Finanças
Nov 30
QDai for FEUNL
Topics covered

Capital budgeting with debt

Adjusted Present Value Approach

Flows to Equity Approach

Weighted Average Cost of Capital Method
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Adjusted Present Value Approach

The value of a project to the firm can be
thought of as

side effects of financing:
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APV Example
Consider a project of the Pearson Company, the timing and size of
the incremental after-tax cash flows for an all-equity firm are:
–$1,000
0
$125
$250
$375
$500
1
2
3
4
The unlevered cost of equity is r0 = 10%:
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APV Example (continued)


Now, imagine that the firm finances the project with
$600 of debt at rB = 8%.
Pearson’s tax rate is 40%
The net present value of the project under leverage is:
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APV Example (continued)


Another way to calculate the NPV of the loan.
Previously, we calculated the PV of the interest tax
shields. Now, let’s calculate the actual NPV of the
loan:
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Flows to Equity Approach
Discount the cash flow from the project to
_________________________________
at the cost of
_________________________
 Three steps in the FTE Approach

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Step One: Levered Cash Flows for Pearson



Since the firm is using $600 of debt, the equity holders only
have to come up with
Thus, CF0 =
Each period, the equity holders must pay interest expense.
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Step Two: Calculate rS for Pearson
To calculate the debt to equity ratio,
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B
B
, start with
S
V
Step Three: Valuation for Pearson

Discount the cash flows to equity holders at
rS = 11.77%
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WACC Method for Pearson


To find the value of the project, discount
___________________________________ at
____________________________________
Suppose Pearson’s target debt to equity ratio is
1.50
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Valuation for Pearson using WACC

To find the value of the project, discount the
unlevered cash flows at the weighted
average cost of capital
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A Comparison of the APV, FTE and WACC

All three approaches attempt the same task:

Guidelines:

Use WACC or FTE if

Use the APV if

In the real world
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Summary: APV, FTE, and WACC
APV
WACC
Initial Investment
Cash Flows
Discount Rates
PV of financing effects
Which approach is best?
Use APV
Use WACC and FTE when
 the most common
 for a highly levered firm
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FTE
Estimating the discount rate






Firm A wants to finance a new project with a B/S
ratio of 1/3. Its borrowing rate is 10%.
Firm B in the same industry has a B/S ratio of
2/3. The beta of its equity is 1.5. Firm B’s
borrowing rate is 12%.
Corporate tax rate = 40%.
Market risk premium = 8.5%
Rf = 8%
What is the discount rate for Firm A’s new
project?
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Estimating the discount rate

Firm B’s cost of equity

Firm B’s cost of capital if unlevered
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Estimating the discount rate
APV
FTE
WACC
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