21/9/2022
Lecture 5:
Financing & Valuation
Part 1
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Learning Outcomes

To understand:
 Valuing
 What
businesses or project analysis;
is capital budgeting and the different methods:
Net
Present Value using WACC
Net
Present Value using Flow-to-equity (FTE) (Week 6)
Adjusted
Issues
Present Value (Week 7)
and considerations when using NPV (Week 7)
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Recall from Week 4
In order to value a project,
you require an appropriate
discount rate
The value of the new project
will add to overall equity value
of the business. You therefore
need to know the value of the
project.
You need a new COC, suitably
adjusted to the new gearing
level, to value the project
In order to calculate the new
COC, you need to know the
new MV of debt and equity
after the project’s acceptance
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Capital Budgeting at its Simplest

The value of a business / project is in simple terms, the sum of the
present value of all its expected future cash flows:
𝐶𝐹
1 𝑟

Through this simple formula, we are simply trying to determine what the
business/project is worth today, given an appropriate discount rate


Recall that the discount rate ‘r’, reflects the expectations on a set of current
and future conditions – firm and/or market – that is taken into consideration
when valuing a firm/asset
By doing this, we are trying to decide whether this business/project will
add value to our firm
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Capital Budgeting at Its Simplest

The simplest – and most common – method of capital budgeting is the Net Present Value (NPV)
method

NPV expands the earlier definition to account for the initial outlay / cost of the investment:
𝐶𝐹
𝑁𝑃𝑉
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
1 𝑟

For example, ABC has a project that is expected to generate revenues of $100,000 per year
for 5 years. Investing in this project will require an initial outlay of $150,000. Assuming r = 5%,
the NPV of this project is:
100,000
100,000
100,000
100,000
$100,000
$150,000
1 0.05
1 0.05
1 0.05
1 0.05
1 0.05
= $282,947.67 (this is also known as Base-case NPV)

General rule of thumb:

If NPV > 0, then we accept the project

If NPV < 0, then we reject the project
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Net Present Value using WACC (NPV-WACC)

Same as base-case NPV method

2 Differences

Use of Free Cash Flow (FCF)

Discounted using WACC
PV 
FCF1
FCF2
FCFH
PVH

 ... 

1
2
H
(1  r ) (1  r )
(1  r )
(1  r ) H
Horizon Value  PVH 
FCFH 1
wacc  g
r = WACC
PV (free cash flows)
PV (horizon value)
𝑊𝐴𝐶𝐶

1
𝑇 𝑟
𝐷
𝑉
𝑟
𝐸
𝑉
NPV = PV – initial investment
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Net Present Value using WACC (NPV-WACC)

Some important points on NPV-WACC:
 FCF
= cash company generates less cash outflows to support
operations and maintain capital assets
 Excludes
non-cash expenses, interest payments and borrowings expenses
 Includes
taxes, spending on equipment and assets, and changes in working
capital from the balance sheet (related to the project evaluated)
 On
the use of WACC, there are two possible scenarios
 Project
has no impact on company’s debt-equity ratio = fixed-debt
 Project
impacts company debt-equity ratio = rebalancing required
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NPV-WACC Example – Fixed Debt
XYZ is considering diversifying its operations by setting up a manufacturing division to produce
medical masks. Its first potential project entails buying 2 machines for a total of RM600,000.
This will produce annual revenue of RM3 million, for 10 years. The cost of production is
expected to be 40% of the revenue and the depreciation is RM50,000 per year, using the
straight-line method. No inflation is considered in this case. After 10 years, this project will
be scrapped to zero value.
Sixty per cent (60%) of the initial cost of the project will be financed by debt. The loan will be
irredeemable and carry an annual interest rate of 6%. The balance of finance will come from a
placement of new equity. It is assumed that there are no issue costs associated to this.
The manufacturing industry (for medical masks) has an average geared equity beta of 1.8 and
a debt-to-equity ratio of 1:5 by market values. XYZ’s current geared equity beta is 1.6 and
30% of its long-term capital is represented by debt that’s generally seen as risk-free. The riskfree rate is 2.5% a year and the expected return on an average market portfolio is 8%.
Corporation tax is set at 30% per annum.
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NPV-WACC Example – Fixed Debt

Lay down the facts:

Initial investment = RM600,000

Annual revenue = RM3,000,000 for 10 years

Cost of production = 40% of revenue

Depreciation = RM50,000

Project is financed 60/40 debt-equity

Cost of debt = 6% p.a.

Industry geared equity beta = 1.8

Industry debt-equity ratio = 1:5

XYZ equity beta = 1.6; 30% of long-term capital is risk-free

Risk-free rate = 2.5% p.a.

Market portfolio return = 8%

Tax = 30%
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NPV-WACC Example – Fixed Debt

Start by calculating FCF
RM Calculation
Annual Revenue
Less: Cost of Production
(40%)
3,000,000
(1,200,000) 3,000,000 x 0.4
Profit before Tax
1,800,000
Less: Tax (30%)
(540,000) 1,800,000 x 0.3
FCF for 1 year
1,260,000
Assumption: The RM3,000,000 revenue is in cash
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NPV-WACC Example – Fixed Debt

We now need a few things, so let’s work backwards:
 We
 To
do so, we need Ke and Kd (Kd already provided)
 We
 To
need to calculate WACC
need to calculate Ke
do so, we need to calculate company beta
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NPV-WACC Example – Fixed Debt

Step 1: Calculate Company Beta
𝛽
𝛽 ∗
𝐷
𝐷
𝐸
𝛽 ∗
𝐸
𝐷
𝐸
From the question:
Industry debt-equity ratio = 1:5
so we assume that XYZ has the same debt-equity ratio: D = 1, E = 5
XYZ’s equity beta = 1.6
XYZ’s debt beta = risk-free = 0
0
1
1
5
1.6
5
1
5
1.333
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NPV-WACC Example – Fixed Debt

Step 2: Calculate Cost of Equity
𝑘
𝑟
𝛽 𝑟
𝑟
From the question:
Rf = 2.5%
Rm = 8%
Company Beta (calculated earlier) = 1.333
Therefore, Ke
0.025
1.333 0.08
0.025
0.098315
9.83%
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NPV-WACC Example – Fixed Debt

Step 3: Calculate WACC of the project
𝑊𝐴𝐶𝐶
1
𝑇 𝑘
𝐷
𝐷
𝐸
𝑘
𝐸
𝐷
𝐸
From the question:
T = 30%
Kd = 6%
Ke (calculated earlier) = 10.04%
Project is financed 60/40 debt-equity
Therefore, WACC:
1
0.3 0.06
0.6
0.098315
0.4
= 0.06453 = 6.453%
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NPV-WACC Example – Fixed Debt

Step 4: Calculate NPV. Since FCF is constant, we can use the
PV of Annuity Formula
1
1 𝑊𝐴𝐶𝐶
𝑁𝑃𝑉 𝐹𝐶𝐹
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑊𝐴𝐶𝐶
FCF = RM1.26mn; WACC = 6.534%; Initial investment = RM0.6mn
Therefore:
𝑁𝑃𝑉
𝑅𝑀1.26𝑚
1
1
1.06453
0.06453
= RM8.478mn
𝑅𝑀0.6𝑚
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NPV-WACC Example – Rebalanced D/E Ratio

ABC is considering diversifying its operations by setting up a manufacturing division to
produce medical masks. Its first potential project entails buying 2 machines for a total of
RM600,000. This will produce annual revenue of RM5 million, for 10 years. The cost of
production is expected to be 50% of the revenue and the depreciation is RM60,000 per
year, using the straight-line method. No inflation is considered in this case. After 10 years,
this project will be scrapped to zero value.

Sixty per cent (60%) of the initial cost of the project will be financed by debt. The loan
will be irredeemable and carry an annual interest rate of 5%. The balance of finance will
come from a placement of new equity. It is assumed that there are no issue costs
associated to this.

The manufacturing industry (for medical masks) has an average geared equity beta of 1.2
and a debt-to-equity ratio of 1:6 by market values. Frost’s current geared equity beta is
1.6 and 30% of its long-term capital is represented by debt that’s generally seen as riskfree. The risk-free rate is 4% a year and the expected return on an average market
portfolio is 10%. Corporation tax is set at 30% per annum.
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NPV-WACC Example – Rebalanced D/E Ratio

FCF = RM5,000,000 – 2,500,000 – 750,000 = RM1,750,000
See if you can figure it out!


In this question, we assume that the project is financially significant enough to alter ABC’s
capital structure and subsequently, WACC – which affects our NPV calculation

In order for ABC to maintain its current capital structure, it would have to rebalance it’s
D/E ratio

There are 4 steps to this:
Step 1: Unlever / ungear equity beta

𝛽
𝛽 ∗
𝐷
𝐷
𝐸
𝛽 ∗
𝐸
𝐷
𝐸

Step 2: Re-calculate the levered equity beta using new debt-equity ratio
𝐷
𝛽
𝛽
𝛽
𝛽
𝐸

Step 3: Recalculate cost of equity using new levered equity beta (use CAPM)

Step 4: Recalculate WACC (as normal)
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NPV-WACC Example – Rebalanced D/E Ratio

𝛽
Step 1: Ungear equity beta
𝛽 ∗
𝛽 ∗
0

𝛽
1.6
Step 2: Re-calculate the levered equity beta using new debt-equity ratio
𝛽
𝛽
1.37

1.37
𝛽
1.37
0
.
.
3.425
Step 3: Step 3: Recalculate cost of equity using new levered equity beta
𝑘
𝑟
𝑘
0.04
𝛽 𝑟
𝑟
3.425 0.1
0.04
0.2455
24.55%
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NPV-WACC Example – Rebalanced D/E Ratio

Step 4: Re-calculate WACC
𝑊𝐴𝐶𝐶
1
𝑇 𝑘
𝑊𝐴𝐶𝐶
1
0.3 0.05 0.6

𝑘
0.2455 0.4
0.021
0.0982
0.1192
11.92%
Finally, Calculate NPV
𝑁𝑃𝑉
𝐹𝐶𝐹
𝑁𝑃𝑉
𝑅𝑀1.75𝑚
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
.
.
𝑅𝑀0.6𝑚
𝑅𝑀9.32𝑚
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Net Present Value using WACC
Fixed‐Debt
Rebalanced
Step 1:
Calculate FCF
Step 2:
Calculate
Company Beta
Step 1: Calculate
FCF
Step 2: Ungear
Equity Beta
Step 4:
Calculate
WACC
Step 3:
Calculate Cost
of Equity
Step 4: Recalculate
Cost of Equity
using new Beta
Step 3: Recalculate
levered equity Beta
Step 5: Recalculate
WACC
Step 6: Calculate
NPV
Step 5:
Calculate NPV
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