%

TARGETED DEBT POLICY

between the bondholders and the equityholders equity, grow at the steady-state rate of 4%. Therefore,

according to their proportional representation in the the required return on levered equity as well as the

capital structure and the returns required by these weighted average cost of capital remain stable at the

two investor groups (rD and rE, respectively). level reached by the end of year 3.7

Then, by manipulating the basic balance sheet Using the WACC method to value Media, the

identity, VL,t = VU,t + DVTSt = Et + Dt, we can solve for firm’s unlevered free cash flows are discounted by

(rE) as follows: the rates given in the second row of Table 5. The

(D t − DVTSt )

value of the firm at time 0 is therefore:

rE,t = rA + (rA − rD ) (7)

Et 12.1 13.6 15.9

VL,0 = + + +

(1.141) (1.141)(1.145) (1.141)(1.145)(1.149)

As Table 4 indicates, the debt/equity ratio, and

(Dt - DVTSt)/Et, change over the early years of the 16.6

transaction. The return the shareholders require (1.141)(1.145)(1.149)(.15-.04)

therefore fluctuates, and can be computed by direct = $132.2 million.

substitution from Table 4 into equation (7). These

returns are given in the first row of Table 5. This solution is identical to that derived using

To calculate the weighted average cost of the APV method. Under this financial policy,

capital, we substitute the required equity return though, the APV approach is clearly preferred. In

(equation (7)) into equation (5) to get: fact, as equation (7) shows, one must know the

DVTSt (DVTSt − TDt )

value of the firm’s tax shields to calculate the

rWACC,t = rA (1 − ) + rD (8) correct equity return and weighted average cost of

VL,t VL,t

capital. That is, one must already have calculated

In this targeted debt case, WACC also changes the firm’s value (using APV or some other means)

if the debt/value ratio is not constant. Specifically, a to be able to derive the discount rates necessary to

decline in the debt/value ratio implies an increase in value the firm using the WACC method.8 In addi-

the cost of capital, since the reduction in leverage tion, the variation in the WACC shown in Table 5

means a loss of interest tax shields.5,6 illustrates the well-known problem with using a

The cost of capital for Media is given in the constant cost of capital, or “hurdle rate,” for

second row of Table 5. After year 3, the value of the capital budgeting when capital structure is chang-

firm (levered and unlevered), and the debt and ing over time.

5. This result may be altered in the presence of costs of financial distress. which, of course, is also constant over time. The reader will recognize these

6. There is a related special case in which the equity return is fixed, even findings as the well-known Modigliani-Miller (1963) results. (See F. Modigliani and

though the firm is targeting the dollar level of debt outstanding. In the standard M. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,”

textbook example, the firm’s expected unlevered cash flows are assumed to be American Economic Review, June 1963, pp. 433-443.) While the weighted average

constant and perpetual, and the firm sets borrowings at the same dollar level, D, cost of capital is independent of the absolute cost of borrowing under these

in perpetuity. In this case, the present value of the tax shields is simply TD, so that conditions, this will not generally be true as shown by equation (8).

the required equity return of equation (7) reduces to: 7. In concluding that various methods imply different values for the same cash

flows and financing policy, Chambers, Harris and Pringle (1982) assume time-

rE,t = rA + ((Dt – TDt)/Et)(rA – rD). independent discount rates for each of the valuation approaches. As equations (7)

= rA + (Dt/Et)(1 – T)(rA – rD). and (8) show, the costs of equity and the weighted average cost of capital will

change over time as long as the capital structure is not constant (as occurs in their

Since the expected future asset cash flows are constant, both the debt and example). Applying equations (7) and (8) to their example implies identical values

equity values are stable as long as the firm makes a commitment to maintaining for their project, independent of the valuation method used.

the same dollar debt level. The equity return is therefore independent of time in 8. We elaborate on this point in our discussion of the “flows to equity”

this case. Substituting the equity return into equation (5) implies a weighted average approach later in the paper.

cost of capital of:

118

JOURNAL OF APPLIED CORPORATE FINANCE

The APV method treats the value of a levered firm at any point in time as its value as

an all-equity entity plus the discounted value of the interest tax shields from the debt

its assets will support.

THE CONSTANT DEBT/VALUE RATIO CASE Suppose, for example, that Media fixes its debt/

value ratio at 40% (debt/equity at 66.7%), and that the

In weighing the pros and cons of debt funding, firm can borrow at an interest rate of 9%. How much

many firms conclude that it is optimal to set and would the resulting tax shields add to the all-equity

adhere to a targeted blend of debt and equity.9 In value? Since debt and levered firm value are simul-

these circumstances, unless the company’s cash taneously determined under this policy, we must

flows are constant over time, the firm will need to solve for the levered value of the firm using the

undertake regular debt-equity swaps to maintain this “iterative” process illustrated below.

target capital structure. We now describe the proper Beginning at the end of year 3 (the point at

application of the APV and WACC methods under which growth stabilizes), we can use equations (2)

this financing policy. and (9) to determine the value of Media as:

rD D 3 rD D 4

The APV Method + +

(1 + r ) (1 + rD )(1 + rA )

+T

D

VL,3 = VU,3

If the company maintains a fixed debt/value rD D 5

+ .......

(1 + rD )(1 + rA )

capital structure in market value terms, the present 2

value of interest tax shields at time t will be:

Since the expected debt level grows at a constant rate

rD D t rD D t + 1

(1 + r ) + (1 + r )(1 + r ) + g after year 3, this relation can be simplified as:

DVTS t = T

D D A (9)

rD D t + 2 TrD D3 (1 + rA )

+ ... VL,3 = VU,3 +

(1 + rD )(rA − g )

(1 + rD )(1 + rA )

2

Defining L to be the debt/value ratio, D/VL,

Why this blending of rA and rD as discount rates Media in period three will be worth:

in this expression?10 Consider the calculation of DVTS

VU,3

at time 0. At that time, the value of the levered firm, VL,3 =

and the dollar level of debt financing for that year TrD L(1 + rA )

1−

(equal to a fixed fraction of firm value), are known. (1 + rD )(rA − g)

This debt level and borrowing rate fix the interest the

firm will pay at the end of the first year. The expected From Table 2, the all-equity value of Media at the end

tax savings resulting from this single year’s interest of year 3 is approximately $118 million. Substituting

tax shield is therefore pre-determined. As a result, this value and the other parameters into the expres-

this cash flow is as risky as the interest payment itself, sion for VL,3, the levered value of Media at the end

so that rD is the appropriate discount rate. of year 3 is expected to be $131 million. The debt

But thereafter, because the firm expects to level would be 40% of this amount, or $52 million.

maintain debt as a fixed fraction of total value, the The difference between the levered and unlevered

amount of debt and interest payments will vary with values of $13 ($131-$118) million is the value of all

the actual (rather than the expected) future asset interest tax shields expected from year 4 on.

cash flow outcomes for the company. Since future Solving recursively, we can describe the ex-

interest payments and tax shields will therefore be as pected evolution in the value, debt, and equity of

risky as the asset cash flows, one must use the higher Media under the fixed debt/value policy. The value

rate rA to discount tax shields after the first year. of the firm at the end of year 2 is:

9. In this paper, we use a targeted blend of debt and equity expressed in terms sense. For an excellent discussion of these issues, see Michael J. Barclay, Clifford

of market values. Some companies, however, set capital structure targets in terms W. Smith, Jr. and Ross L. Watts,”The Determinants of Corporate Leverage and

of book values. That characterization of debt capacity leads to a somewhat different Dividend Policies,” Journal of Applied Corporate Finance, Vol. 7 No. 4 (Winter,

financing strategy—one that requires a modification of the analysis presented 1996), 4-19.

below. Our focus on market values in this paper reflects the well-known principle 10. The argument in the text is a heuristic version of ideas presented in Miles

that use of book values is likely to understate debt capacity because the book values and Ezzell (1980). In that paper, the authors show the equivalence of the APV and

of assets reflect “historical costs” rather than current values of assets based on their WACC approaches in a finite-lived capital budgeting context when the project is

cash-flow-generating capacity. Nevertheless, for companies whose current value financed with a constant blend of debt and equity. As we show, their approach can

consists primarily of intangible future growth opportunities as opposed to tangible be extended to the case in which the firm’s unlevered cash flows are expected to

“assets in place,” targeting debt-equity ratios in terms of book values may still make continue indefinitely.

119

VOLUME 10 NUMBER 1 SPRING 1997

TABLE 6 Value as of time: Year 0 Year 1 Year 2 Year 3

DEBT, EQUITY AND TOTAL

VALUE OF MEDIA, INC.: Unlevered value 101,711 107,919 113,792 118,344

40% DEBT/VALUE MIX Levered value 113,012 119,712 126,076 131,110

($000’s)) Discounted value of tax shields 11,301 11,794 12,284 12,775

Value of Debt (40% of value) 45,205 47,885 50,430 52,447

Value of Equity (60% of value) 67,807 71,827 75,645 78,671

+ + on the realizations of future cash flows. It is not

(1 + rD ) (1 + rD )(1 + rA )

VL,2 = VU,2 +T surprising that the value of interest tax shields as of

rD D 4

+ ....... the end of year 3 is much lower in this case than

(1 + rD )(1 + rA )

2

under the targeted debt case ($12.8 million vs. $32.8

which can be rewritten as: million; see Tables 6 and 4). Though the expected tax

DVTS 3

savings are approximately the same from that point

TrDD2

VL,2 = VU,2 + + on, the risk of these cash flows is significantly higher

(1 + rD ) (1 + rA )

in the constant debt/value case because future debt

Since D2 = L VL,2, the value of the company at the levels depend on as yet unknown operating results

end of year 2 is: for the firm.11,12

DVTS3

The example reveals the complexity of us-

VU,2 + ing the APV technique to value a firm that fol-

(1 + rA )

VL,2 = lows the constant debt/value policy. Since the

TrD L

1− amount of the firm’s outstanding debt depends

(1 + rD ) on realizations of future cash flows, dollar debt

Using the all-equity value as of the end of year levels are not pre-determined as in standard APV

2 of $114 million, the end-of-year 3 tax shields of $13 calculations. The simultaneous determination of

million, and the other parameters of the example, debt and value requires an iterative solution.

Media will be worth approximately $126 million at While this method is perfectly legitimate, the

the end of year 2. Debt and equity will again be 40% WACC method is simpler when the firm pursues

and 60%, respectively, of the total value of the firm. this financial strategy.

Continuing the solution process in this fashion,

one can calculate the present value of the company The Weighted Average Cost of Capital (WACC)

and its debt and equity. Table 6 summarizes the Method

results of the recursive solution process. Media is

initially worth approximately $113 million: $45 mil- Reconsider equation (5) describing the firm’s

lion (40%) is debt, $68 million (60%) is equity. The weighted average cost of capital. If the company

present value of the interest tax shields on projected follows a fixed debt/value policy, Dt/V Lt and Et/V Lt

borrowings is: will, by definition, be constant over time. If we

assume the borrowing rate is fixed, the weighted

D3

D2 + average cost of capital will be independent of time

TrD D1 (rA − g )

DVTS0 = D0 + + ≅ $11 Million since the equity return will also be constant under

(1 + rD ) (1 + rA ) (1 + rA )2 these conditions.

To show that the equity return will be constant

To repeat, the return on assets plays a promi- under this financial policy, let’s go back to the

nent role in calculating the value of the tax shields analysis of the distribution of the firm’s income

11. Even in the targeted debt example, one might argue that after year 3 the 12. One should not conclude, however, that the targeted debt policy is

firm would vary its borrowings as future cash flow outcomes are realized. One superior to the constant debt/value strategy based on the levered values as

would then value the tax shields from year 3 on using the method described in calculated in the two examples. The former may involve higher costs of financial

this section of the paper. We assume in the previous section that the firm distress which are ignored in this analysis.

commits to exogenous debt levels in order to show the two financing policies in

their purest forms.

120

JOURNAL OF APPLIED CORPORATE FINANCE

When a company’s debt ratio is changing over time, one must already have

calculated the firm’s value (using APV or some other means) to be able to derive the

discount rates necessary to value the firm using the WACC method.

between bondholders and stockholders we pre- Substituting this equity return (equation (10))

sented earlier. Once again, the value of the company into the weighted average cost of capital (equa-

is the sum of its all-equity value and the expected tion (5)), we obtain the following expression for

present value of interest tax shields. As we argued WACC:

in the APV section above, the value of the interest (1 + rA )

rWACC,t = rA − TrDL (11) 14

tax shield for the first year (TrDD/(1+rD)) is pre- (1 + rD ) (11)14

determined, and therefore earns a return of rD. But

since subsequent tax shields (DVTS-TrDD/(1+rD)) This constant weighted average cost of capital

vary with future free cash flow outcomes for the firm, properly accounts for the higher discount rate ap-

the appropriate return for these tax shields is the propriate given the greater riskiness of future interest

higher asset rate, rA. tax shields.

Revising equation (6a) to take account of the Using the parameters of our example in equa-

greater risk of future tax shields under this financial tion (11), the weighted average cost of capital for

policy, Media, Inc. is found as:

TrD D t

VU, t (rA ) + (rD ) + rWACC,t = .18 - (.35)(.09)(.40)((1.18)/(1.09)) = 16.6%.

(1 + rD )

(6b)

Tr D To value Media, we discount the unlevered cash

(DVTS t − D t )(rA ) = D t (rD ) + E t (rE, t )

(1 + rD ) flows (given in Table 1) by this constant weighted

average cost of capital:

One can again use the balance-sheet equalities, VL,t 12.1 13.6 15.9

= VU,t + DVTSt = Et + Dt, to solve equation (6b) for VL,0 = (1.166)

+

(1.166) 2 +

(1.166)2 (.166-.04)

the equity return:13

≅ $113.0 million.

Dt TrD

rE, t = rA + (1 − )(rA − rD ) (10)

Et (1 + rD )

This answer is identical to that derived using the

It follows that the equity return is constant if the more complicated APV method (see Table 6). While

firm fixes its debt/value (debt/equity) ratio. Using the APV and WACC methods yield the same results,

the parameters of the example, the required equity the simplicity of the WACC approach in this case

return is: indicates that it is far more practical than APV if the

firm being valued follows a constant debt/value

2 .35(.09)

rE = .18 + (1 − )(.18−.09) ≅ $23.8% policy.15,16

3 1+.09

13. For the reader who is uncomfortable with the informality of this derivation, rE,t = rA + (Dt/Et)(1 – [TrD/(1 + rD)])(rA – rD). (10)

one can calculate the return shareholders earn in the following way. Note that the

14. This formula is derived in Miles and Ezzell (1980), equation (20).

cash flow to stockholders, CEt, is the unlevered free cash flow net of debt service

15. The relative simplicity of the WACC method for a firm using a constant debt-

and taxes:

equity blend is recognized by R. Brealey and S. Myers, Principles of Corporate

CEt = Ct – rDDt–1(1 – T) + Dt – Dt–1 (F-1) Finance, 5th Edition, McGraw-Hill, New York, 1996. See Chapter 19.

16. We have outlined two plausible financial policies. A third case, observed

At any point in time, the required return on equity, rE,t, must satisfy the

in many highly levered transactions, occurs when a firm is required (by debt

equality:

covenants) to dedicate its entire free cash flow to interest and principal payments.

Et = (CEt+1 + Et+1)/(1 + rE,t) (F-2) Under these conditions, the amount of debt outstanding and, therefore, the interest

tax shields at any point in time are a direct function of the unlevered free cash flows

where Et and Et+1 are the values of equity at time t and t+1, respectively.

of the firm. Since the debt balance then becomes as risky as the operating cash

Since VL,t+1 = Dt+1 + Et+1, equation (F-2) can be inverted and rewritten using

flows, the required return on assets, rA, is the appropriate discount rate to be used

equation (F-1) as:

in calculating the present value of interest tax shields. This is yet another case in

(1 + rE,t) = (Ct+1 + VL,t+1 - Dt[1 + rD(1 – T)])/Et. (F-3) which the APV and WACC methods yield identical values. One can demonstrate

this equivalence using the procedures given in the previous section with proper

From our prior observation that future interest tax shields are as risky as

adjustment of the discounting of the tax shields. This case corresponds to the

corresponding unlevered cash flows under this financial policy, we know that the

“Compressed Adjusted Present Value” technique referred to in S. Kaplan and R.

firm’s value evolves intertemporally according to:

Ruback, “The Market Pricing of Cash Flow Forecasts: Discounted Cash Flow vs. The

VL,t = (Ct+1)/(1 + rA) + (TrDDt)/(1 + rD) + (VL,t+1)/(1+rA). Method of ‘Comparables’,” Journal of Applied Corporate Finance, Volume 8,

Number 4, Winter 1996, pp. 45-60.

Solving this relation for Ct+1 and substituting into equation (F-3),

1 + rE,t = ((1 +rA)VL,t – Dt[1 + rD(1 – T) + TrD(1 + rA)/(1 + rD)])/Et.

Finally, dividing the numerator and denominator of the right hand side of this

expression by VLt, we can simplify to get:

121

VOLUME 10 NUMBER 1 SPRING 1997

SOME COMMENTS ON THE “FLOWS fluctuates based on unlevered cash flows yet to be

TO EQUITY” APPROACH realized. Thus, the change in outstanding debt

principal, and the equity cash flow, depend on the

A third approach to valuation, popular among value of the firm. It follows that, under the constant

certain practitioners,17 is the “flows to equity” method. capital structure financial policy, the estimation of

To use this method to calculate the value of a the flows to equity requires prior knowledge of total

company, one first values the outstanding equity, firm value.

and then adds the market value of debt. To estimate In sum, application of the “flows to equity”

the value of the levered equity, one must first project approach to valuation in each financing case re-

the cash flows the stockholders expect to receive net quires prior knowledge of what the company is

of debt service (as described in equation (F-1) in worth. It still may be of interest, for purposes other

footnote 13). One must then discount these flows by than valuation, to calculate the cash flow to share-

the required equity return as given by equation (7) holders and the required equity return. But one will

or (10), depending on the financial policy of the firm. already be in a position to use the APV or WACC

It is useful to recognize that, whether the firm methods to value the company directly.

pursues the targeted debt strategy or the constant

debt/value policy, the flows to equity approach is CONCLUSION

not an independent valuation technique. Suppose,

for example, that the firm targets an absolute dollar In this paper, we have compared two popular

debt level. Under these conditions, the cash flows to approaches to valuing a company, the Adjusted

the shareholders are exogenous, given the unlevered Present Value (APV) and the Weighted Average Cost

cash flows and pre-determined debt repayment of Capital (WACC) methods. To illustrate the ap-

schedule. However, as equation (7) shows, the proaches, we have assumed that the company being

required return to equity (the discount rate to be valued follows one of two plausible financing strat-

used in this approach) depends on the present value egies: In the first, the company commits to a pre-

of interest tax shields. If the value of these tax shields determined schedule for the absolute amount of

is known, the value of the company can also be debt to be used. Under a second scenario, the firm

calculated directly as the sum of the tax shields and is financed with a constant blend of debt and equity.

the firm’s unlevered value. We have shown that both valuation methods,

Suppose, instead, the firm pursues the constant when properly formulated to take into account the

capital structure policy. It is then impossible to evolution of the firm’s cash flows and capital struc-

estimate the equity cash flows without first having ture, give identical results under each of these

used one of the two methods described above to financing alternatives. But, although the approaches

value the firm as a whole. While the projected are equivalent, our analysis also reveals that it is more

unlevered cash flow is assumed known, and the debt practical to apply the APV technique when the firm

level as of the beginning of the year is pre-deter- targets the dollar level of debt outstanding over time,

mined, the debt outstanding at year end will depend and the WACC approach when the firm instead

on the value of the company at that time. This value intends to maintain a fixed debt/value ratio.

leveraged leasing and project finance transactions.

is Adjunct Professor of Finance, as well as the former Vice Dean is Adjunct Professor of Finance and the Director of the Executive

and Director of the Graduate Division, at the University of MBA Program at the Wharton School.

Pennsylvania’s Wharton School of Business.

122

JOURNAL OF APPLIED CORPORATE FINANCE

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