Valuation and Capital
Budgeting for the
Levered Firm
Key Concepts and Skills
Understand the effects of leverage on project
value
 Value levered projects using

 Adjusted
Present Value (APV)
 Flows to Equity (FTE)
 WACC
2
Leverage and Project Value

Why might leverage affect the value of a
project?

What will/should happen to the value of the
project as more debt is used to finance the
project?
3
Adjusted Present Value Approach
 Project
value =
No
debt (NPV)
plus PV of financing (NPVF)
APV = NPV + NPVF
4
APV Example
Consider a project with perpetual cash flows of $140,000 per year.
If the tax rate is 34%, should the firm take the project if it costs
$475,000?
0
1
2
The unlevered cost of equity is rE = 20%:
PV =
NPV =
5
APV Example


Now, assume the firm uses 126,229.50 of debt to
help finance the project, the cost of debt is 10%
We can adjust the unlevered firms NPV by adding
the tax shied to find the levered value of the project
APV = NPV + PV(Tax Shield)
6
Flow to Equity Approach

Discount cash flows to equity holders of
the levered firm at the cost of levered
equity capital, rE
1. Calculate the levered cash flows to equity
(LCFs)
2. Calculate rE
3. Value the LCFs at rE
7
First Find Re of the Levered Firm
D
RE  RU  (1  tC )( RU  RD )
E
D = 126,229.50
V=
E=

8
Calculating LCF
The project makes $140,000 per year
 What do the equity holders get?

9
Alternative LCF Calculation
The only difference between the unlevered
firm’s cash flow to equity and the levered
firm’s is the after tax interest payment
 Unlevered: 92,400
 After Tax Interest Payment:
 Cash flow to equity :

10
Flow to Equity NPV
Eq. PV =
 Eq. NPV =

11
WACC Method
rWACC
E
D

RE 
rD (1  tC )
DE
ED

Discount the unlevered cash flows at the levered
WACC

D = 126,229.50; V = 504,918; E = 378,688.5
12
WACC Valuation
Unlevered Cash flows = 92,400
 WACC = 18.3%
 NPV =

13
Notes on APV, FTE, & WACC
WACC or FTE if the firm’s target
debt-to-value ratio applies to the project
over the life of the project.
 Use the APV if the project’s level of debt
is known over the life of the project.
 Use

14
WACC is the most widely used in practice.
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment
Cash Flows
Discount Rates
15
All
UCF
rU
All
UCF
rWACC
Equity Portion
LCF
rE
Summary
16
1.
The APV formula can be written as:
2.
The FTE formula can be written as:
3.
The WACC formula can be written as