Valuation Lecture I: WACC vs.
APV and Capital Structure
Decisions
Financial Decisions
Timothy A. Thompson
Market value balance sheet
Market value assets
Market value claims
Total enterprise value
Total enterprise value
Notation
Asset or claim
C = excess cash
A = value of projects
(unlevered)
D = mkt value debt
E = mkt value equity
TS = debt tax shields
Net debt = D’ = D – C
TEV = D – C + E
Required return, beta
rc, βc
ra, βa,reu,βeu
rd,βd
reL,βeL
rTS,βTS
Balance sheet mathematics

Logic:
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LHS and RHS of B/S must be equal
Assume that TS refers to the present value of tax shields net
of costs of financial distress
V  C  A  TS  D  E
TEV  ( A  TS )  ( D  C )  E
E  ( A  TS )  C  D
Calculating the equity value of the
firm

Equity method

Present value of all future cash flows to equity




Discounted at the required return on the levered equity
of the firm, reL, (based on levered equity beta, βeL)
reL is greatly affected by differences in leverage
Method buries future net debt payments into the equity
cash flow
Valuation by components

E = TEV + C – D
Valuation by components method

Value the total enterprise value of the firm by
discounting all the operating asset cash flows

Discounted at either


Or at


The unlevered cost of equity reU (APV method)
What is the difference between WACC and reU?


WACC (using the WACC method)
TAX SHIELDS
Equity = Total enterprise value + Excess Cash –
Market Value of Financing Obligations
Value of investment is the present value
of the investment’s cash flows (DCF)

Cash flows are measured as free cash flows from
operations



From operations means no financing-related cash flows are
included
Free cash flows means after expected new investments
When financial structure matters either

Discount operating free cash flow at WACC


WACC incorporates tax benefits of debt into the valuation by
reducing the discount rate relative to reU , WACC method
Discount operating free cash flow at reU (gives VU)

Then add the present value of tax benefits of debt financing
explicitly (VL = VU + PVTS), APV method
What about costs of financial distress?


Theoretically, whatever costs of financial
distress (COFD) have not been subtracted off
in the operating cash flows should be
subtracted from either method (WACC or
APV)
Often difficult to estimate COFD


Good to develop intuition about what COFD are
Understand what business likely to suffer from
large/small COFD
Capital Structure

Tradeoff theory of the capital structure




Value of the firm is a function of capital structure
(in particular, the debt/value ratio)
As firm levers up (from zero leverage, holding
investments fixed) value increases due to PVTS
(and perhaps for other reasons)
As firm levers up, the value decreases due to
COFD
Want to find the happy medium!
Tradeoff Theory of the Capital Structure
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
How do you calculate PVTS?
Simple model, Fin II
 For example in the 40% debt scenario

Assume that the level of debt in the scenario is
perpetual debt
How do you calculate COFD?


Difficult
COFD is the present value of all future
expected costs associated with financial
distress

If you did a method in Fin II, you can go ahead
and attempt it


You would need inputs that are not in the case, and you
would have to look them up
If you didn’t learn a method in Fin II

You can try to figure out a good guess from Chapter
17/18 of BM
Structure of COFD

COFD is a function of


The probability of financial distress
The cost of financial distress conditional on the
firm becoming financially


COFD could be small even if distress is likely, if the firm
would not likely incur large costs in distress
However, if we are pretty certain that the probability of
distress is very small, then the above “product” is likely
to be very small and PVTS is likely to exceed COFD
Bond Ratings

Investment Grade Ratings


Junk Bond Ratings


AAA, AA, A, BBB (S&P)
BB, B, CCC, etc.
If proforma bond rating (based on a certain
capital structure) is high investment grade


AAA or AA, maybe even high A
Then probability of subsequent bankruptcy is very low
(see BM) – these would very likely be safe capital
structures