INTRODUCTION TO FINANCE

NOTES ON VALUATION: UNLEVERING &

RELEVERING

NPV: Measuring Value Creation

The value of a new idea is captured as NPV:
C
1

( )

( )

n
2
NPV = I +
+
+
...
+
n
2
0 1+ r
1+ r
1+ r

where I0 (or C0) is the investment cost of the project

and Ci is the cash flow in period I
And value of an existing entity is given by?
Just remove the N from NPV and -I0 from the right hand
side of the equation!

Valuing an Idea/Project
There are two basic ingredients to conducting a
valuation:
Cash Flows: Who do they belong to?
Cost of Capital, r: Who does this belong to?

We have spent some time on cash flows

We have also spent some time on risk and
return, and the cost of capital
For convenience, we assumed all
ideas/projects/firms were equity financed
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Cash Flows From Real Assets

Assumptions
Let us assume for convenience that
EBIT*(1-Tc) is FCF
We will also assume that depreciation is
not part of COGS
We will use perpetuities when valuing
companies
5

Financing: The Real World

Two reasons why capital structure might affect
firm value in the real world:
Capital structure policy may result in the realization of
tax benefits due to the interest tax shields provided by
debt at the corporate level
The capital structure policy adopted by a company's
management may lead to costs incurred due to the
presence of debt, especially if the firm is in financial
distress

Financing: The Real World (Cont.)

There are four methods of valuation

Enterprise Value (WACC) Method

Adjusted Present Value (APV) Method
Equity Valuation Method
Multiples

Here we will focus on the first three methods

We will assume that costs of bankruptcy are low
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Method I: Enterprise Value Method

The value of a company is given by

EBIT (1 Tc )
V =
L
WACC
Where,

D
EL
L
WACC = ( 1 Tc )E(Rd ) +
E(Re )
VL
VL
8

Method I: Components of WACC

Need weights to be determined (of equity and
debt: a policy decision)
Need returns on debt and equity
Need tax rate
But need return on assets from comparables to
figure out return on equity!
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Method II: Adjusted Present Value (APV)

(a) Assume tax shield as risky as debt and if
debt is fixed:

V = V + PV (TS )
L U
EBIT (1 Tc ) Tc DRd
=
+
= V + Tc D
U
Ra
R
d

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Method II: Adjusted Present Value (APV)

(b) Assume tax shield as risky as assets:

V = V + PV (TS )
L
U
EBIT (1 Tc )
=
+ PV (TS )
Ra
The tax savings generated from interest
payments on debt will be discounted by
return on assets
11

Method II: Components of APV

Need return on debt and levels of debt today
and in the future
Need tax rate
But need return on assets from comparables to
figure out value of unlevered firm!

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Method III: Equity Valuation Method

The third method is to value the equity and
debt,

V =E+D
L
[ EBIT I ] (1 Tc )
=
+
D
=
E
+
D
L
Re

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Method III: Components of Equity Valuation

Need weights to be determined (of equity and
debt: a policy decision)
Need return on equity
Need levels of debt now and in the future to
calculate interest payments
But need return on assets from comparables to
figure out return on equity!

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The Firm With Tax Shield

ASSETS

LIABILITES

REAL ASSETS

EQUITY

Tax Shield (TS)

DEBT

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Un-levering: Big Picture

To figure our return on assets in the business
need comparables (all valuation is relative!)
Have to assume whether the tax shield provided
by the interest payments on debt is as risky as
debt OR as risky as assets

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Un-levering I
Suppose tax shield from debt is as risky as debt

D (1 T )
E
c
R =
R +
R
a E + D (1 T ) e E + D (1 T ) d
c
c
Beta equation is identical: replace Rs by
betas

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Un-levering II
Suppose tax shield from debt is as risky as
assets

E
D
R =
R +
R
a
E+D e E+D d
Beta equation is identical: replace Rs by
betas
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Re-levering
Used in Enterprise Valuation and Equity
Valuation Methods to figure out your
return on equity
Same equations but now need to re-lever
based on your capital structure

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Why Dont Firms Have 100% debt?

The tax-deductibility of interest on debt implies
that firms should have 100% leverage, but firms
do not borrow 100% (average in mid 30%s)
Why?
Some potential reasons:
1.

Personal taxes favor equity

2.

Bankruptcy-related costs

Valuation methods ignore these issues in practice

and should be adjusted for these effects (more
advanced topics)
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