Chapter 3

CAPITAL BUDGETING
Dr. Nguyen Quynh Tho
 Key Concepts and Skills

● Understand the effects of leverage on the value created

by a project

● Be able to apply Adjusted Present Value (APV), the

Flows to Equity (FTE) approach, and the WACC method
for valuing projects with leverage
 Chapter Outline

1. Adjusted Present Value Approach

2. Flows to Equity Approach

3. Weighted Average Cost of Capital Method

4. A Comparison of the APV, FTE, and WACC Approaches

5. Beta and Leverage

 Part 1.
Adjusted Present Value
Approach
 Adjusted Present Value Approach
APV = NPV + NPVF

●The value of a project to a levered firm (APV) is equal to the value of the
project to an unlevered firm (NPV) plus the net present value of the
financing side effects (NPVF).

●There are four side effects of financing:

○The Tax Subsidy to Debt

○The Costs of Issuing New Securities

○The Costs of Financial Distress

○Subsidies to Debt Financing

 Adjusted Present Value Approach
APV = NPV + NPVF

●The value of a project to a levered firm (APV) is equal to the value of the
project to an unlevered firm (NPV) plus the net present value of the
financing side effects (NPVF).

●There are four side effects of financing:

○The Tax Subsidy to Debt

○The Costs of Issuing New Securities

○The Costs of Financial Distress

○Subsidies to Debt Financing

 Example

Consider a project of the Pearson Company. The timing and size of the
incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500

0 1 2 3 4

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%,
 APV Example

Consider a project of the P. B. Singer Co. with the following characteristics:

Cash inflows: $500,000 per year for the indefinite future.

Cash costs: 72% of sales.
Initial investment: $475,000.
tC = 34%
R0 = 20%, where R0 is the cost of capital for a project of an all-equity firm.

The firm plans to finance the project with $126,229.50 debt.

Should the firm accept the project?

 Part 2.
Flow to Equity Approach
 Flow to Equity Approach

● Discount the cash flow from the project to the equity holders of the
levered firm at the cost of levered equity capital, RS.

● There are three steps in the FTE Approach:

○ Step One: Calculate the levered cash flows (LCFs)

○ Step Two: Calculate RS.

○ Step Three: Value the levered cash flows at RS.

 Example

Consider a project of the Pearson Company. The timing and size of the
incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500

0 1 2 3 4

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%,
 Part 3.
Weighted Average Cost of Capital
Method
 WACC Method

S B
RWACC = RS + RB (1 − TC )
S+B S+B

● To find the value of the project, discount the unlevered

cash flows at the weighted average cost of capital.
 Example

Consider a project of the Pearson Company. The timing and size of the
incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500

0 1 2 3 4

The unlevered cost of equity is R0 = 10%.

The firm finances the project with $600 of debt at RB = 8%.
Pearson’s tax rate is 40%,
Suppose Pearson’s target debt to equity ratio is 1.50.
 Part 4.
A Comparison of the APV, FTE,
and WACC Approaches
 Summary: APV, FTE, and WACC

APV WACC FTE

Initial Investment

Cash Flows

Discount Rates

PV of financing effects

Which approach is
the best?
 A Comparison of the APV, FTE, and WACC Approaches

● All three approaches attempt the same task: valuation in the

presence of debt financing.

● Guidelines:

○Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project
over the life of the project.

○Use the APV if the project’s level of debt is known over the life of the project.

● In the real world, the WACC is, by far, the most widely used.
 Valuation When the Discount Rate Must Be Estimated

● A scale-enhancing project is one where the project is similar to those

of the existing firm.

● In the real world, executives would make the assumption that the
business risk of the non-scale-enhancing project would be about equal
to the business risk of firms already in the business.

● No exact formula exists for this. Some executives might select a

discount rate slightly higher on the assumption that the new project is
somewhat riskier since it is a new entrant.
 Part 5.
Beta and Leverage
 Beta and Leverage: No Corporate Taxes

● In a world without corporate taxes, and with riskless

corporate debt (bDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm and
the beta of levered equity is:
Equity
Asset =  Equity
Asset
• In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship
 the beta of the unlevered firm and the beta of
between
levered equity is:
Debt Equity
Asset =  Debt +  Equity
Asset Asset
 Beta and Leverage: With Corporate Taxes

● In a world with corporate taxes, and riskless debt, it can

be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:
 Debt 
Equity = 1 +  (1 − TC )Unlevered firm
 Equity 
 Debt 
• Since1 + Equity  (1 − TC ) must be more than 1 for a


levered firm, it follows that Equity > Unlevered firm


 Beta and Leverage: With Corporate Taxes

●If the beta of the debt is non-zero (i.e., not risk free), then:
B
Equity = Unlevered firm + (1 − TC )(Unlevered firm − Debt ) 
SL

●If the debt is risk free:

Equity = [1 + (1 – TC) B/SL]*Unlevered Firm.

 APV, FTE, WACC: Example

Bruin Industries just issued $265,000 of perpetual 8 percent debt

and used the proceeds to repurchase stock. The company expects
to generate $123,000 of earnings before interest and taxes in
perpetuity. The company distributes all its earnings as dividends at
the end of each year. The firm’s unlevered cost of capital is 14
percent, and the corporate tax rate is 40 percent.
a. What is the value of the company as an unlevered firm?
b. Use the adjusted present value method to calculate the value of
the company with leverage.
c. What is the required return on the firm’s levered equity?
d. Use the flow to equity method to calculate the value of the
company’s equity
 Summary
1. The APV formula can be written as:

Additional
UCFt Initial
APV =  t + effects of −
t =1 (1 + R 0 ) investment
debt
2. The FTE formula can be written as:

LCFt  Initial Amount 
FTE =  t − − 
 t =1 (1 + R S )  investment borrowed 
3. The WACC formula can be written as

UCFt Initial
 NPVWACC = t −
t =1 (1 + RWACC )
investment
 Summary

4 Use the WACC or FTE if the firm's target debt to value ratio
applies to the project over its life.
• WACC is the most commonly used by far.

• FTE has appeal for a firm deeply in debt.

5 The APV method is used if the level of debt is known over the
project’s life.
• The APV method is frequently used for special situations like interest
subsidies, LBOs, and leases.

6 The beta of the equity of the firm is positively related to the

leverage of the firm.
 ✓ Explain how leverage impacts the value
created by a potential project.
Quick Quiz
✓ Identify when it is appropriate to use the APV
method? The FTE approach? The WACC
approach?