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PV 15 3.98.
1.054
Notice that the chance Robin Hood intercepts
your shipment goes into the NUMERATOR. It
reduces your expected payoff. Remember the
numerator in the present value equation
contains the expected cash flows from the
project.
PV More on the Practical Issues
In some cases the investment calculations are
difficult to carry out.
Employee safety equipment investments.
Investments for environmental reasons
Solution
If you must make an investment to meet regulations,
or satisfy a labor agreement there is no need to
calculate anything. You just have to do it.
Otherwise, the standard PV calculations apply. You
need to estimate productivity gains, legal costs,
etcetera.
The correct discount rate is likely to be the risk free rate as
the cash flows are probably uncorrelated with the market.
WACC and APV
I am assuming future debt levels are a <blank>
and I want to make my life <blank>:
APV WACC
Weighted Average Cost of Capital
(WACC)
Ninety-nine times out of a hundred people
will use a firm's WACC as the discount
rate for any project a firm undertakes.
While this may be tempting, it only works if
two important assumptions hold:
The firm maintains a constant debt/equity
ratio over its lifetime.
The project has the same risk as the rest of
the firm.
WACC Defined
WACC is defined by:
D E
WACC 1 TC rD rE .
D E D+E
where:
D = dollar value of the outstanding debt
E = dollar value of the outstanding equity
rD = expected return on the firms debt
rE = expected return on the firms equity
TC = firms tax rate.
Using the WACC
The WACC makes it easy to value marginal
projects.
Use market values to find E and D.
Use past market returns to estimate rE and rD.
Use the accounting statement to get TC.
Once you have the WACC
Calculate the firms cash flows under the assumption
it is 100% equity financed.
Discount these cash flows at the WACC to get the PV.
Example: Marginal Industries
D TC rD D TC rD
rE = rA 1+ 1- -rD 1- .
E 1+rD E 1+rD
How to Value Your Company
1. For each comparable firm estimate rA using the
previous formula (just rearrange for rA).
For each firm use its E, D, rD, rE, and TC.
2. Calculate the average value of rA and assume
that is the asset return for your firm.
3. Calculate the equity return using the previous
equation.
If You Like Betas Better
D TC rD D TC rD
E = A 1+ 1- - D 1- .
E 1+rD E 1+rD
Do You Believe in the WACC?
If you really believe, why not also believe
that firms adjust their debt-equity ratio to
the target level 24 hours a day seven days
a week?
Why? Makes it really easy to calculate
asset betas!
Unlevering With When Debt-Equity
Ratio is Adjust Continuously
As the time between adjustments goes to zero, the per
period risk free rate rD goes to zero.
This causes the rD/(1+rD) terms in the equations relating
equity betas and returns to asset and debt betas and
returns to go to zero. Leaving:
D D
rE = rA 1+ -rD ,
E E
and
D D
E = A 1+ - D .
E E
D D D/E .75 3
L= = = .
EV D+E D/E+1 1.75 7
Solution Continued
From the ME formula
3 1.2118
WACC = .2118 - .3 .05 .204381
7 1.05
Fill in the perpetuity formula to get GPs enterprise value
(EV).
EV =
1-.31.5 = 5.40 .
.204381-.01
To get the equity value subtract the value of the debt
from the enterprise value.
E = EV (D/EV)xEV = 5.4 (3/7) 5.4 = 3.087.
Target Amount of Debt
So far every problem has assumed the firm
maintains a target D/E ratio. Not every firm does
this.
Highly levered firms may be looking to reduce their
outstanding debt.
Firms with little debt may seek to increase it
substantially to finance a new project and then pay it
off.
If the ratio is not constant you cannot use WACC
to get the present value of the cash flows.
Adjusted Present Value
(APV)
APV = PV(All Equity Cash Flows) +
PV(Debt Tax Shield).
Advantages
Easy to use when a firm has a target dollar value of
debt.
Can be adjusted (with some work) for cases where a
firms dollar value of debt varies over time.
Can handle (again with some work) even the case
where the firm maintains a constant D/E ratio.
Constant $ Amount of Debt
Example
The Perpetual Rest Lounge Company (PRLC)
has $12 million in outstanding debt, and it does
not plan to either add to or subtract from this.
The firm pays interest on the debt at a rate of
5% per annum. Assume the debt is risk free.
Starting next year the firm expects to generate
earnings before interest and taxes (EBIT) of $2
million, and that this figure will grow at a rate of
1% per year.
PRLC Continued
Assume
rf = 5%
rm = 15%
A = .8
Tc = .4
What is PRLCs enterprise value?
What is the value of PRLCs equity?
PRLC Solution
First calculate PRLCs value as an all
equity firm. In this case it produces after
tax profits of (1-.4)2 = 1.2 in year 1 and
this grows at 1% per year.
Since the asset beta is .8, its
rA = .05+.8(.15-.05) = .13.
PV(All Equity) = 1.2/(.13-.01) = 10.
PRLC Continued
Now calculate the PV of the debt tax shield.
The company pays 12.05 = 0.6 in interest each year.
This generates a tax shield of 0.6.4 = .24 per year.
Because this amount never varies and is risk free
PV(Debt Tax Shield) = .24/.05 = 4.8.
EV of PRLC =
PV(All Equity Cash Flows) +
PV(Debt Tax Shield) =
10 + 4.8 = 14.8.
Note: Since PRLC is growing its D/E ratio declines over
time! It does not maintain a constant D/E ratio so the
WACC will not generate the correct EV for the firm.
Asset to Equity Betas
Constant Amount of Debt Case
E D 1-TC
rA = rE +rD .
E+D 1-TC E+D 1-TC
E D 1-TC
A = E + D .
E+D 1-TC E+D 1-TC
Adjusting the APV
Constant D/E Ratio Case
The APV can be adjusted to handle the
very case the WACC is designed for: the
constant D/E case.
The key to understanding how is through
the famous question, Just how much debt
will you have and when will you know it?
An example will explain why.
Valuing Golden Products with the
APV
The first part is relatively easy
Calculate the value of the firm without any
debt financing.
After tax cash flows start at 1.5.7 = 1.05 and grow
at 1% per year.
Have rA equal to .2118.
All Equity Value
All Equity Value =
1.05/(.2118-.01) =5.203171
Yes, a lot of decimal places but we want to
show the APV gives the same exact answer
as the WACC when both are calculated
correctly.
Debt Tax Shield
Calculating the PV of the debt tax shield is
somewhat tricky until you get the hang of it.
The problem is the amount of debt the firm will
have outstanding depends on how well it does
over time.
Good years more debt higher tax shield.
Bad years less debt lower tax shield.
Tax shield is pro-cyclical with the economy as so has
a positive beta!
From the original problem D starts at 2.32. Use
that to begin the debt tax shield calculation.
The Tax Shield: What do You
Know and When?
The following table describes the expected debt
tax shield. Arrows indicate which debt amounts
generate which tax shields.
0 2.32
1 2.34 2.32.05.3=.0348
2 2.36 .0351
3 2.39 .0355
Expectations vs. Realizations
The year one debt level produces the year
two tax shield.
In year one you will know with certainty
what the year two tax shield will be.
Prior to that you are not certain.
The firm is expected to grow at a rate of 1%
per year. In actuality it may grow faster or
slower. That will impact the amount of debt it
will eventually have.
Numerical Example
Each year the firms value goes up by
either 22% or down by 20% with equal
probability. Notice that on average it
grows at 1%.
Year 0: No debt tax shield
Year 1 Debt Tax Shield
Year 1 Good Bad
Economy
Year 1
Tax Shield 2.32.05.3 = .0348 .0348
Debt 2.321.22 = 2.83 2.32.8 = 1.856
Today you know for sure what next periods tax shield
will be. Therefore you get its present value by
discounting at the risk free rate of .05, assuming its debt
is risk free.
PV(Year 1 tax shield) = .0348/1.05.
Year 2
Year 1 Good Good Bad Bad
Economy
Year 2 Good Bad Good Bad
Economy
Year 2
0 700,000
1 700,000 .05(.4)(700000)=14000
2 1.022700000=728,280 .05(.4)(700000)=14000
3 1.022700000=728,280 .05(.4)(728280)=14565.6
4 1.024700000=757,702.51 .05(.4)(728280)=14565.6
PV of the Debt Tax Shield: Year 1
You discount the first years tax shield by
the risk free rate since you know with
certainty what it will be as of today. There
is no market risk.
so WACC = .1579.