Capital Budgeting and

Valuation with Leverage

Finance for AE

dr. Mario Bersem

University of Amsterdam

Finance for AE Lecture 12 Mar 17, 2020 1

 Today’s Agenda

Chapter §18.1 - §18.5:

• Takes into account effect of tax deductibility of interest
payments on the investment decision (also cf. Chapter 15);
• three methods are covered:
– WACC (§18.2)
– Adjusted Present Value or APV (§18.3)
– Free Cash Flow to Equity or FCFE (§18.4)

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 Assumptions
1. The project under consideration has the same risk as
the firm
– Assumption allows the use of the firm’s cost of capital to value
the project. It is maintained in §18.1 – §18.4 and relaxed in
§18.5.

2. The leverage ratio (D/E) remains constant

– Assumption allows use of the WACC method (cf. exercises in
tutorial #6).

3. Taxes are the only imperfection

– Taxes are only departure from perfect market assumptions.

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 The Weighted Average Cost of Capital
(WACC) method
• Use after-tax WACC as a discount rate
• If we have constant D/E ratio, then we can discount
unlevered cash flows to determine levareged value:

E D
rwacc = rE + rD (1 - t c )
E + D E + D

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 Table 18.1: determine FCF

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 Value of Levered Project
• Because the WACC incorporates the tax savings from
debt, we can compute the levered value of an
investment, by discounting its future free cash flow
using the WACC.

FCF1 FCF2 FCF3

V 0
L
= + + + !
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) 3

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 Exercise
Suppose telco equipment co. Alcatal Lucent has:
• equity cost of capital of 9.4% ; debt cost of capita of
7.1% ;
• market capitalization of 9.49 bn ; enterprise value of
13 bn ;
• and the tax rate is 33%.
(a) Calculate WACC
(b) Given constant D/E-ratio, what is the value of the
project with the following expected cash flows:
Year 0 1 2 3
FCF -100 52 100 65
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 Solution
9.49 13 - 9.49
a. rwacc = 9.4% + 7.1%(1 - 0.35) = 0.0686 + 0.0125 = 0.0811 = 8.11%
13 13
b. Using the WACC method, the levered value of the project at date 0 is
52 100 65
VL = + + = 48.10 + 85.56 + 51.44 = 185.1.
1.0811 1.08112 1.08113
Given a cost of 100 to initiate, the project’s NPV is 185.1 – 100 = 85.1.

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 Debt Capacity
• Fixed D/(D+E) ratio (=d), therefore adjustments to
debt level are required over time
• Debt capacity = the level of debt that is needed to
maintain d:
Dt = d ´ Vt L
• VLt calculated as:
Value of FCF in year t + 2 and beyond
!
FCFt + 1 + Vt L+ 1
Vt L
=
1 + rwacc

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 The Adjusted Present Value Method (APV)
• Calculate the levered value of the firm (VL) by:
1. Calculating the unlevered value of the firm (VU)
2. Then adding the value of the interest tax shield:
V L = APV = V U + PV (Interest Tax Shield)

Nota Bene: Use unlevered cost of capital (also called

pre-tax WACC) as a discount rate:
E D
rU = rE + rD = Pretax WACC
E + D E + D

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 APV
1. Determine unlevered firm value:
T
FCFt
V =å
U

t =1 (1 + rU )
t

2. Add present value of the interest tax shields:

ITSt = t c ´ INT = t c ´ rD ´ Dt -1

T
ITSt
PV ( ITS ) = å
t =1 (1 + rU ) t

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 Exercise

• Equity cost of capital: 10%

• Market capitalization: 10.8 bln
• Enterprise value: 14.4 bln
• Debt cost of capital: 6.1%
• Tax rate: 35%
– (a). What is the unlevered cost of capital?
– (b). What is the unlevered value of the project?
– (c). What are the interest tax shields from the project?
What is their present value?

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 Solution
10.8 14.4 − 10.8
rU = 10% + 6.1% = 9.025%
14.4 14.4
50 100 70
VU = + 2
+ 3
= 184.01
1.09025 1.09025 1.09025
• Using the results from the previous example:
Year 0 1 2 3
FCF –100 50 100 70
VL 185.86 151.64 64.52 0
D = d*VL 46.47 37.91 16.13 0.00
Interest 2.83 2.31 0.98
Tax Shield 0.99 0.81 0.34

The present value of the interest tax shield is

0.99 0.81 0.34
PV(ITS) = + 2
+ 3
= 1.85
1.09025 1.09025 1.09025

VL = APV = 184.01 + 1.85 = 185.86 Check answer with the WACC method!

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 The Flow-to-Equity Method
• Calculate Free Cash Flow to Equity: i.e. excluding payments to
creditors (debt holders: interest and repayment)
• Value Equity Cash Flows using equity cost of capital
• Net Borrowing at t = Dt - Dt-1

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 FCFE
• The FCFE can also be calculated, using the free cash flow, as

FCFE = FCF - (1 - t c ) ´ (Interest Payments) + (Net Borrowing)

After-tax interest expense

Unlevered Net Income

FCF = (Re venues - Costs - Depreciation) ´ (1 - t C ) +

Depreciaiton - CapEx - DNWC )
T
FCFEt
NPV ( FCFE ) = å
t =0 (1 + rE ) t

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 Example (18.10, BM 3rd Ed, 18.11 BM 4th Ed)
• Equity cost of capital: 10%
• Market capitalization: 10.8 bln
• Enterprise value: 14.4 bln
• Debt cost of capital: 6.1%
• Tax rate: 35%
– Calculate FCFE
– Is the result the same as before?

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 Solution
• Using the debt capacity calculated in problem 5, we can
compute FCFE by adjusting FCF for after-tax interest expense
(D ´ rD ´ (1 – tc)) and net increases in debt (Dt – Dt – 1)
Year 0 1 2 3
D 46.47 37.91 16.13 0.00

FCF -$100.00 $50.00 $100.00 $70.00

After-tax Interest Exp. $0.00 -$1.84 -$1.50 -$0.64
Inc. in Debt $46.47 -$8.55 -$21.78 -$16.13
FCFE -$53.53 $39.60 $76.72 $53.23

39.60 76.72 53.23

NPV = −53.53 + + 2
+ 3
= $85.86
1.10 1.10 1.10

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 Project-Based Cost of Capital
• What if the risk and the leverage of an investment project differ
from those of the company?
• Determine project-based cost of capital (cf. §18.5):
– Estimate unlevered cost of capital using other similar companies’ debt
and equity cost of capital ;
• Use the unlevered cost of capital to determine APV ;
• For WACC and Flow-to-Equity method: use project leverage to obtain equity cost of
capital, rE , and the WACC, rWACC

[Note:] If the leverage of the project differs from the risk of the
company
– Cash is negative debt
– Optimal leverage depends on project and firm characteristics
– Safe cash flows can be 100% debt financed

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 Summary
• Three different methods to evaluate
investment projects (WACC, APV, FCFE)
• WACC method: if D/E ratio is constant
• APV: in all other cases easier as the discount
rate is independent of leverage (constant cost
of capital)
• FCFE: in some more complicated cases

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 Summary Finance for AE
• The Firm, Balance sheet, Profit and loss statement, Cash flow statement
• Time value of money: present value and future value
• Bond valuation
• Investment decision rules (e.g. NPV, IRR, payback)
• Capital budgeting (finding the cash flows)
• Equity valuation
• Pricing of Risk, CAPM & efficient portfolio
• Capital structure perfect market (MM)
• Capital structure and tax shield, financial distress costs, agency costs
• Capital budgeting and valuation with leverage (WACC / APV)

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