Chapter-16

Valuation and
Financing
Chapter Objectives
 Understand the relationship between leverage, beta
and the cost of capital.
 Explain the unlevering and levering of beta for
calculating the cost of capital.
 Discuss the utility and limitations of WACC in
evaluating an investment project.
 Compare the free cash flow (FCF) approach and the
capital cash flow (CCF) approach of investment
evaluation.
 Focus on the advantages of using the adjusted present
value (APV) approach in project evaluation.
 Explain the methodology for determining the value of
the firm and the value of equity.

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Asset Beta
 The unlevered beta is a measure of the business risk of the
firm.
 A firm has a portfolio of assets, and therefore, the asset beta
of a firm, a is the weighted average of betas of individual
assets.
 Average asset beta = beta of asset 1  weight of asset 1 + beta
of asset 2  weight of asset 2 +…+ beta of asset n  weight of
asset n.
 A firm’s assets are generally financed by debt and equity.
Therefore, a firm’s asset beta is also equal to the weighted
average of the firm’s equity beta and debt beta. Assuming no
corporate tax, the beta of assets will be as follows:

E D
a  e  d
V V
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Equity Beta and Cost of Equity
 Equity beta of a levered firm:
D
e   a  ( a   d )
E
 Cost of equity of a levered firm with risky debt as follows:
 D
ke  rf  rp   a    a   d  
 E
 We can rewrite Equation as follows to decompose risk premium into
business risk and financial risk:
D
ke  rf  rp  a  rp   a   d 
E
 You may notice that shareholders of the levered firm demand
premium equal to rpβa for assuming the business risk and additional
premium equal to rp(βa – βd)D/E for assuming the financial risk.

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Cost of Capital
The asset or opportunity cost of capital is the
same as the pre-tax WACC. Hence,
E D
Pre-tax WACC  ke  kd  k a
V V
 E D
 rf  rp   e   d 
 V V
 rf  rp  a

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Unlevering and Relevering Beta
 The equity beta of the firm will change when its
financial risk has changed. Two steps are involved in
estimating the new equity beta of the firm:
 You should unlever the firm’s equity beta. This means that
you should estimate the firm’s asset beta:
E D
a  e   d 
V V
E
a  e  (If  d  0)
V
 You should now relever the equity beta to reflect the new
debt-equity ratio:

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Unlevering and Relevering Beta
 You should now relever the equity beta to
reflect the new debt-equity ratio:
E
e  a  (a  d ) 
S
a  D
e    a 1  
E /V  E

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Corporate Taxes, Interest Tax
Shields and Beta
 Fixed debt-to-value ratio
 The beta of the interest tax shields will be equal
to the asset beta. This implies that interest tax
shield will not reduce the risk of the firm.
 The asset beta of the levered firm (1) will be
equal to the asset beta of the unlevered firm
(u).

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Corporate Taxes, Interest Tax
Shields and Beta
 Fixed amount of debt
 The interest tax shields are as safe or risky as
debt is. Hence the beta of the interest tax
shields will be equal to the beta of debt. We
discount the interest tax shields by the cost of
debt.
 The equality of the betas of the interest tax
shields and debt under the fixed debt
assumption means that a levered firm
(or project) will have lower systematic risk.
Therefore, the asset beta should be adjusted
for the tax effects of debt.
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 Summary of Methods of Calculating
Asset Beta and Equity Beta
Fixed Debt Ratio Fixed Amount of Debt
Risky Debt Risk-free Debt Risky Debt Risk-free Debt
No Corporate Taxes
Asset E D E E D E
beta  a   e   d a  e a  e  d a  e
V V V V V V
Equity D  D D  D
beta  e   a  ( a   d )  e   a  1    e   a  ( a   d )  e   a 1  
E  E E  E
Corporate Taxes
Asset E D E  E D  1  e
beta  a   e   d     a   e   d   a 
V  1  D V T 
a e
V V V  D 
 V
1  1  T  
 E 
Equity E  E  E  E  E 
beta  e   a  ( a   d )   e   a 1    e   a 1  1  T     d  e   a 1  1  T  
S  S  S  S  S 

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Free Cash Flow and WACC
 FCF is calculated as follows:
 FCF = EBIT (1 – T) + DEP – NWC – CAPEX
 FCFs are unlevered cash flows, which are
available for serving both equity shareholders
and debt holders.
 WACC is the ‘levered’ cost of capital. How
can you determine the ‘unlevered’ cost of
capital?
 The opportunity or the asset cost of capital of a
pure-equity firm is the unlevered cost of capital.
Under CAPM, the opportunity cost of capital, ka,
can be calculated. Shown earlier that the
opportunity cost of capital, ka, is also equal to the
pre-tax WACC.
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Adjusting the Firm’s WACC for the
Project’s Risk and Debt Capacity
 The following steps are involved in calculating
the project’s cost of capital:
 First, calculate the firm’s opportunity cost of
capital (assuming that MM Proposition I
works).
 Second, calculate the new cost of debt.
 Third, calculate the project’s cost of equity.
 Fourth, calculate the project’s cost of capital
as the after-tax weighted average cost of debt
and the cost of equity.

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Equity Cash Flows and The Cost of
Equity
 In the equity cash flow (ECF) approach,
ECFs are calculated net of debt flows
(i.e., interest, interest tax shield and
repayments). Since these residual cash
flows include the effect of debt, they are
also called levered cash flows. This
approach discounts ECFsthe cash flows
available to shareholders at the levered
cost of equity, ke.

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Limitations of the WACC
 This approach has the following limitations:
 Cash flow patterns
 Business risk
 Debt capacity
 Issue costs
 Financing effects
 We need alternative methodologies than the WACC
approach to evaluate projects that do not have
constant debt ratio, have different cash flow patterns
and have several financing effects. We discuss two
alternative approaches – the capital cash flows (CCF)
and the adjusted present value (APV).

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 Capital Cash Flows and the
Opportunity Cost of Capital
 In this approach capital cash flows are
discounted at the project’s opportunity cost of
capital. Capital cash flows are the free-cash
flows plus the interest tax shields:
Capital cash flows (CCF)  Free cash flows  Interest tax shield
 ( EBIT  kd D )(1  T )  kd D  DEP  NWC  Capex
  EBIT (1  T )  DEP  NWC  Capex   Tkd D
                
Free Cash Flows Interest
Tax Shield

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Adjusted Present Value (APV)
 The APV approach can handle any patterns of cash flows
(perpetuity or uneven cash flows) and it can be extended to
calculate the adjusted present value of an investment project
incorporating several financing effects. It divides the net present
value of a project into two main parts: the first part consists of the
all-equity NPV or the base-case NPV assuming that the project is
entirely equity financed and the second part consists of the value of
the interest tax shields and other financing effects:
 APV = All-equity NPV + Value of financing effects

 The application of the APV approach involves the following three

steps:
 First, find the ‘all-equity NPV’, or the “base-case NPV”.
 Second, find the present value of cash flows resulting from the financing of the
project. Each cash flows are discounted by the discount rate appropriate to the
risk of each cash flow.
 Third, sum the ‘all-equity NPV’ and the present value of financing effects to arrive
at the project’s NPV.

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Adjusted Present Value (APV)
 Issue Costs:
 APV = All-equity NPV + PV of interest tax shields – Issue
costs
 Fixed Debt Ratio:
 Under the assumption of the constant capital structure (fixed
debt ratio), the CCF approach, the modified (compressed)
APV approach and the FCF will give the same value for the
project.
 Fixed Debt:
 APV approach considers them less risky and discounts at
the cost of debt (the market interest rate).

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APV and Subsidised Financing
 The interest tax shields are discounted at the
pre-tax cost of debt, and the after-tax interest
subsidies are discounted at the after-tax cost
of debt. The project’s APV will be as shown
below:
 APV = Investment + All-equity PV + PV of
interest tax shields + PV of interest subsidies.
 Value of the Subsidised Financing
 amount is equal to the present value of the
interest subsidy.

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Adjusted Cost of Capital
 The project’s NPV will be zero at this rate.
The adjusted cost of capital is equal to the
opportunity cost of capital less the value
created by the project by adding to the firm’s
debt capacity. This minimum rate is the
adjusted cost of capital, k*.
 Instead of using APV approach, we can
discount a project’s free cash flows at the
adjusted cost of capital.
 The adjusted cost of capital is the MM
formula for the cost of capital of a levered firm
(project).
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Miles and Ezzell’s Formula for Adjusted
Cost of Capital
 We can use the Miles–Ezzell formula when
debt ratio is fixed and the amount of debt
rebalances.
D  1  ka 
k  ka  Tkd 
*

V 1  k d 

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Valuation of a Firm
 The value of a firm depends on the expected cash flows
and the discount rate.
 Value of the firm is given as follows:
n
FCFt
V 
t  1 (1  k0 )
t

where FCF is the free cash flow and k0 is the weighted

average cost of capital (WACC).
 If we assume constant relations of earnings, working
capital and capital expenditure to sales, we can write the
equation for the free cash flows as follows:
NCF  FCF  SALES  p  (1  T )  DEP  (w  f )SALES

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Estimating Free Cash Flows
 Sales projections
 Estimate of expenses
 Estimate of depreciation
 Capital expenditure
 Estimates of increase in net working
capital
 Treatment of interest expenses
 Tax rate
 Inflation

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Horizon Period and Terminal Value
 In the case of a firm, it continuously makes investments
that generate revenues and cash flows, theoretically,
forever. Therefore, the financial analyst assumes a
horizon period because detailed calculations for a long
period become quite intricate. The financial analysis of
such projects incorporate an estimate of the value of
cash flows after the horizon period without involving
detailed calculations. Thus, the value of the firm is given
as follows:
H
FCFt TVH
V  
t  1 (1  k0 ) (1  k0 ) H
t

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Methods of Valuing Terminal Value
 Constant perpetual cash flows
 Growing perpetual cash flows
 Price-earnings (P/E) ratio
 Market-to-book value (M/B) ratio
 Replacement cost of assets

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Value of the Firm’s Equity
 Identify sales growth and profitability assumptions.
 Consider depreciation, change in net working capital, capital
expenditure and taxes in estimating the free cash flows.
 Estimate the amounts of free cash flows for the horizon period.
 Estimate the cash flow patterns beyond the horizon period and
determine the terminal value.
 Estimate the firm’s weighted average cost of capital.
 Be consistent in treating inflation in the estimation of free cash
flows and WACC.
 Compute present value cash flows using WACC as the discount
rate.
 Subtract the value of the outstanding debt from the value of the
firm to find out the value of its equity.

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Growth Patterns and the Firm Value
 The DCF valuation of a firm makes
assumptions about the growth patterns of the
firm during the horizon period and beyond.
Generally, there are the following four
possibilities:
 No growth
 Constant growth
 Two-stage growth
 Three-stage growth

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Comparative Firms Valuation
Approach
 Identify the comparable firms based on the criteria of
similar products, size, age, growth and profitability
trends.
 For the comparable firms, calculate the firm value as
a ratio of sales, EBIT, free cash flows and market
value-to-book value of assets. Sales, EBIT, free cash
flow and book value of assets are assumed as value
drivers. Notice that firm value to EBIT ratio is
equivalent of price-earnings (P/E) ratio.
 Average the ratios of the comparable firms, and apply
them to the sales, EBIT and free cash flow data of
the firm.

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Balance Sheet Approach to Firm
Valuation
 Balance sheet or adjusted book value uses
assets and liabilities information to determine
the value of the firm.
 One approach to estimate the adjusted book
values of assets is to determine their current
or replacement costs.

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