ACF213214 Finance I Finance II Lecture 11 Learning

ACF-213/214 Finance I / Finance II Lecture 11

Learning Outcome Understand the nature and implications of alternative longterm financing decisions

Topics Financial Risk and Expected Returns Corporate Valuing Using and Personal Taxes Businesses WACC in Practice

Table 17. 1 Macbeth Spot Removers

Table 17. 2 Macbeth Spot Removers

Table 17. 3 Macbeth’s Leverage

Figure 17. 1 Macbeth’s EPS

Financial Risk and Expected Returns

Financial Risk and Expected Returns Continued

Financial Risk and Expected Returns Continued 2 Example: Macbeth continued

Financial Risk and Expected Returns Concluded

Table 17. 4 Macbeth Shares

Leverage and the Cost of Equity

Figure 17. 2 MM’s Proposition

How Changing Capital Structure Affects Beta

A Final Word on the After-Tax Weighted. Average Cost of Capital • WACC is the traditional view of capital structure, risk, and return. • The tax benefit from interest expense deductibility must be included in the cost of funds • This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate

After-Tax WACC Tax-Adjusted Formula

Figure 17. 4 Estimated After-Tax WACC

Table 18. 1 Median Book-Value Ratios of Debt to Debt-Plus-Equity Note: Debt-to-total capital ratio = D/(D + E), where D and E are book values of long-term debt and equity.

Table 18. 3 Market Value Balance Sheets

Figure 18. 4 Ace Limited Total payoff to Ace Limited security holders. There is a $200 bankruptcy cost in the event of default (shaded area).

Debt and Incentives Circular File Company has $50 of 1 -year debt

The Trade-Off Theory of Capital Structure Trade-Off Theory that capital structure is based on trade-off between tax savings and distress costs of debt

The Pecking Order of Financing Choices Pecking-Order Theory stating firms prefer to issue debt over equity if internal finances are insufficient Starts with asymmetric information, meaning that managers know more about their companies’ prospects, risks, and values than do outside investors.

Implications of the Pecking Order 1. Firms prefer internal finance 2. Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends

Implications of the Pecking Order Continued 3. Internally generated cash flow is sometimes more than capital expenditures, other times not 4. Due to dividend policies, plus fluctuations in profitability and investment opportunities If more, firm pays off debt or invests in marketable securities If less, firm first draws down cash balance or sells holdings of marketable securities If external finance is required, firms issue the safest security first They start with debt, then possibly hybrid securities, such as convertible bonds, then equity as a last resort

Chapter Opening—Financing & Valuation Adjust the Discount Rate Modify the discount rate to reflect capital structure, bankruptcy risk, and other factors Adjust the Present Value Assume an all-equity-financed firm and then make adjustments to value based on financing

Chapter Opening—Financing & Valuation Continued Adjusted present value APV = base-case value + value of financing side effects Base-case value = all-equity-financed firm NPV Value of financing side effects = all costs/benefits directly resulting from project

The After-Tax Weighted-Average Cost of Capital Tax-Adjusted Formula

Example 19. 1 Calculating Sangria’s WACC Sangria is a U. S. -based company whose products aim to promote happy, lowstress lifestyles. The firm’s cost of debt is 6% and the cost of equity is 12. 5%. The market-value balance sheet shows assets worth $1, 250 million.

Example 19. 1 Calculating Sangria’s WACC Continued

Example 19. 1 Calculating Sangria’s WACC Continued 2 Sangria is consistently profitable and pays taxes at the marginal rate of 21%. The inputs for WACC are summarized below.

Example 19. 1 Calculating Sangria’s WACC Concluded Sangria’s after-tax WACC is:

Example 19. 2 Using Sangria’s WACC to Value a Project Sangria’s enologists have proposed investing $12. 5 million in the construction of a perpetual crushing machine. The machine never depreciates and generates a perpetual stream of earnings and cash flow of $1. 487 million per year pretax.

Example 19. 2 Using Sangria’s WACC to Value a Project Continued Note: This after-tax cash flow does not account for interest tax shields on debt supported by the perpetual crusher project.

Example 19. 2 Using Sangria’s WACC to Value a Project Continued 2 The crusher generates a perpetual after-tax cash flow of C = $1. 175 million, so NPV is: NPV = 0 is a barely acceptable investment.

Example 19. 2 Using Sangria’s WACC to Value a Project Continued 4 Calculate the expected dollar return to shareholders: After-tax interest = r. D(1 − Tc)D =. 06 × (1 −. 21) × 5 =. 237 Expected equity income = C − r. D(1 − Tc)D = 1. 175 −. 237 =. 938

Valuing Businesses Valuing a business or project The value of a business or project is usually computed as the discounted value of FCF out to a valuation horizon (H) The valuation horizon is sometimes called the terminal value

Valuing Businesses Continued Valuing a business or project PV (free cash flow) PV (horizon value) In this case, r = WACC

Valuing Rio Corporation FCF = Profit after tax + depreciation + investment in fixed assets + investment in working capital FCF = 10. 6 + 9. 9 − (109. 6 − 95. 0) − (11. 6 − 11. 1) = $5. 3 million

Valuing Rio Corporation Continued Estimating Horizon Value To find the present value of the cash flows in years 1 to 6, we discount at the 9. 4% WACC:

Table 19. 1 Free-Cash-Flow Projections and Company Value for Rio Corporation ($ millions)

Table 19. 1 Free-Cash-Flow Projections and Company Value for Rio Corporation ($ millions) Continued

Valuing Rio Corporation Continued 2 The free cash flow is $8. 5 million so,

Valuing Rio Corporation Concluded This is the total value of Rio. To find the value of the equity, we simply subtract the 40% of the firm value that will be financed with debt.

Example: Sangria Corporation APV for the perpetual crusher APV is the sum of base-case value and PV (interest tax shields):

Example: Sangria Corporation Continued Suppose Sangria plans to keep project debt fixed at $5 million. We assume the risk of the tax shields is the same as the risk of the debt and discount at 6% rate on debt:

Example: Sangria Corporation Concluded Suppose Sangria has to finance the perpetual crusher by issuing debt and equity. It issues $7. 5 million of equity with issue costs of 7% ($. 53 million) and $5 million of debt with issue costs of 2% ($. 10 million). APV = – 0. 63 + 1. 05 –. 53 –. 10 = –. 21 million, or $210, 000

APV for Entire Businesses Example: Rio Sangria decided to make an offer for Rio. If successful, it plans to finance the purchase with $62 million of debt and intends to pay down the debt to $53 million in year 6. Rio’s horizon value is $132. 7 million Debt ratio at the horizon is projected: 53/132. 7 =. 40, or 40%

APV for Entire Businesses Continued Table 19. 2 shows projections of free cash flows from Table 19. 1 (next slide) The resulting base-case value for Rio is: $28. 5 + 75. 3 = 103. 8 million APV = base-case NPV + PV(interest tax shields) = $103. 8 + 3. 6 = $107. 5 million