CH 1: The Corporation and Financial Markets

1.1 THE FOUR TYPES OF FIRMS

1 SOLE PROPRITERSHIP
2 PARTNERSHIPS
3 LLC
4 CORPORATIONS

1 SOLE PROPRITERSHIP

A busines owned and run by one person

usually very small, with few, if any, employees
do not account for much sales and revenue in economy
they are most common type of firms in world

72% of businesses in US are Sole propritership

they generate only 4% of revenue

sole
corporations
propritership
% of businesses in US 72% 18%
revenue contribution 4% 82%

Features
1 Sole propriterships are stratght forward to set up ---> many new businesses use this organizational form
2 limitation--->
a. no separation between firm and owner.
b. Firm can have only one owner
c. if there are any invesors, they cant hold ownership stake in firm
3 owner has unlimmited personal liability of any firm's debts
i.e if firm defaults on any debt re[ayments--> owner has to repay from personal assets
owner who cant repay the loan must declare bankruptcy
4 life of a sole propriterships is limited to life of owner
difficult to transfer the ownership of SP

2 PARTNERSHIP

Similar to sole propritership

except it has more than 1 owner
 Features--->
1 All partners are liable to firms debts
a lender can require any firm to repay all the firms O/S debts
2 Partnership endson withdrawl or exit of any partner
althouh a partner can avoid liquidation if the partnership agreement provides for alternatives such as buyout of a

some old business remain as SP or PARTNERSHIPS

OFTEN these atre the firms where owners personal image reputation is the basis for businesses
example --->
law firms
group of doctors
accounting firms
For such enterprises, the partners’ personal liability increases
the confidence of the firm’s clients that the partners will
strive to maintain their reputation.

LIMITED PARTNERSHIP
partnership with 2 kinds of owners --->
a. general partner
b. limited partners

General Partner
Same rights and previliges as partners in a general partnership
i.e personally liable for firms debt obligations

Limited Partners
have limited liability--> no debt obligation liability
i.e.their private property cant be seized
death/ exit of a limited partner doesn’t dissolve the pertnership
limited partner's interet is transferrable
has no management authority
cant be legally involved in managerial DM

Examlples -
PE
VC
general partners---> contribute some oftheir own capital and raise addl capital from outside investors who are limi
General partners---> contraol how capital is invested
most often---> they will participate in running businesses they choose to invest in
the outside investore play no role in partnerships other than monitoring how their investments are performing

2 LIMITED LIABILITY COMPANIES

 A limited partnership wihout a general partner
i.e all the owners have limited liability
but unlike limited partners, they can also run the business

First state to pass LLC----> Wyoming in 1977

last---> hawaii in 1997

LLc rose into prominence first in Germany---> GmbH (Gesellschaft mit beschränkter Haftung)
then----> European and latin American countries

France---> SARL (Société à responsabilité limitée)

Italy ----> SRL
Spain ---> SL

3 CORPORATONS

Distinguishing feature of corporation--->

it is a legally defined arificial being (a separate legal entity)--> separate from its owners
it has many legal powers hat a person can have
It can enter onto contracts
acquire assets
incur obligatins
enjoys protection under US constitution against seizureof property

Formation of a Corporation
must be legally formed
means the state in whicit is incorporated nust give its consent
setting up is more costly than SP
for jurisdiction purpose--> corporation is a citizen of state where its incorporated
most attractive rues in DELAWARE

Ownership of a Corporation.
no limit on number of owners
many owners--> each own only small no of shares (STOCK)
collection of O/S shares of corp ---> equity of corp
owner of a share of stock of corp--->
shareholder, stockholder, equity holder
entitled to dividend payment ----> payments made at the discretion of the corporation to its equity holders
dividend is proportional to the shareof stock owned

UNIQUE FEATURE--->
no limitation on who can own its stock
i.e owner need not have any special expertise or qualification
 This feature allows free trade of shares----> provides one of most imp advantage of organizing as a corporation rat

corporations can raise substantial amounts of capital because---.

they can sell ownership shares to anonymous outside investor

availability of outside funding---> enabed corporations to dominate the economy

Tax Implications for Corporate Entities

An imp diff in the type sof organizational forms is the way they are taxed
Corporation---> is a separate legal entity hence
corporation profits are subject to taxayion separate from its owners tax obligations

S/H of a firm---> pays tax twice---> DOUBLE TAXATION

first…corp pays tax on ots profits
second… when profits are distributed, S/H pay ther own income tax

Problem: taxation of corp earnings

per share earning before tax 8

corp tax 25%
income tax 20%

earnings of S/H after tax 4.8

effective tax rate 40.00%

s`

A S CORPORATIONS
Exempt from double taxation

firms profits are not subjected o corporate tax

rather distributed to S/H based on ownership share
S/H must incl these profits as their income on their indiv tax returns (even if no money is distributed)
 Problem: Taxation of S Corporation Earnings

In the above prob, assume corporation has elected s chapter

and Income tax rate 35%

tax to be paid (irrespective of whether corp distributes cash) 2.8

thi tax is lower by an amount = 0.4

Restrictions by US govt--->
1 S/H must be individuals who are citizens of US
2 no of S/H not more than 100

most of the corporations ---> C

only 1/4 of revenue is contributed by --->S

1.2 OWNERSHIP VS CONTROL OF CORPORATIONS

SOMETIMES THERE ARE MANY OWNERS--->

ITS NOT FEASIBLE FOR OWNERS OF A CORP TO HAVE A DIRECT CONTROL OF THE FIRM
Hence
ina corp--> ownership and control are separate
Rather than the owners,
Board of Directors and CEO possess direct control

B The Corporate Management Team

S/H of a corp exercise the control by appointing BoD

BoD---> ultimate Decision Making

each shareof a stock--. Gives S/H 1 vote in the election of the BoD
so invesors with most influence---> max influence

when 1/2 S/H very large proportion of shares--->

they may be on Board
or have right to appoint a no of directors

BoD--->
makes rules as how corp should run (incl how top managers are compensated)
 sets policy
monitors performance

BoD delegates the decisions involving day-to-day running of corp to management

CEO--->. Charged with running the corp
by instituting the rules and policies set by BoD

Size of management aries from corp to corp

sometines CEO is also the chairman of the BoD

most senior financial manager---> CFO---> reports to CEO

C FINANCIAL MANAGER

FM is responsible for--->
1 making investment decisions
2 making financial decisions
3 managing firms CF

1 INVESTMENT DECISIONS
FMs most imp job is to mke firms investment decisions
by weighing all costs and benefits
and decide which of them qualify as good uses of money stockholders have invested in firm

these investment decisions fundamentally shape

what the firm does and
whether it will add value for its owners?

2 FINANCING DECISIONS
Once the FM has decided which investment to make--->
he/she decides how to pay for them

Large invet--> may require to raise addl money

FM to decide--->
whether to raise money new and existing owners by selling more shares--> equity
or to borrow money--> debt

3 CASH MANAGEMENT
FM must ensure that there is enough cash to meet day to day obligations
this is known as managing working capital---> in ayoung company it means SUCCESS or FAILURE

D THE GOAL OF THE FIRM

 THEORETICALLY--->
firms goals should be determined by owners

SP---> single owner---> goals of SP=goal of owner

But in corporations--->there are too many owners---. Having different interests and priorities
whose interest and priorities determine the goal of firm

surprisingly--> interests of S/H are aligned more or less

because no matter what their personal interests and stages in life are--->
they are better off if management makes decisions whichincrease the value of theis shares

E FIRM AND THE SOCIETY

ARE THE DECISIONS THET INCREASE THE VALUE OF FIRMS EQUITY BENEFICIAL FOR SOCIETY AS WHOLE
MOST OFTEN THEY ARE
e.g.---. Apple increseing its S/H value --. s/h becoming richer
society is also better off with produsts like iphone and ipad

but sometimes it’s not the case--->

a corp which in due course of its business--. Pollutes the env
and doesn’t pay costs to clean pollution

sometimes--> corp may not pollute itself but use of its products arm the environment
in above 2 cases S/h wealth can be costly for society as whole

2008 Financial crisis

in early part of last decade--> banks took excess risk
this benefitted the banks' shareholders
but when bets went bad---> resulting Financial crises harmed the broader economy

when actions of a corp impose harm to economy/ society as a whole---> public plicy and regulations are required
to ensurethat corporate interests and societal interests remail aligned

Sound Public policy---. Allows firms to continue to pursue the maximization of S/H value ina way thet benefts socie

G ETHICS AND INCENTIVES WITHIN CORPORATIONS

when the goals of a corp are agreed uponby all the S/H--> these goals must be implemented

in simple form--. SP---> owner who runs the firm can ensure the firm's goals match his own
buyt in Corporation--->managers have little incentive to work in the interest of the S/H when this mean working ag

AGENCY PROBLEM--->
when managers hired to work in the interest of the goals of the firm, put their self interest ahead of all
managers face ethical delimma---> oersonal interest vs responsiility

solution--->
1. reduce no of decisions for which self interest differs largely from the firms interest
e.g.--->managers compensation contracts are designed to ensure that most decisions in shareholders interest also
S/H often tie up compensation of managers to firms profits

but there is a limitation to this strategy

by tying compensation too closely--->
S/h might be asking managers to take on more risk thanthey are comfortable in

if compensation contracts are such that it reduces managers

risk by rewardinggood performance but limitis the penalty
associated with poor performance----->

managers may have an incentive to take excessive risk

Further, the potential conflict of interest and ethical considerations arise

when some S/H benefit and
when othes loose

The CEO’s Performance.---->

anothey wat S/H can encourage managers to work in firms interest--->
is to discipline them if they don’t

if s/h are unhappy with CEO performance---> they could in principle pressure the BoD to oust the CEO
but thi shappens rarely
rather dissatisfied investors sell their shares

but if large group ofS/H is dissatisfied---> who will buy?

to entice others in buying their shares--> lower the value of share

similarly, for a successful firm--->

more and more wants wo buy the shares
this drives the stoct price to go up

STOCK PRICE is a barometer for corp leaders that continuously gives them feedback on their S/H opinion for perf

when STOCK performs poorly--->

S/H might want to replace CEO

but most of the times BoD dosent have the will to do so

because the BoD are friends with CEO--> objectivity lack
In corp where CEO is entrenched and doing a poor job---> expectation of continuous perf will decrease the share p
Low stock prices--> create profit opportunity

in hostile takeover--->
an individual or organization ---> known as corp raider--->
can purchase large fraction of shares---> and acquire enough votes
to replace the BoD and CEO

with new superior management team--> stock is much more attractive--->price rise--->profit for corp raider and S/

nostile & raider----> negative connotation---> but provide imp service to S/h
mere threat of being removed as a result of hostile takeover is enoug to discipline bad managers
and motivate Bod to make difficult decisions

Consequently, when a corporation’s

shares are publicly traded, a “market for corporate control”
is created that encourages
managers and boards of directors to act in the interests of
their shareholders.

Corporate bankruptcy.---->
when corp borrows--> debt holders also become investors
debt holders don’t exercise control over firm
but if firm fails to repay debt---> they are entitled to seize firms assets

to avoid this seizing activity--->

firm may attemptto renegotiate with debt holders or
file bankruptcy protection in a fedral court

if unable to repay and renegotiate---> control of corp assets is transferred to debt holders
I.e. a change of ownership---> control parring from---> equity holders to debthholders
ganizational form
ernatives such as buyout of a deceased or withdrawn partner

utside investors who are limited partners

estments are performing

oration to its equity holders
ganizing as a corporation rather than SP, Partnership, LLC

ey is distributed)
CIETY AS WHOLE

nd regulations are required

e ina way thet benefts society as whole

when this mean working against their self interest

rest ahead of all

in shareholders interest also ar ein managers interests

to oust the CEO

n their S/H opinion for performance

erf will decrease the share price

profit for corp raider and S/h

CH 4: The Time Value of Money

4.2 The Three Rules of Time Travel

compare and combine values at same point in time and in

same units

a dollar today is more valuable than a dollar an year after

because u can earn interest on the dollar today

Problem: Present Value of a Single Future Cash Flow

return AFTER 10 YRS 15000
time IN YEARS 10

IF MARKET INTEREST RATE 6%

WHAT IS THE BOND WORTH TODAY?

PV 8375.921653727

Problem: COMPUTING FV
PLAN TO SAVE AMOUNT AT THE END OF EACHYR FOR 3 YR = 1000
INTEREST RATE 10%

method 1
amount in bank after 3 yrs 3641
 Method 2 - PV of all transactions

PV of all transactions 2735.537190083

value at end of yr 3 3641

4.3 VALUING STREAM OF CASH FLOWS

Present Value of a Stream of Cash Flows

Problem
You have just graduated and need money to buy a new car.
Your rich Uncle Henry will lend you
the money so long as you agree to pay him back within four
years, and you offer to pay him the
rate of interest that he would otherwise get by putting his
money in a savings account. Based on
your earnings and living expenses, you think you will be able
to pay him $5000 in one year, and Problem
You have just graduated and need money to buy a new car.
Your rich Uncle Henry will lend you
the money so long as you agree to pay him back within four
years, and you offer to pay him the
rate of interest that he would otherwise get by putting his
money in a savings account. Based on
your earnings and living expenses, you think you will be able
to pay him $5000 in one year, and
0 1
5000
DISCOUNT RATE 6% 6%
PV 4716.98113208
NPV 24890.656222352

UNCLE HENRY WOULD BE WILLING TO LEND AOUNT = 24890.656222352

VERIFICATION:
IF UR UNCLE KEPT SAME AMOUNT IN FD AT 6% FOR 4 YEARS
THEN FV = 31423.88

NOW HE GIVES U THE MONEY AND DEPOSITS UR PAYMENTS N FD 26%

THEN FV = 5955.08
 NET FV 31423.88

4.4 CALCULATING NPV

NPV = PV(BENEFITS) - PV(COSTS)

=PV(BENEFITS - COSTS)

Net Present Value of an Investment Opportunity

PROBLEM:

INVESTMENT 1000
REPAYMENT 500
FOR YEARS 3

IF OTHERWISE I CAN EARN INTEREST = 10%

TIME 0 1
CF -1000 500
DISC RATE 10% 10%
PV -1000 454.545454545
NPV 243.4259954921

THIS WAY U CAN BORROE 1000 TO INVEST AND 243 TO SPEND TODAY
TOTAL AMOUNT BORROWED 1243.425995492

FV OF THIS IN 3 YEARS 1655

AT THE SAME TIME INVETMENT GENERATES CF

IF U PUT THESE CF INTO BANK ACCOUNT--->HO
HOW MUCH U WILL HAVE SAVED IN 3 YEARS 1655

4.4 PERPETUITIES AND ANNUITIES

A PERPETUITIES
 Perpetuity is a stream of equal CF theat occur at regular intervalsand last forever
example--> british CONSOL bond---> it promises investor fixed CF every year

Time line

this is same as if u put 100 in bank at 5%---> u withdraw 5 at end of each year and reinvest 100

PRESENT VALUE OF Perpetuity =

problem: Endowing a Perpetuity

PV = 30000/0.08 375000

if u donate 37500 today and if university invests it at 85 then MBAs will get 30000 every year

B ANNUITIES
Stream of n equla CF paid at regular intervals
 Present value of annuity

Problem: Present Value of an Annuity Due

a 30 payments of $1 million per year (starting today), or

PV = 11.15840601058
initial inves 1
NPV 12.15840601058

$15 million paid today. If the interest

b
rate is 8%, which option should you take?

Future value of annuity

 Problem: Retirement Savings Plan Annuity

payment annual 10000

yeas 30
rate of interest 10%

Fv 1644940.226889

C GROWING CF
PAYMENT INCREASE AT REGULAR INTERVALS
RATE OF INCREASE=35 3%
FIRST PAYMENT 100
C1 GROWING PERPETUITY
0 1

0 100

0 100
 g<=r

problem: Endowing a Growing Perpetuity

PV(PERPETUITY) = 375000
PV (GROWING PERPETUITY) = 750000

C2 GROWING ANNUITY
 PROBLEM: Retirement Savings with a Growing Annuity

SAVING PER YEAR 10000

INCREASE IN INVESTMENT PER YEAR 5%
INTEREST ON SAVINGS 10%

AMOUNT SAVED BY THE AGE OF 65

AMOUNT SAVED BY THE AGE OF 65

PV = 150463.14700582

FV 2625491.978747

4.4 NON ANNUAL CASH FLOWS

Example: Evaluating an Annuity with Monthly Cash Flows

 car cost 20000
loan repayment installment PER MONTH 500
PERIOD (MONTHS) 48
INTEREST RATE ON CASH = 0.50%

PV = 21290.15889141

ABOVE IS COSTLY THAN PAYINH 2000 UPFRONT

4.8 Solving for the Cash Payments

EXAMPLE: Computing a Loan Payment
COST 500000
DOWNPAYMENT 20%
100000
INTERET RATE 0.50%

MONTHLY INSTALLMENT C

C= 9394.011619175

FV OF ANNUITY
4.9 IRR

INTEREST RATE AT WHICH INITIAL INVESTMENT = PV OF FUTURE CF

PRINCIPAL 1000
PAYOFF YEARLY 2000
PAYOFF TIMES 20

NPV = -1000 + 2000/(1+R)^6

NPV = 0
R= 0.122462048309

PROBLEM: COMPUTING IRR FOR PERPETUITY

INITIALINVEST 1000000
 GROWTH RATE 4%
CF @ YR1 100000

R= 14.00%

A IRR OF GROWING PERPETUITY

IRR OF GROWING PERPETUITY = (C/P)+G

EXAMPLE: PURCHASE NEW FORK LIFT

OPTION 1: PRICE IF U PAY CASH

OPTION 2: ANNUAL PAYMENTS IF U TAKE LOAN

INITIAL PAYMENT 40000

YEARLY CF 15000
R??

B Computing the Internal Rate of Return for an Annuity

 2 3 4
8000 8000 8000
6% 6% 6%
7119.972 6716.954 6336.74931

8988.8 8480 8000

 2 3
500 500
10% 10%
413.2231 375.6574
 2 3 4
100*1.03 103*1.03 106.09*1.03
= 103 =106.09 =109.27
103 106.09 109.2727
CH 4: interest rates

5.1 Interest Rate Quotes and Adjustments

annually
semiannually
monthly

discount rate should match the time peiod of CF

A The Effective Annual Rate (EAR)

1 Adjusting the Discount Rate to Different Time Periods.

1 General Equation for Discount Rate Period Conversion.

discount rate = r
equivalent disc rate for n periods = (1+r)^n - 1

problem: Valuing monthly CF

EAR 6%
FV 100000
monthly interest rate 0.4868%
time In years 10

FV (annuity) = C*(1/r)*((1+r)^n - 1) 100000

C= 615.4852048784

B Annual Percentage Rates (APR)

amount of simple interest earned in 1 years---> without any compounding
hence APR<actual interest rate

no of periods of compounding = k

1+EAR = (1+APR/k)^k

example: Converting the APR to a Discount Rate

period in years 4
cost of system 150000

lease vs buy?
 lease amount 4000
interest rate 5% APR with semiannual compounding 5%

semiannual interest rate = r

1+r = (1+5%/2)^(1/6)
r= 0.4124%

PV = 173867.2198322

5.2 Application: Discount Rates and Loans

A Computing Loan Payments

CH 4: Capital Markets and the Pricing of Risk

10.2 Common Measures of Risk and Return

EXAMPLE:Calculating the Expected Return and Volatility

RETURN 45% -25%

PROBABILITY 0.5 0.5

Expected return = 10.00%

volatility
variance = 0.1225
SD 35%
CH 12

CH 12: ESTIMATING COST OF CAPITAL

12.1 EQUITY COST OF CAPITAL

Ri = Rf +(EMRP)*B

Example 12.1 - Computing the equity cost of capital

Disney volatility 20%
Beta 1.29
Chipotle volatility 30%
Beta 0.55

Rf = 3%
E(Rm) 8%
E(Rm) - Rf 5%

Disney, Ri 9.45% 1----> higher cost of equity cap

Chipotle, Ri 5.75%

12.2 MARKET PORFOLIO

a Constructing market Porfolio

b Market Indicies
c Market Risk Premium

c1 Determining Risk Free rate

it is the rate at which the invetors can borrow and save
Generally, Risk free rate is determined using the yields US treasury securities
Another consideration in deermining Risk free rate is the choice of maturity ---->
Short term risk free rate for short term projects and
Long term Rf for long term projects

c2 Historical risk Premium

method to determine E(Rm) - Rf is
to use historical average excess return of market over risk free interest rate
 same horizon as used for estimating Rf

Trade-off
many years required to produce moderately accurate estimates of expected returns
however, too old data may be less relevant for investor

Historical excess return of S&P 500 - 1 yr and 10 yr treasury security

S&P Excess Return Versus 1926 - 2015 1965 - 2015
1 yr Treasury 7.70% 5%
10 Yr Treasury 5.90% 3.90%

c3 a FUNDAMENTAL Approach
Using Historical Market risk premium suffers from 2 drawbacks -
1. despite 50 yrs of data, STD ERRORS are large
because they are backward looking, we cant be sure they are of current expectations

An Alternative

Expected market return = Divident Yield + Expected Dividend growth rate

This is highly inaccurate for individual firm

works best for overall market

12.3 BETA ESTIMATION

Difference in Beta for different firms----> reflect the sensitivity of each firm's profits to general health of economy

Technology stocks ----> beta = 1

because demend for their products fluctuates with business cycle

Personal and household product company stocks --->Beta very low

demand is very less related to state of economy

methods - Regression---> best fitting line

12.4 THE DEBT COST OF CAPITAL

1. Debt Yield Vs returns

2. Debt Betas
 3
A Debt Yield Vs returns

Yield to maturity of a bond ----> is the IRR an investor will earn from holding the bond to maturity
--------------------------------------> and receiving the promised paymenst

If there is a little risk that the firm wil default---->

we can use bonds yield to maturity as an estimate of investors return

If there is a significant risk that the firm wil default---->

using bonds yioeld to maturity will overstate the investors expected return

Relationship between debt's yield and its Expected Return

Consider a 1 year bond with yield to maturity of "y" y
1 dollar invested in bond today, bond promises to pay 1(1+y) after 1 years

bond default probability is "p" p

Expected loss per 1$ of debt in case of default is "Y" Y
hence, after 1 year bond holders wil only receive (in default) (1+y-L)

Expected return of bond = (1-p)*y + p*(y-L) = y - pL

'= (Yield to maturity) - Prob (default) x Expec

Average default Rate of unsecured Bond = 60%

Table 1 - Annual default rates by debt rating

Rating AAA AA
Default Rate:
AVG 0% 0.10%
in recession 0% 1%

For a B-rated Bond

expected return to debt holders = bonds yield - (0.055 x 0.6) = bonds yield - 3.3%
0.6----> avg default rate of unsecured bond
0.055 ---> avg default rate of B rated bond

A Debt Betas
Alternatively we can calculate the debt cost of capital using CAPM
for this we have to calculate debt betas using their historical returns in same was as equity beta

Can estimate Debt betas using estimates of Debt betas of BOND INDICIES by rating category as shown below
 table 2 - AVG DEBT BETA BY RATING AND MATURITY
By Rating A & Above BBB
AVG BETA < 0.05 0.1

By Maturity BBB & Above 1 - 5 yrs

0.01

As the table indicates,

debt betas tend to be low, thoug they can be significantly higher for risky debt with low credit rating and long ma

Problem: Estimating Debt Cost of capital

outstading Bond - 5 yrs
yield to maturity 6%
Rating B
Rf 1%
EMRP 5%

given the low rating of debt, the yield to maturity of KBs debt is likely to overstate iots expected returns
METHOD 1 - debt ratings
using avg estimates in table 1
expected loss rate 60%
Default rate = 5.50%
Rd = 2.700%

METHOD 2 - CAPM
Beta (from table 2) = ` 0.26
Rd = 2.30%

12.5 THE PROJECTS COST OF CAPITAL

Estimating project beta----> comparabe firm approach, because unlike equity and debt, a new projis itself not a tra

Cost of assets of coparable firms----> proxy for proj cost of capital

A All equity comparables

find Equity financed firm---> no debt

an all equit firm---> holding its stock is equivalent to owning the portfolio of its underlying assets
Thus if the firms avg investment has similar market risk to our proj , them-->
1. we can use the comparable frms equity beta and cost of capital as estimates for cost of capital for proj
 Problem: Estimating the Beta of a Project from a Single-Product Firm

New business of designer clothing and accessories

believe that firm will face same market risk as LULULEMON (LULU)
to develop financial plan, u require cost of capital of this opportunity
Rf 3%
Rm-Rf 5%

LULU---> no debt
Lulu beta--->projects beta (as calculated above) = 0.8
R project = 7.00%
or simply we cansay that rather investing in new business, u could invest in fashio n industry by simply buyinh LULU

B Levered Firms as comparables

If the comparable firm has debt, ---> CF generated are used to pay both SH and DH
hence returns of firm's equity alone arenot representative of the underlying assets
because of debt, firms equity will be more riskier
thus beta of levered firm is not a good estimate of its assets and our project

then how??

C The Unlevered Cost of Capital

Return of a portfolio is weighted avg of itsexpected returns of its securities in portfolio

weights correspond too relative MV of its securities

asset cost of capital or unlevered cost of capital, Ru = (Re *E/V)+(Rd*D/V)

Unlevered Beta / Asset beta, Bu = (Be*E/V)+(Bd*D/V)

Example Problem: Unlevering the Cost of Capital

you firm is planninng to expand household prod division

P&G a firm with comparable investments
P&G equity MC = 144
beta 0.55
P&G debt (AA rated) 37
debt yield = 3.10%

Estimate CoC of ur firms investment given a risk free rate = 3%

EMRP 5%
 Re for P&G = 5.7500%
Ru for P&G 5.21%
unlevered beta for P&G 0.438

our proj cost of capital = 5.19%

diff in vales id due to the assumption of debt

in one case we assumed P&G debt yield = 3.1%
and in anotherwe assumed Beta debt=0 i.e debt yield equak to Rf

Cash and Net Debt

if firm maintains large cash balances, in excess of their operating needs
Cash represents fisk free asstes on firms BS
and reduces avg risk of firm's assets
and we are ierested in risk of underlying business operations, separate from cash holdings
i.e we are interested in risk of firms EV(as in ch 2)---> combined MV of debt, equity less any cash

Net Debt = Debt - Excess Cash and Short@Term Investments

e.g ---> $1 cash and $1 debt---> interest payment is covered by cash

as interest earned on cash = interest paid

Cash>>debt------> Net debt is negative

unlevered beta and cost of capital---> will exceed its equity beta and cost of capital
risk of firms equity is mitigated by cash holding

exmple: Cash and Beta

in 2018,
MC of Microsoft = 716
debt 89
cash 133
estimetad equitybeta = 1.04
find beta of MS underlying enterprise

net debt -44

MS EV 672

Beta unlevered = 1.108095238

Note that MS equit is less risky than its nderlyinh business activities due cash holdinsg

D Industry Asset Betas

 Problem: US dept stores data

company ticker Equity beta

Dillard's DDS 2.38
JCPenney's JCP 1.6
Kohl's KSS 1.37
Macy's M 2.16
Nordstrom's JWN 1.94
Saks's SKS 1.85
Sears's SHLD 1.36

The diff in equity beta is due o leverage

12.6 Project Risk Characteristics and financing

projects cost of capital is evaluated by comparing it with unlevered assets of the fir in same line of business
analysis to accont for difference between projects bothin terms of Risk and Financing mode

A Differences in Project Risk

Firm asset beta---> reflets market risk of avg proj in firm

but individual projects may be more or less sensitive to market risk

a financial manager evaluating a new investment should try to assess how his proj might compare with avg project

Example--->3M conglomerate
divisions--->
Heakthcare
computer
graphics

All above divisions have different market risks---> diff asset betas
3Ms asset beta--> avg risk of firm---> using it for appropriate measure of risk for projects in either divison is not cor
Hence---> evaluating projects based on assets betas of fims that concetrate in similar line of business
thus for multi divisional firm---> identifying set of pue play comparables for each division is helpful in determining a

Firm in one business line---> CISCO

Cisco eveluating between lease and buying of office space
the CF associated with this decision had very diff market risk from CF of typical proj of S/W development
hence different CoC for leasing decision

Another factor tht can affect Market riskof proj is OPERATING LEVERAGE
OPERATING LEVERAGE = FC/VC
High FC--->inc sensitivity of projects CF to market risk---> high asste Beta
to account for this---> we should assign projects with an above avg proportion of FC
Thus greater than avg operating leverage--> higher CoC

Example: Operating leverage and Beta

Problem:
Expected annual revenue = 120
cost in perpetuity 50
profit margin is constant
proj beta 1
Rf 5%
E(Rm) = ` 10%

I. value of proj??
Expected CF 70
Ru 10.0%

Value of proj if revenue is fixed and costs vary 700

II. value of proj if revenues vary with beta 1 and costs are fixed??
present value of revenue = 1200
present value of costs (its fixec hence discount at Rf0 1000
Hence with Fixed costs---> value of proj = 200

II. What is beta of proj now?

Beta = 6
proj cost of capital = 35.00%
present value of expectde profits = 200
A Financing and Weighted Avg Cost of capital
in prev section we assumed that projects are all equity financed
important to think --->
1. whats the importance of this financing assumption
2. how mighthe proj CoC change if firm uses leverage

Perfect Capital Markets--->

no taxes, no transation costs etc--> choice of financing doesn’t change the CoC or NPV
rather the CoC and NPV are solely dependent on Free CF
But there are imperfections---> taxes

I Taxes--> bigh imperfection

this is because of the Corporate tax code
which allows the deduction of interest paymments from taxable income

if interest rate paid is "r" and tax rate is "t"

then the effective tax rate = r*(1-t)

II Weighted Avg Cost of capital

whicle calculating NPV, the changes due to tax is incorporated by using effective aftretax Cost of capital
i.e weighted Average Cost of Capital (WACC)

Rwacc = (Re*E/V)+(Rd*(1-t)*D/V)

Compating Rwacc with Ru

Ru---> pre tax WACC

1. Ru--- expected return of investors by holding firms assets--->used to evaluate all equity firms with same risk
2. Rwacc-->eff after tax Cost of Capital
because interest is deductible
WACCis less than expected return of firms assets
WACC can be used to evaluate a project with the same risk and the
same financing as the firm itself.

Rwacc = Ru - (Rd*t*D/V)
Rwacc < Ru

Example: estimating WACC

Problem: Dunlap Corp
MC = 100
O/S debt 25
Re 10%
Rd 6%
whats is Ru?
Tax rate 25%
Whats Rwacc

V 125
Ru 9.2%
Rwacc (1st method) 8.900%
Rwacc (2nd method) 8.900%
---> higher cost of equity capital
general health of economy
to maturity

urity) - Prob (default) x Expected lss rate

A BBB BB B CCC CC-C

0.20% 0.50% 2.20% 5.50% 12.20% 14.10%

3% 3% 8% 16% 48% 79%

tegory as shown below

 BB B CCC
0.17 0.26 0.31

5 - 10 yrs 10 - 15 yrs >15 yrs

0.06 0.07 0.14

ow credit rating and long maturity

expected returns

t, a new projis itself not a traded security

t of capital for proj

dustry by simply buyinh LULU stocks
 D/V debt rating Debt beta Asset beta
0.59 B 0.26 1.13
0.17 BB 0.17 1.36
0.08 BBB 0.1 1.27
0.62 BB 0.17 0.93
0.35 BBB 0.1 1.30
0.5 CCC 0.31 1.08
0.23 BB 0.17 1.09
avg 1.16
median 1.13

same line of business

ht compare with avg project

cts in either divison is not correct

ine of business
on is helpful in determining approprate CoC

S/W development
ax Cost of capital

uity firms with same risk

HOmeNet
Feasibility 300000 SC
Cost of Capital 12%

Sales Forecast 100000 125000 125000 50000

life (yrs) 4
Retail price (per unit) 375 337.5 303.75 273.375
Whole sale price (per unit) 260 234 210.6 189.54

Engineering and design cost 5000000

outsourcing cost (per unit) 110 99 89.1 80.19
Software development cost 10000000
Equipment cost 7500000
Marketing and support cost (per year) 2800000 2912000 3028480 3149619.2
Depriciation 1500000

0 1 2 3 4
Sales 26000 26000 26000 26000
COGS 11000 11000 11000 11000
Gross Profit 15000 15000 15000 15000
SG&A 2800 2800 2800 2800
R&D 15000
Depreciation 1500 1500 1500 1500
EBIT -15000 10700 10700 10700 10700
Tax (@20%) 3000 -2140 -2140 -2140 -2140
Unlevered NI -12000 8560 8560 8560 8560

Opportunity cost
Rent of building 200 208 216.32 224.9728
Tax 20%
net reduction in incremental earnings 160

0 1 2 3 4
Sales 23500 23500 23500 23500
COGS 9500 9500 9500 9500
Gross Profit 14000 14000 14000 14000
SG&A 3000 3000 3000 3000
R&D 15000
Depreciation 1500 1500 1500 1500
EBIT -15000 9500 9500 9500 9500
Tax (@20%) 3000 -1900 -1900 -1900 -1900
Unlevered NI -12000 7600 7600 7600 7600
Add : Depreciation 1500 1500 1500 1500
Less : total expenses 7500
Less : Change in WC 2100
Free Cash Flow -19500 7000 9100 9100 9100

PV -19500 6250 7254.4643 6477.2003 5783.2145

NPV 7626.7035
IRR 27.86%

0 1 2 3 4
Sales 23500 26437.5 23793.75 8565.75
COGS 9500 10687.5 9618.75 3462.75
Gross Profit 14000 15750 14175 5103
SG&A 3000 3120 3244.8 3374.592
R&D 15000
Depreciation 1500 1500 1500 1500
EBIT -15000 9500 11130 9430.2 228.408
Tax (@20%) 3000 -1900 -2226 -1886.04 -45.6816
Unlevered NI -12000 7600 8904 7544.16 182.7264
Add : Depreciation 1500 1500 1500 1500
Less : total expenses 7500
Less : Change in WC 2100 262.5 -236.25 -1360.8
Free Cash Flow -19500 7000 10141.5 9280.41 3043.5264

PV -19500 6250 8084.7417 6605.6125 1934.216

NPV 3979.1352
IRR 21.80%

Gain on sale
Free Cash Flow (w/o addl equip) -19500 7000 9100 9100 9100
Dep tax shield -200
After tax SV -1800
New FCF -21300 6800 9100 9100 9100
PV -21300 6071 7254 6477 5783
NPV 6011

Terminal Value or Continuing Value

assumed that CF will grow at a particular
rate beyong forecast horizon

Example
0 1 2 3 4
Cash flow projections -10.5 -5.5 0.8 1.2 1.3
-10.5 -5.5 0.8 1.2 1.3

After year 4, CF grows at rate of 5%

Let Cost of Capital be 10%

TV = FCF(1+g)/(r-g)
TV (IN YEAR 4) 27.3
PV (in year
4)

0 1 2 3 4
New FCF -10.5 -5.5 0.8 1.2 28.6
PV -10.5 -5 0.661157 0.9015778 19.534185
NPV 5.5969196

Tax Loss Carryforwards

NOL present yr 140000

yearly income 50000
tax carryforward allowed 80%
0 1 2 3 4
pre tax income -140000 50000 50000 50000 50000
Max Tax loss carryforward allowed 40000 40000 40000 40000
tax loss carryforward 40000 40000 40000 20000
Taxable income 10000 10000 10000 30000

0 1 2 3 4
pre tax income -140000 60000 50000 50000 50000
Max Tax loss carryforward allowed 48000 40000 40000 40000
tax loss carryforward 48000 40000 40000 12000
Taxable income 12000 10000 10000 38000

Break even analysis

Units sold
Whole sale price
COGS
 29250000

1500
-1500
300
-1200

31250

5 Existing Device whole sale price 0.1 0.09

Loss in sales 25% 25%
total sales 100000 125000
0 Expected $ loss in sales 2500 2812.5

new expected sales 21000

1500 COST 60 54
-1500 Dec in cost 1500 1687.5
 300
-1200
1500 Payables 15%
receivables 15%
-2100 Net WC 2100
2400 0 1
Payables 15%
1361.8244537 receivables 15%
Net WC 0 2100
Change in WC 2100

1500
-1500
300
-1200
1500

-765.45
1065.45

604.56494343

2400 Equipment resale value 2000

BV 1000
640 SV (aftre 5 yrs) 800
3040
1725
 5 6
1.3*(1.05)^1 1.3*(1.05)^2
1.365 1.43325

0 1 2 3 4
4 5 6 7 8
1.3*(1.05)^0 1.3*(1.05)^1 1.3*(1.05)^2 1.3*(1.05)^3 1.3*(1.05)^4
1.3 1.365 1.43325 1.5049125 1.580158125

1.3 1.2409090909 1.18450413223141 1.1306630353 1.079269261

5
50000
40000

50000

5
50000
40000

50000
 31250 12500

0.081 0.0729
25% 25%
125000 50000
2531.25 911.25

48.6 43.74
1518.75 546.75
 2 3 4 5
15% 15% 15%
15% 15% 15%
2362.5 2126.25 765.45
262.5 -236.25 -1360.8 -765.45
 5 6
9 10
1.3*(1.05)^5.3*(1.05)^6
1.65916603125 1.7421243

1.0302115673 0.9833838
IRR

IRR is Rate of return for which NPV = 0

example: fertilizer business

initial investment 250
benefit per year 35

Time 0 1 2
Cash Flow -250 35 35
NPV (disc rate = r) -250+35/r
IRR (NPV = 0) 14%

Estimated Cost of capital (by managers) 10%

Hence, IRR > Cost of capital

NPV (using CoC) 100

permissible error in Cost of capital 4%

Pitfall 1: Delayed Investments

upfront payment 1000000

opportunity cost (1-3 yrs) 500000
opportunity cost of capital 10%

0 1 2
cash flow 1000000 -500000 -500000
PV 1000000 -454545.455 -413223.1
NPV -243426
IRR 23.38%

IRR > Opp cost of capital

hence, go for project
But, NPV < 0
hence, NPV & IRR rule contradicting

So, accept only if CoC >23.38%

Pitfall 2: Multiple IRR

upfront 550000
Opp cost (1-3 years) 500000
4 th year payment 1000000
opportunity cost of capital 10%

0 1 2
Cash Flow 550000 -500000 -500000
PV 550000 -454545.455 -413223.1
NPV -10412.5401
IRR 7.16% 33.67%

Multiple IRRs
Follow NPV rule
NPV < 0 , hence don’t accept

Pitfall 3: Non - existent IRR

upfront 750000
Opp cost (1-3 years) 500000
4 th year payment 1000000
opportunity cost of capital 10%

0 1 2
Cash Flow 750000 -500000 -500000
PV 750000 -454545.455 -413223.1
NPV 189587.46
IRR Err:523

No IRR exists
Follow NPV rule
NPV > 0 , hence accept

Example

Project 0 1 2
A -375 -300 900
B -22222 50000 -28000
C 400 400 -1056
D -4300 10000 -6000
PAYBACK RULE

Farm example
Assume he wants payback period = 5

initial investment = 250

CF per year = 35
Payback period = 7.14285714

Actual payback period > desired

Don’t accept the project

But, as seen earlier

CoC = 10%
NPV = 100
Hence rejecting the project is wrong idea

Payback rule Shortcomings:

1. Ignores CoC and time value of money
2. ignores CF after payback period
3. relies on ad-hoc decision criteria i.e. the desired payback period

Choosing between Projects

NPV Rule and Mutually Exclusive Projects

Example:

Initial Growth
Project Year 1 CF
investment rate

Book Store 300000 63000 3%

Coffee Shop 400000 80000 3%
Music Store 400000 104000 0%
Electronic Store 400000 100000 3%

IRR Rule and Mutually Exclusive Projects

IRR cannot be used as criteria for evaluating mutualu exclusive projects, because projects differ in
1. their scale of investments,
2. timings of CF
3. riskiness
So their IRRs cant be compared
1. Difference in scale
500% return on $1 vs 20% return on $1mn tempted to choose 500%
i.e $5 vs $200000 but latter is better
Hence< IRR fails
Previous example, Book store Vs Coffee shop
BOOK store: -300000 + 63000/(IRR-3%) = 0 IRR = 24%
Coffee shop: -400000 + 80000/(IRR-3%) = 1 IRR = 23%
As per IRR, accept Book store
But actually coffee shop is better

2. Difference in Timings
earning return is more valuable if earned for longer periods
CoC 10%
return (IRR) 50%
Initial investment 100
0 1 2
Short term proj -100 -150
Long term proj -100
NPV (short term) -236.363636
PV long term) -100 0 0
NPV (long term) 371.51213

Coffee Shop vs Music Store

Initial Growth
Project Year 1 CF
investment rate

Coffee Shop 400000 80000 3%

Music Store 400000 104000 0%

Same initial investment

same horizon
But IRR (coffee shop 20%) <IRR (music store 26%)
still NPV (coffee shop) > NPV (music store) because coffee shop has a higher growth rate
Hence, initial CF of coffee shop is lower but due to higher growth rate, has higher lon run Cash flows

3. Difference in Risk
Project Risk --->> project cost of capital
and to see whether IRR of a project is attractive, we must comp[are it with Proj Cost of Capital
Hence IRR attractive for a safe project need not be attractive for risky project

example
option 1-- you have a risk free investment with return = 10%
option 2-- you have a risky investment with return = 10%
You will not be pleased by option 2
and want a higher return on option 2, to hedge against the riskiness of project

Initial Growth
Electronic store Year 1 CF
investment rate

Electronic Store 400000 100000 3%

IRR (electronic store) higher than IRRof all other investment

But, NPV is lowest
This is because this investment id most risky owing to highest Cost of Cpital (which translates to riskyness of projec

INCREMENTAL IRR
Better alternative to comparing IRR of two projects, is to compute the incremental IRR

Incremental IRR,
Tells us the discount rate at which becomes profitable to switch from one project to another

Example problem
Overhauling of production plant--------->. 2 proposals
Cost of Capital 12%

Proposal 0 1 2
Minor O/H -10 6 6
Major O/H -50 25 25

IRR (Minor) 36.31%

IRR (Major) 23.38%
NPV (Minor) 4.41
NPV (Major) 10.05
0 1 2
Incremental IRR (major - minor) -40 19 19
Incremental IRR 20.0%

Incrmental IRR (20%) > Cost of Capital (12%)

switching to major O/H is attractive
larger scale is sufficient to make up for its lower IRR

at 12% CoC, NPV of majot O/H doesn’t exced that of Minor

This Incremental IRR also tels the cross over point
at Cost of capital = Incremental IRR, decision will switch
Problems when using Incremental IRR
1. all -ve cash Flows to preceed positive cash flows
2. Incremental IRRonly indicates whether its profitable to
switch or Not. It doesn’t indicate that the eithe rproj has +ve
NPV on its own or not

3. if different projects have different Cost of capital, then its

not obvious that what CoC should be compared to
Incremental IRR.
In this case only NPV rule prevails

Mistake example -
Restructuring CFs may lead to manipulation of IRRs
for e.g., by means of financing a portion of initial investment, IRR can be increased

Equipment buying 0 1 IRR

investment option 1 -100 130 30%

if equip seller lends $80, we need to initially pay only $20

and balance $80 + $ 20 shall be aid after an year 0 1 IRR
Investment option 2 -20 30 50%

Option 2 IRR > Option 1 IRR

so as per IRR-----> option 2 is better
But, actually, no
we cant compare IRRs
option 2 is a smaller scale investment
with introduction of Financing, there comes a riskiness for shareholders

loan of 80$ ----- >> final payment after 1 yr is 100$

hence IRR of this loan is (20/80 = 25%)
this borrowing cost is much higher than if we would have borrowed from other means
so including this financing option is a mistake despite higher IRR

PROJECT SELECTION WITH RESOURCE CONSTRAINT

A companyb should take up all NPV positive projects

but, there is a resource constraint always, e.g only 1 property available to open either a book store or coffee shop o

managers have budget constraints on the amount of capital to be invested

Goal is to maximize NPv with staying in the budget
example 10%
 Profitabili
Project NPV Initial invest
ty index
I 110 100 1.1
II 70 50 1.4
III 60 50 1.2

w/o any budget constraint, all positive NPV proj to be taken up

i.e. A, B and C
but with an initial constraint of $100
if project I chosen--->> highest NPV
all $100 utilized with NPV of 110
But if II and III chosen
$100 utilized but total NPV = 130
hence its better to choose II and III

PROFITABILITY INDEX

PI = Value Created / Resource consumed

= NPV / Resource consumed

Example problem (new router business)

Expected NPV = 17.7
no of engineers required = 50
total engineers preent = 190
competing projects
Engg.
Project NPV
Headcount
Router 17.7 50
Proj A 22.7 47
Proj B 8.1 44
Proj C 14 40
Proj D 11.5 61
Proj E 20.6 58
Proj F 12.9 32

How to prioritize these projects?

Soln:
Maximize NPV within budget

Engg.
Project NPV PI
Headcount

Proj A 22.7 47 0.4829787

 Proj F 12.9 32 0.403125
Proj E 20.6 58 0.3551724
Router 17.7 50 0.354
Proj C 14 40 0.35
Proj D 11.5 61 0.1885246
Proj B 8.1 44 0.1840909

calculate PI
SORT on PI from highest to lowest
Choose Project A, F , E and Router

This also provides info about the value of that resource

In proj C, 350000 NPv is generated per engineer
if EHC has been allocated to another division with PI < 350000, then,.
its worthwhile to relocate back the EHC to proj C

Shortcomings of PI
essential conditions for using PI rule
aftre ranking / sorting, the projects undertaken should exhaust available resource
and ther is only one resource constraint
 3
35 …….infinity

3
-500000
-375657.4

23.38%
 3 4
-500000 1000000
-375657.4 683013.455365071

3 4
-500000 1000000
-375657.4 683013.455365071

IRR
20% CORRECT, FIRST -ve cf, THEN +ve
5% Incorrect, 2 IRR
20% Incorrect delayed investments, incorrect IRR (inconsistent with NPV, CoC)
Err:523 Incorrect, No IRR exists
CoC Terminal value Tot yr 1 PV NPV IRR

8% 1297800 1360800 1260000 960000 24.00%

8% 1648000 1728000 1600000 1200000 23.00%
8% 1300000 1404000 1300000 900000 26.00%
11% 1287500 1387500 1250000 850000 28.00%
 3

3 4 5

759.375

0 0 471.51213

CoC Terminal value Tot yr 1 PV NPV IRR

8% 1648000 1728000 1600000 1200000 20%

8% 1300000 1404000 1300000 900000 26%

higher growth rate

Cash flows
 CoC Terminal value Tot yr 1 PV NPV IRR

11% 1287500 1387500 1250000 850000 28%

ates to riskyness of project)

0 1 2
-50 25 25
3 -50 22.321429 19.929847
6
25

3
19
book store or coffee shop or music store
 IRR logic NPV

Cummulat
ive Engg
HC
47
 79
137
187
227
288
332
 3
25
17.794506
CH 14: CAPITAL STRUCTURE IN PERFECT MARKET

WHEN A FIRM NEEDS TO RAISE FUNDS TO UNDERTAKE ITS INVESTMENTS

it must decide, which type of security it will sell to the investors

in the absence of a need for new fund, firm can

issue new securities
and use the funds to repay its debt OR repurchase shares

case of CFO(EBS) - planning major expansion

plans to raise $50mn from outside investors
Options -
1. selling shares of EBS stock ----->
Equity investors will require 10% Risk premium over 5% Risk free rate
i.e. Equity cost of capital = 15%
2. Borrowing $50mn --->
--not borrwed previously and as per B/S --->
shall be able to borrow at a rate of 6%

does the borrowing rate being les than equity cost of capital mean that it should borrow?
if borrow then --->
effect on NPV?
Change in value of firm?
change in share price?

EQUITY Vs DEBT FINANCING

Capital Structure ----> proportion of D, E and other securities

when raising funds ---> must decide which type of security to sell
options -
equity alone
mix of debt and equity

Financing with Equity Only

Enterprenuer with following investment opportunity
Initial investment = 800
CF next year will be either 1400 or 900 depending upon economy is strong or weak
risk free rate 5%
risk premium 10%
Cost of Capital 15%
date 0 Date 1
(economy strong or weak is equally likely) Strong weak
-800 1400 900
 0 1
Expected CF -800 1150
NPV = 200
Thus NPV is positive

In the absence of arbitrage, price of security = PV of its CF

PV (equity CF) = 1000
as the firm has no ther Liabilities, the equity holders willreceive all CF generated by proj on date 1
hence the MV of firm's equity today = 1000

So the enterprenuer can raise $1000 by selling all equity

After paying the investment cost of 800, he can keep the remaining 200 as profit
NPV is the value created by proj to the current owners of firm

Equity in a firm with NO DEBT is called UNLEVERED EQUITY

because there is no debt, the CF of unlevered equity are equal to those of Project

Date 1
Date 0
CF
Initial Value Strong
Unlevered Equity 1000 1400

Shareholders returns are either 40% or -10%

Expected return on unlevered equity 15%

(economy strong or weak is equally likely)

Financing with Debt and Equity

Enterprenuers option 2 - mix of debt and equity
selling equity
plus borrowing $500 500

because the project's CF will be always enough to repay debt, she can borrow at Risk free interest rate i.e. 5%
Risk free rate 5%
in an year she will owe the debt holders = 525

Equity in afirm that also has DEBT is called LEVERED EQUITY

Payments ro debt holders to be always made before equty holders

hence, in strong economy, shareholders will get only = 875

hence, in weak economy, shareholders will get only = 375
 date 0: CF date 1: CF
Initial Value strong
Debt 500 525
Levered Equity ?? 875
Firm 1000 1400

According to Miller - Modigliani, firm value is indifferent to change in capital structure

reason-- PV of Future CF Is still the same
hence FV = 1000 which is the CF of proj
and
CF of Debt + CF of Equity = CF of project

so the Levered Equity = 500

CF of levered equity are smaller than that of Unlevered equity, the Levered equity will sell at lower price

Effect of leverage on Risk and Return

PV of levered equity 543.48

this is >500 (value of levered equity as per Miller-Modigliani)
but discount rate of 15% is inappropriate for this Capital stru
due to debt being in picture, the shareholders will demand an even higher return rate (>15%)

levered equity vs unlevered equity

case 1: debt 500 and equity 500
case 2: 1000 equity
date 0 Date 1: CF
Strong
Initial value
Economy
Debt 500 525
levered equity 500 875
unlevered equity 1000 1400

Relationship between Risk and Return ---->> sensitivity of each security's return to systematic risk of the economy
i.e. security Beta
debt return ---->> bears no systematic risk ---- risk premium = 0

in general, systematic riskof levered equity = 2x that of Unlevered equity

so levered equity holders receives twice the Risk premium

Systematic Risk & Risk premium for Debt, U/L equity and Lev Equity
Reurn Sensitivity
(Systematic Risk)
 ∆R = R(Strong) - R(Weak)

Debt 5% - 5% = 0%
Unlevered Equity 40% - (-10%) = 50%
Levered Equity 75% - (-25%) = 100%

This shows that, in a perfect capital markets

if firm is 100% equity financed ---- S/H will require 15% expected return
if firm is financed 50:50 D:E ------a. debt holders will require a lower return of
b---------------------------------------- Equity holders will require higher expected return of
c----------------------------------------because of increased risk

hence, leverage increases the risk even if there is no risk that the firm will default

Thus, even if the debt is cheaper when considered on its own, it raises the Cost of capital for equity
Considering the given 50:50 D/E, the CoC for this = 15%

Practice example
debt 200
Firm value from above 1000
value of equity 800

Cost of Debt 5%

date 0: CF date 1: CF
Initial Value strong
Debt 200 210
Unlevered equity 1000 1400
Levered Equity 800 1190
Expected return of levered Equity
Return sensitivity of levered equity (A)
Return sensitivity of unlevered equity (B)
A is 125% of B
Risk premium of levered equity (C)
Risk premium of unlevered equity (D)
C is also 125% of risk premium of unlevered equity i.e D

Both being 125%------- its appropriate compensation for risk

With this 200 Debt i.e 20% debt-------the firms WACC = 15%

Modigliani - Miller I: Leverage, Arbitrage and Firm Value

Now we have seen that there is law of one price that prevails
that is, the FV remains constant and the change in capital stru merely changes the allocation of CFs between debt a
without altering the Tot Cash Flows of the firm
But this holds true only in Perfect capital Markets:
1. Investors and firms both can trade same set of securities at competitive market prices equal to PV of their Futur
2. There are no taxes, transaction costs or issuance costs associated with security trading
3. A firms financing decision do no change the CFs generated by its investments nor do they reveal new info about

MM proposition I
In a perfect Capital Market, the Tot value of firm's securities is equal to the MV of the tot CFs generated by its as
choice of Capital Structure

MM and Law of 1 price

In the absence of taxes and other transaction costs
Tot CF paid out to all of security holders = Tot CF generated by Firms assets
Therefore, by the Law of One price,
MV of assets = MV of all securities

Thus as long as the choice of securities doesn’t change the CF generated by assets,
This decision will not change the Tot Firm Value of the amt of capital it must change

Homemade leverage
FV is independent of Capital Structure
if investors want different Cap Stru than the one chosen by Firm
they may borrow or lend on their own and chieve the same result
example - if an investor wants more leverage then he can borrow and add leverage to his own portfolio
This is known as Homemade leverage
Contition that the investors can borrow at same rate as firm, Homemade Leverage is perfect substitute for use of le
Example 1
if enterprenuer uses no leverage ---- all equity financed
an investor would prefer to hold leveraged protfolio---->he can do by using leverage in his own portfolio----
i.e. he can buy stock on margin as shown below

Replicating Levered Equity Using Homemade Leverage cost of debt 5%

date 0 date 1
Initial Cost strong
Unlevered equity 1000 1400
Margin Loan -500 -525
levered equity 500 875

if CF of Unlevered equity serves as collateral for margin loan, then its risk-free
and investor should be able to borrow at risk free rate of 5%
Although the firm is UNLEVERED
the investor has replicated the payoffs to the levered equity as calculated earlier
Again by Law of 1 price, the value of Levered equity must be 500

Example 2
if the firm uses debt and the investor desired to hold unlevered equity
the investor can replicate the payoff by buying both debt and equity
Combining the CF of 2 securities produces CF identical to that of Unlevered equity

Replicating Unlevered Equity by holding both debt and cost of debt 5%

Equity date 0 date 1
Initial Cost strong
debt 500 525
levered equity 500 875
levered equity 1000 1400

Investors choice of portfolio doesn’t affect the FV

problem: Homemade leverage and Arbitrage Problem

firm 1 and firm 2 identical except Cap stru
both has CF of either 1400 or 900
Firm 1 - UnLevered
MV of equity 990
Firm 2 - levered
MV debt 500
MV equity 510

MM I dosent hold
Tot MV of Firm 1 990
Tot MV of Firm 2 1010
both are diff---> violation of MM I conditions'
therefore----> law of 1 price is violated and arbitrage opportunity exists

we can
borrow 500 500
buy equity of Unlevered firm for 990 990
levered firm ---> use homemade leverage for a cost = 490
then sell the equity of levered firm for 510
arbitrage 20

Market Value of Balance Sheet

Apart from the above assumed capital stru, there may be any choice of D/E.
Also there may be other types of securities that a fiorm issues such as,
convertible debentures
warrants
stockoptions
But the MM principle applies to all
because the investors can buy / sell securities on their own, no value is created when the firm buys or sells the secu

1 application of MM principle ----> MARKET VALUE OF BALANCE SHEET

MV of B/S <---------> Accounting B/S
only 2 differences -
1. all Assets / liabilities are included, incl intangible assets such as reputation, brand name, human capital, etc
2. All values are Current MV rather than historical values as in case of Acc B/S

MV of B/S captures the idea that value is created by a firm's choice of assets and investments.
by choosing +ve NPV projects worth more than initial investments, firm can enhance its value
but if CF are held fixed, and only the Capital Stru is changed, then there is no change in firm value
instead it merely divides the FV in different proportions among diff securities

MV of Equity + MV of debt = MV of Assets

example prob:
3 securities
debt 500
equity x
warrant pays 210 when CF of firm is high and 0 when CF is low
60
and is priced fairly at

MV of equity = x = 440

Application: A leveraged capitalization

example:
harrison industries, all equity firm , operating in perfect capital Markets
shares O/S (million) 50
price per share ($) 4
MV of equity ($) 200

plan to borrow (million) 80

no of shares to repurchase 20
price of shares to be repurchased 80

Market Value balance Sheet

Leverage and Equity Cost of Capital
As per MM - I proposition
E+D=U=A
E = MV of Equity
D = MV of Debt
U = MV of equity when all equity / unlevered
A = MV of assets

Ru = (Re * E/V) +(Rd *D/V)

Re = Ru + {(D/E)*(Ru - Rd)}…. {}-addl risk due to leverage

I.E THE LEVERED Equity return = UNLEVERED equity return + "kick" due to leverage
this "kick" pushes the return of levered equity even higher when firm performs we;; (Ru >Rd)
but maked them drop even lower if firm performs poorly (Ru<Rd)

The amount of additional risk depends upon the amount of leverage, measured by firms D/E

MM Proposition II -
The cost of capital of levered equity increases with the firms MV D/E

Cost of capital of levered equity

rE = rU + {(D/E)*(rU - rD)}

previous example
all equity financed, --- , unlevered E = 1000
expected return on uinlevered equty = 15%
with Debt = 500
expected retun of debt = risk free rate = 5%
hence acc to MM-II, the expected return on equity of levered firm
rE = 15+ (500/500)*(15-15) = 25% 25% matches the expected return on lev

CAPITAL BUDGETING AND WEIGHTED COST OF CAPITAL

Unlevered CoC (pretax WACC)

Ru = (Re * E/V) +(Rd *D/V)

As in perfect capital markets, there is no tax…hence-->

pre tax WACC = Rwacc = Ru = Rassets
i.e firms WACC and unlevered Cost of Capital is same

Practice Problem
E D V
1000 0 1000
800 200 1000
500 500 1000
100 900 1000

Enterprise Value
EV = Future Free CF discounted by Rwacc
as we know leverage doesn’t lower the Rwacc
Hence the EV will also remain same (doesn’t depend on finanching choices)

Reducing Leverage and Cost of capital

Practice problem
NRG Energy Company---
Market D/E = 2
Rd = 6%
Re = 12%

NRG wants to issue equity and reduce its D/E to = 1

it will lower its Rd to = 5.50%

D/V 0.67
E/V 0.33
Ru = 8.0%

new D/V = E/V = ` 0.5

Ru = constant = 8.0%
Hence Re = 10.5%

Rwacc old = Ru = Ra = ` 8.0%

Rwacc new = 8.00%

Computing wacc with multiple securities

Earlier we calculated Wacc only with 2 securities - debt and equity
if > 2 securities, the Rwacc is weighted avg cost of capital of all securities
Equity (E )= 440
Debt (W)= 500
Warrant (pays 210 when Cf is high, 0 when CF is low) (W)= 60
FV= 1000
Rf = 5%
Rd = Rf = 5%
 Debt CF 525

Expected payoff of warrant = 105

Rw = 75%
Expected Equity Payoff (when CF is high)= 665
Expected Equity Payoff (when CF is low)= 375
Thus overall Equity payoff expected = 520
Thus Overall cost of Equity, Re = 18.18%

Rwacc = 15%

LEVERED AND UNLEVERED BETA

Problem - CVS company
Beta equity = 0.8
D/E = 0.1
beta debt = 0
D/V = 0.09
E/V = 0.91

beta Asset = 0.73

New D/E = 0.5

Debt beta remains = 0
New Equity beta = ??
beta Asset = ( beta equity *E/V) + (beta debt * D/V)
Therefore, Beta Equity = Beta asset + (Beta asset - Beta debt)*D/E

Therefore new Beta Equity = 1.09

Assets ona Firms B/S include any holdings of Cash and Risk free securities
As these securities are risk free, they reduce risk --- and therefore the required risk premium--- of firms assets

Hence, Effect of holding excess cash is opposite to that of leverage,,,, on risk and return

So we can view as Negative debt

so we should measure leverage as net of Debt and cash (or short term investments)

CASH AND COST OF CAPITAL

Example - Cisco
Market cap = 200
Debt = 40
Cash and Short term investment = 75
equty beta = 1.2
 debt beta = 0
Rf = 3%
E(Rm) - Rf = 5%
Soln:
E= 200
D= -35
V= 165

Beta asset = 1.45

R (Unlevered) = Rwacc = Rasset = 10%

CAPITAL STRUCTURE FALLACIES

As the MM I and II state that
with Perfect capital markets, Leverage has no effect on FV or Firms overall Cost of Capital

2 incorrect arguments cited in favour if Leverage

LEVERAGE AND EPS

Incorrect statement 1 - Leverage can increase Expected earnings per share'

Example - levitron Industries

Currently all equity
Expected EBIT = 10
Shares O/S = 10
Price per share = 7.5

Now planning to take debt and use the cash to repurchase shares
Debt = 15
Rd = 8%
No of shares to be repurchased = 2
balance no of shares = 8

Earnings = EBIT (as on Perfect capital markets, tax & interest =

10
0) =
therefore, EPS = 1.00

New debt will have interest payments,

Interest per year = 1.2
New earnings = 8.8
New number of shares = 8
New EPS = 1.1

From above we can see that the EPS has increased

But from MM I ,
we know that the financial transactions have NV = 0 as long as the securities are fairly priced
But this contradicts the increase in EPS
Answer:
Risk of earnings has changes
we have only calculated it effect on EPS
we havent considered its effect on risk of earnings
hence we need to compute the effect of leverage on EPS in variety of scenarios

Suppose,
earnings before interest = 4
without increase in leverage, New EPS = 0.4
with debt
Earnings after interest payment = 2.8
New EPS = 0.35
i.e EPS has decreased

Let EBIT be = x
Interest = 1.2
Earnings after interest = x-1.2
EPS with debt (y1) = (x-1.2)/8
i.e
EPS without debt (y2) = x/10

solve for y1 = y2
x/10 = (x-1.2)/8
8x = 10x - 12
2x = 12
x=6
y1 = y2 = 0.6

i.e at EBIT = 6,
EPC with debt and EPS without debt curve crosses]
at EBIT >6
EPS with debt > EPS without Debt
at EBIT <6
EPS with debt <EPS without Debt

slope of with debt line > without debt line

i.e with debt, fluctuations in EBIT are more magnified with debt

MM PROPOSITIONS AND EPS

Problem - LVI's EBIT n ot expected to grow
all earnings paid as dividends
without Debt,
EPS, therefore dividends = 1
share price = 7.5
Ru = cost of capital w/o debt =
P = 7.5 = Div / Ru = EPS / Ru = 1/Ru
so Ru = 13%
WE can vlaue LVI as perpetuity
MV stock w/o leverage = 75
shares repurhased = 2
debt = 15
Therefore Equity = 60
D/E after leverage = 0.25
Re = Ru + (Ru - Rd)*D/E = 14.66%

New EPS = 7.5021312873

Even though EPS is higher, but due to increased risk, S/H will demand even higher return
This cancels out, so price per share remains constant

Incorrect statement 2 -Issuing equity will dilute the existing S/H ownership, hence Debtshould be used instead
Dilution - by dilution, proponents mean that if the firm issues new shares
then the CF generated by firm will have to be divided among larger number of shares
thereby reducing the value of each share

Problem with above - ignores the fact that issuing new shares will increase the cash
hence increasing the assets of the firm

Example - Jet Sky airlines

Shares = 500
share price = 16
announced expansion and will require $1bn for new planes 1000
and will finance through equity

Market Cap = Equity = 8000

for raising 1bn, no of shares to be sold = 62.5

after
Before Equity
equity
issue
issue
cash 1000
existing assets 8000 8000
Total value 8000 9000
shares O/S = 500 562.5
Value per share = 16 16
From above, we can interpret that when equity is issued,
first, assets grow because of additional cash generated
second, number of shares inccrease
thereby, cancelling out each other's effect

Henca, as long as a Firm sells shares at a fair price, there will be no gain / loss to S/H
Setting of perfect capital markets
1 all secirities are fairly priced
2 no taxes
3 no transaction costs
4 Tot CFs arent affected by how the firm finances them
implies law of one price ---->
choice of Debt or Equity wont affect the Firm value, Share price or CoC
 Date 1 Date 1
CF Returns
Weak Strong Weak
900 40% -10%

nterest rate i.e. 5%

 date 1: CF
weak
525
375
900

at lower price

Date 1: CF Date 1: return

Weak Strong Weak Expected
economy Economy economy Return
525 5% 5% 5%
375 75% -25% 25%
900 40% -10% 15%

atic risk of the economy

∆𝑅=𝑅 (𝑆𝑡𝑟𝑜𝑛𝑔) − 𝑅 (𝑊𝑒𝑎𝑘)

Risk Premium
 E[R] - Rf

5% - 5% = 0%
15% - 5% = 10%
25% - 5% = 20%

5%
25%

date 1: CF date 1: Return

weak strong weak
210 5% 5%
900 40% -10%
690 48.75% -13.75%
17.50%
62.50%
50%
125.00%
12.50%
10.00%
125.00%

on of CFs between debt and equity

qual to PV of their Future CFs

y reveal new info about them

CFs generated by its assets and isnt affected by the

own portfolio

ct substitute for use of leverage by firm

own portfolio----

date 1
Weak
900
-525
375
 date 1
Weak
525
375
900

firm buys or sells the securities for them

, human capital, etc
e expected return on levered equity calculated earlier
 Re Rd Rwacc
15% 5% 15%
17.50% 5% 15%
25.00% 5% 15%
75.30% 8.30% 15%
m--- of firms assets
hould be used instead
Omit 15.4

CH 15: DEBT AND TAXES

Perfect capital markets ---> law of one price----> all transactions have NPV 0----> neither create nor destroy value
Choice of Debt/equity---->doesn’t affect the Firm value

Funds raised from issuing debt = PV of future interest and principal payments the firm will make

Leverage / debt ----> increases Risk ----> increases the equity cost of capital----> but WACC remains same

But in real world, the firm invests following resources in managing the Capital structure-----
1. managerial time and effort
2. investment banking fees

hence, sometimes the choice of leverage is critical to firm value and future success

Vertex Pharma

Debt 600
cash 2800
equity 43000
D/E 0.014
Net debt -2200

why such difference in capital stru if Cap stru choice doesn’t matter?
as per MM, choice of Cap Stru doesn’t matter in perfect markets
but in real world markets are not perfect
Assumptions of perfect Capital Markets
1. investors and firms can trade same set of securities at competitive market prices equal to the PV of their Future
2. there are no taxes, transaction costs or issuance costs associated with security trading
3. a firms financing decisions do not change the CF generated by its investments nor do they reveal new info about

hence, it means the differences in the Capital stru of variuos companies stems from market Imperfections

15.1 The interest Tax Deduction

corporations are required to pay taxes on earnings

they pay taxes on profits after interest is deducted--->interest expenses reduce their tax amount the corporations

Example - Macy's inc - with and without leverage

WITH LEVERAGE

EBIT 2800
 INTEREST EXPENSE -400
INCOME BEFORE TAX 2400
TAX RATE 35%
TAXES -840
NET INCOME 1560

Macy's Debt oblicagion reduced the income avaailable to the S/H

but most importantly, total amount available to all investors is higher with leverage

interest paid to debt holders 400

income available to all equity holders 1560
Tot availa to all investors 1960

firm is better off with leverage even though its earnings are lower
but Firm value is total amount it can raise from all investors not just equity holders
leverage allows firm to pay out more in total to investors-- incl interest payments to debt holdres--
it will be able to raise more total capital initially

ADDITIONAL AVAILABLE 140

THIS ADDITIONAL AVAILABLE IS THE TAX SHEILD OR TAX REDUCTION

THERE IS NO TAX ON 400

INTEREST TAX SHIELD = CORP TAX RATE * INTEREST PAYMENT

EXAMPLE-COMPUTINH INT TAX SHIELD - DF BUILDERS

TAX RATE 25%

DBF INC STSTEMENT 2019

TOT SALES 3369
COGS 2359
SGA 226
DEP 22
OPERATING INC 762
OTHER INC 7
EBIT 769
INT EXP 50
INC B4 TAX 719
TAX 179.75
NI 539.25

TAX SHIELD 12.5

15.2 VALUING INTEREST TAX SHIELD

DEBT----> INT TAX SHIELD---->CORP BENEFIT

BENEFIT OF LEVERAGE----> PV OF ALL FUTURE TAX SHIELD

INT TAX SHIELD AND FIRM VALUE

(CF TO INVESTORS WITH LEVERAGE) = (CF TO INV W/O LEV) + (INT TAX SHIELD)

VL = VU + PV(INT TAX SHIELD)

Example - DFB RESTRUCTURES THE DEBT

NEW INTEREST EACH YR 80
FINAL PAYMENT IN YEAR 10 1600
TAX RATE 25%
Rf 5%

INTEREST TAX SHIELD 20

THIS IS FOR 10 YEARS, YEARS 10
HENCE CAN BE SEEN AS ANNUITY FOR 10 YEARS

TAX SAVINGS ARE RISK FREE, THEY CAN BE DISCOUNTED AT Rf

PV(INT TAX SHIELD) 154.4346985837

INT TAX SHIELD WITH PERMANENT DEBT

IN REAL WORLD, hence the amount of interest change because of--->

1---the amount of debt o/s changes over the years
2---changein interest rateriskof default
3---failure to make interest payment
4--- corp tax rate my change due to changes in firm income bracket

FIRM WANTS TO KEEP THE DEBT AMOUNT CONSTANT

OPTION 1 --- CONSOL BOND ISSUES-- ONLY INTEREST PAYMENTS AND NO PRINCIPAL REPAYMENTS
OPTION 2--- 5 YEAR COUPON BOND AND WHEN ITS TIME TO REPAY PRINCIPAL, THE FIRM AGAIN ISSUES DEBT TO R
THIS WAY THE DEBT IS CONSTANT --- REFINANCING
------- PERMANENT DEBT

Suppose,
Debt D
tax rate t
Risk free int rate Rf
int tax shield each year D x t x Rf
this tax shied can be seen as an infinite perpetuity

MV of Debt = D = PV(future interest payments)

PV(tax shield) = PV(future interest payments)
=txD

WEIGHTED AVG COST OF CAPITAL WITH TAXES

INTEREST RATE, R 10%

DEBT, D 100000
tax rate, T 21%

INT EXPENSE R x 100000

TAX SAVINGS T x R x 1000
eff after tax cost of debt R x (1-T)x100000

WACC AFTER TAX, Rwacc = (Re*E/V)+(R*(1-T)*D/V)

= (Re*E/V) + (R*D/V) - ((R*T)*D/V)

FIRM WANTS TO KEEP THE D/E CONSTANT

When a firm targets a particulat D/E ratio--->

its amount of debt will inc/dec with the size of firm

to do so, the firm constantly adjusts its debt over time so that D/E is constant

VL ----> discounting FCF by WACC

int tax shield = VL - VU

VU--> discounted at pretax wacc

example prob - Valuing tax shield with target D/E ratio

FCF 4.25
FCF GROWTH RATE 4%
Re 10%
Rd 6%
Tax rate 21%
 D/E 0.5
E/V 0.666666666667
D/V 0.333333333333

int tax shield??

Pre tax WACC 8.67%
WACC with tax 8.25%

V (unlevered) 91.07142857143
V(levered) 100.0784929356

PV (int tax shield) = V(levered) - V (unlevered) 9.007064364207

15.3 RECAPITALIZING TO CAPTURE TAX SHIELD

SIGNIFICANT CHANGE IN CAPITAL Structure----> known as recapitalization

leverage recapitalization---> issues large amt of debt and uses the proceeds to buy back shares or pay special divid
famous in 1980's---> firms found that this can reduce their tax payments

Now, lets see how this transaction affects the current shareholders

MIDCO----
shares o/s 20
price per share 15
Debt 0
Tax rate 21%
MV of equity 300

Management plans to birrow 100MN on permanent basis through leveraged recap

expectation-- tax will reduce and stock price and benefit to Sheraholder will inc

The Tax Benefit

Debt 100
V(unlevered) 300
PV (inet tax shield) 21
V(levered) 321

E = V(levered) - D 221
although Equity value has dropped, still benefits to S/H will increase
because, S/H will also get the 100 payout for share repurchase

tot payment to s/H 321

The Share repurchase
Current Share price 15
no of shares repurchased 6.666666666667
balance no os shares 13.33333333333
new Equity 221
new share price 16.575

S/H who kept their shares, earned a capital gain per share = 1.575

Now, why would a shareholder agree to sell at 15 when share price is 16.575

No arbitrage pricing
above situation creates arbitrage possibility
Investors could buy shares immediately b4 repurchase at price = 15
and could sell immediately after repurchase at price = 16.575

but in reality, this will increase the share price even before repurchase activity
once the investors know that repurchase will happen the share price will rise immediately to a level which reflects

i.e the value of MIDCO's equity will rise immediately to = 321

shares number 20
share price 16.05

with the repurchase price of 16.06, both who tender their shares and
1.05
who hold their shares gain
hence we can see that benefit of tax shield goes to all 20mn Sh o/s 21

ALTERNATIVE REPURCHASE PRICES

Problem - MIDCO

midco announces a price at which it will repurchase 100mn worth shares

show that 16.05 is the lowest price midco could offer
how will the benefit be divided if midco offers > 16.05 shareprice

repurchase price

15
15.55
16.05
16.55
17.05
 share price > 16.05---> all shareholders will be eager to sell shares because the shares wil have lower value after tr
share prics < 16.05---> all shareholders will be eager to buy shares because the shares wil have lower value after tr

ANALYSING THE RECAP: MV OF BALANCE SHEET

TOT MV OF FIRMS SECURITIES = TOT MV OF FIRMS ASSETS

IN presence of corp taxes, we must include inttax shield as one of the assets

RECAP STEPS -
1. RECAP ANNOUNCED ----> INVESTORS ANTICIPATE FUTURE INTTAX SHIELD
RAISING Midco's assets by 21
2. midoc issues debt, increasing midco cash andliabilities by that amt
3. midco uses the cash to repurchase shares at their market price = 16.05
MIDCO's cash decline and no of shares also

MV BALANCE SHEET INITIAL

Assets
Cash 0
Original assets 300
interest tax shield 0
Tot assets 300
Liabilities
Debt 0
Equity 300
Shares o/s 20
price per share 15

15.4 PERSONAL TAXES

PERSONAL TAXES ARE LEVIED BOTH ON INTEREST INCOME AND EQUITY INCOME(DIVIDENDE/CAPITAL GAINS)

DEBT--- INTEREST INCOME--- TAXED ONCE--- INTEREST PAID BEFORE CORP TAX IS LEVIED
EQUITY--- S/H INCOME---TAXED TWICE---- PAID AFTER CORP TAX IS LEVIED

Including personal taxes in Interest tax Shield

personal taxes also reduce the CF to the investors

hence diminish the Firm value

Hence actual interest tax shield depend upon the reduction in total taxes (corp+personal)
Personal taxes--- offsets some of the corp tax benefits of leverage
interest income taxed more heavily than capital gains from equity

To determine true tax benefit of leverage--- we need to evaluate the combined effect of both corp and personal ta

Tax rate for interest income ----> Ti 37%

Tax rate for corporate income ----> Tc 21%
Tax rate forequity income ----> Te 20%

After tax CF
To debt holders (a) (1-Ti)
To equity holders (b) (1-Tc)*(1-Te)

tax advantage of debt falls--- from 21% to T*

T* = (a-b)/b
T* = -0.32%
T* -----> effective tax advantage of debt
if corporation pais (1-T*) in interest, debt holders would receive same
amount as equity holders would receive if firm paid $1 in profits to
equity holders.
That is,
(1-T*)*(1-Ti) = (1-Tc)*(1-Te)
T* = 1- ((1-Tc)(1-Te)/(1-Ti))

T*-----> effective tax advantage of debt

problem--- Calculating Efective tax adv of debt

T*(1980) = 1-((1-0.46)*(1-0.49)/(1-0.7)) 8.20%

T*(1990) = 1-((1-0.34)*(1-0.28)/(1-0.28)) 34.00%

Valuing Interest Tax Shield with Personal Taxes

V
V(levered) = V(unlevered) + (T* x D)
T* < Tc generally
hence, benefit of leverage is reduced by personal taxes

Personal taxes have indirect effect on WACC (similar to corp tax)

We will still compute WACC using Corp tax rate…

Firms equity and dect Cost of Capital will adjust to compensate for respective tax burdens

personal tax disadv for debt---> causes WACC to declinemore slowly with leverage than otherwise

Estimating Int tax shield with personal Taxes

Problem - MOreLev--- wants permanent debt

Market cap 500

shares O/s 40
corp tax rate 21%
Ti 20%
Te 10%

220mn leverage recap

Debt 220

original share price 12.5

T* = 1-((1-Tc)(1-Te)/(1-Ti)) = 11.12%

PV(int tax shield) 24.475

New MV of equity 524.475
New share price 13.11
--> neither create nor destroy value

he firm will make

> but WACC remains same

tructure-----

ford motor

3.8

ices equal to the PV of their Future CF

s nor do they reveal new info about them

from market Imperfections

their tax amount the corporations must pay

WITHOUT
LEVERAGE
2800
 2800
35%
-980
1820

0
1820
1820

nts to debt holdres--

FROM WHERE??

2020 2021 2022

3706 4407 4432
2584 2867 3116
248 276 299
25 27 29
849 1237 988
8 10 12
857 1247 1000
80 100 100
777 1147 900
194.25 286.75 225
582.75 860.25 675

20 25 25
 CIPAL REPAYMENTS
, THE FIRM AGAIN ISSUES DEBT TO REPAY
10000
-2100
7900
buy back shares or pay special dividend
mmediately to a level which reflects $21mn int tax shield tha the firm will receive]

entive tax shield value distributed to all 20mn shares

amt for repurchase 100

no of shares 20
new equity 221

shares shares new share

repurchased remaining price

6.67 13.33 16.575

6.43 13.57 16.286967
6.23 13.77 16.05
6.04 13.96 15.83355
5.87 14.13 15.635062
 shares wil have lower value after transaction
shares wil have lower value after transaction

STEP 1 STEP 2 STEP 3

0 100 0
300 300 300
21 21 21
321 421 321

0 100 100
321 321 221
20 20 13.77
16.05 16.05 16.049383

ME(DIVIDENDE/CAPITAL GAINS)
effect of both corp and personal taxes

using current tax rates

0.63
0.632

age than otherwise

CH 18: CAPITAL BUDGETING AND VALUATION WITH LEVERAGE

18.2 WACC METHOD

Rwacc = (Re*E/V)+(Rd*(1-Tc)*D/V)

1 ASSUME FIRM HAS CONSTANT D/E RATIO

Value of levered firm = PV OF FCF DISCOUNTED BY Rwacc

As Rwacc incorporates tax savings

VL0 = FCF1/(1+Rwacc) + FCF2/(1+Rwacc)2 + FCF3/(1+Rwacc)3 +...

Problem - AVCO
New line of packaging -- RFID tag
Useful Life (years) 4
annual sales 60
manuf cost 25
operating expenses 9
developing-- R&D cost 6.67
investment in equipment 24
Net WC at all years 0
corp tax rate 25%

depraciation annual 6

FREE CASH FLOW FROM AVCO PROJECT 0

sales
manuf cost
Gross profit
operating expenses 6.67
Depreciation
EBIT -6.67
Income tax 1.6675
Unlevered NI -5.0025

FCF
Plus: dep 0
Plus: Capex -24
Plus Inc in NWC 0
Free Cash Flow -29.0025
PV( FCF) -29.00
V (levered firm) 70.73
Rwacc 7.25%

Example: Valuing an Acquisition using WACC Method

AVCO is considering acquisition of another firm--- specializing in custom packaging

From aacquisition ---->

expected increase in FCF in first year 4.25
Growth rate for this inc in FCF 3%
Negotiated Purchase Price 80

Rwacc as calculated earlier 7.25%

V(levered) = inc in FCF / (R-g) = 100

Acquisition NPV = 20

IMPLEMENTING A CONSTANT D/E

By undertaking RFX project, AVCO adds new assets to firm

with initial MV V(levered at 0) = 70.73

To maintain its D/E = 1, AVCO has to add new Debt 35.36591131498

it can be done either by decreasing Cash or increasing Borrowing

suppose, AVCO decides to spend cash = -20

and borrow amount = 15.365

Tot Net Debt 35.365

Amount required to fund the project at T=0` 29.0025

balance remaining paid to S/H thru dividend = 6.3625

MV OF AVCO EQUITY EARLIER 300

MV OF AVCO EQUITY NOW 335.365911315
INCREASE IN MV OF AVCO EQUITY 35.36591131498

TOTAL GAIN FOR S/H = BALANCE PAID AS DIVIDEND + INC IN EQUITY 41.72841131498
This is exactly same as NPV for RFX proj
)
Debt at any time t = (D/V)*(CONTINUATION VALUE OF LEVERED FIRM AT TIM

Example - CV and debt Capacity of RFX proj over time

0
FCF -29.0025
levered Value at Rwacc $70.73
Debt Capacity Dt (D/E = 1) $35.37

Example: DEBT CAPACITY FOR AN ACQUISITION

Suppose AVCO proceeds with the acquisition
how much debt should avco use to finance acquisition to maintin its D/E ratio.
How much acquisition cost must be financed with equity

MV of assets acquited, VL = 100

to maintain D/E = 1,
AVCO muct increase its debt by amount = 50
negotiated price = 80
balance amount = 30
this balance amt to be financed with equity

NPV of this acquisition = 20

total increase in MV of AVCO's equity = 50
 1 2 3 4 ASSETS
60 60 60 60 Cash 20
25 25 25 25 Existing Assets 600
35 35 35 35 Tot Assets 620
9 9 9 9
6 6 6 6
20 20 20 20
-5 -5 -5 -5
15 15 15 15

6 6 6 6
 0 0 0 0
0 0 0 0
21 21 21 21
19.58 18.26 17.02 15.87

MV B/S WITH RFX PROJ

ASSETS LIABILITIES
Cash - Debt 335.36591
Existing Ass 600 Equity 335.36591
RFX PROJ 70.73 Tot Liab & Equity 670.73182
Tot Assets 670.73182
F LEVERED FIRM AT TIME t)

1 2 3 4
21 21 21 21
$54.86 $37.84 $19.58
$27.43 $18.92 $9.79
 Liabilities Cost of Capital
Debt 320 Debt 6%
Equity 300 Equity 10%
Tot Liab & Equit 620

Net Debt 300

Ned D+E 600
CH 18: CAPITAL BUDGETING AND VALUATION WITH LEVERAGE

18.3 ADJUSTED PRESENT VALUE METHOD

VL = AVP = VU + PV(Interest Tax Shield)

RETURNING TO AVCO RFX PROJECT

UNLEVERED VALUE OF PROJECT

UPFRONT COST 29.0025

PER YEAR FCF(YR1-4) 21

Rwacc (PRE TAX) 8.00%

V (UNLEVERED)
FREE CASH FLOW FROM AVCO PROJECT 0
FCF -29.0025
PV (FCF) -29.0

VU 69.6

VALUING INTEREST TAX SHIELD

INT PAID IN YEAR T = Rd *D(t-1)

corp tax rate 25%
INTEREST TAX SHIELD 0
DEBT Capacity $35.37
interest paid
Interest tax shield
PV (Int tax shield)
PV (Int tax shield) 1.18

VL 70.73

example: using AVP method to value an acquisition

again consider AVCO's acquisition
acquisition will contribute per year in FCF = 4.25
growth rate of FCF 3%
acquisition cost 80
debt 50
constand d/v = e/v = 0.5

V(unlevered) = 85

first year interest 3

first year int tax shield 0.75
int tax shield will also grow at same rate of FCF
PV(int tax shield) 15

V(Levered) = 100.00

NPV acquisition (with leverage) = 20.00

NPV acquisition (without leverage) = 5
 ASSETS Liabilities Cost of Capital
Cash 20 Debt 320 Debt 6%
Existing As 600 Equity 300 Equity 10%
Tot Assets 620 Tot Liab & 620

Net Debt 300

Ned D+E 600

1 2 3 4
21 21 21 21
19.4 18.0 16.7 15.4

1 2 3 4
$27.43 $18.92 $9.79 $0.00
$2.12 $1.65 $1.14 $0.59
$0.53 $0.41 $0.28 $0.15
0.491193 0.352751 0.225273 0.107941
CH 16: financial distress, managerial incentives and information

16.1 Default and Bankruptcy in a Perfect Market

FINANCIAL DISTRESS
when a firm has trouble meeting its debt obligations

leverage----> risk of bankruptcy

if a firm defaults on interest / principal repayments---->

debt holders are entitled to sertain rights of the firm
extreme case---> legal ownership of firm goes to debt holders---> BANKRUPTCY

A Armin Industries: Leverage and the Risk of Default

options -
new prod succeeds, armin worth = 150
new prod fails, armin worth 80

2 capital stru options -

1. all equity
2. with debt of 100$ 100

Scenario 1: suceeds
worth 150
no leverage---> equity holders hold entire amount 150
with leverage----> equity holders hold 50

what if armin doesn’t have 100 cash at end of year

value may come from anticipated future profits and no cash in hand
will it be forced to default?
with perfect capital markets---> NO
as long as value of assets > value of liabilities---> armin will be able to repay loan
eveni f it doesn’t have cash in hand, it can rase cash by additional loan or by issuing new shares

for e.g--->armin has shares o/s = 10million 10000000

value of equity = 50000000
share price 5

at this price armin can isse new shares for repaying debt (number)= 20000000
aftre the debt is repaid, firms equity will again be = 150000000
 balance no of shares = 30000000
share price 5

Scenario 1: fails
worth 80000000
no leverage---> equity holder gets all, no legal consequence, but s/h unhappy

with leverage
debt 100000000
firm will be unable to make this payment
hence default

in bankruptcy---> debt holders will get legal ownership of firms assets leaving s/h with nothing

asstes that debt holders reveive 80000000

hence the loss for D/H 20000000

B Bankruptcy and Capital Structure

Problem: Bankruptcy Risk and Firm Value

Rf 5%
product likely to suceeed 0.5
product likely to fail 0.5
beta (risk is diversifiable) 0
cost of capital = Rf 5%

Sol:
without leverage
Equity(unevered) = Vu= 109.523809524
 Equity(levered) = 23.8095238095
debt 85.7142857143
VL 109.523809524

16.2 The Costs of Bankruptcy and Financial Distress

perfect markets---> riskof bankruptcy is not disadvantage of debt--->it simply shifts ownership and Valueof firm rem

its not simple in real---> equity holders don’t just hand the keys to debt holders
rather bankruptcy is a long and complicated process
imposes direct and indirect costs on firm and invetors

A The Bankruptcy Code

US bankruptcy code - 2 types of protection

1 liquidation - ch 7
trustee is appointed and he oversees the auction whose proceeds are used to pay firm's creditors and the firm cea

2 Reorganization - ch 11
al pending collection actions are suspsnded
firms existing management is given opportunity to propose reorganization plan
while developing plan, management continues to operate the business.
reorg plan---> specifies treatement of each creditor of firm
in addition to cash payment, crditors will also receive debt or equity securities
value of cash + securities < amount owed but > amount which they would have received on firm shut down/liquida
creditors must approve the plan and aopproved by bankruptcy court
if plan is not acceptable---> court may force ch 7---> liquidation

B Direct Costs of Bankruptcy

1 firms spend money on --->

investment bankers
consultants
legal professionals
accounting experts

2 creditors incur costs during bankruptcy process

ch11---> creditors wait longer periods for plan to be approved and receive payments
also creditors may hire legal experts to assist in valuing their claims

both the above reduce firms value

many cases---> reorg costs = 10% of firm value
 to avoid these costs and degradationin FV---> firms in financial distress may avoid to file bankruptcy by first negotia

C Indirect Costs of Financial Distress

Loss of customers
Loss of suppliers
Loss of employees
Loss of receiveles
fire sales of assets
inefficient liquidation
Costs to creditors

16.3 Financial Distress Costs and Firm Value

ARMIN industries example

if prod fails and armin has debt---> forced into bankruptcy

some value of assets is lost to bankruptcy and financial distress costsin turn--> D/H will receive <80

assume they received only 60

vale of debt = 76.1904761905

Value of levered firm = E+D 100

Vu(calc earlier) = 109.523809524

bankruptcy costs = 9.52380952381

loss = PV of $20 mn in financial distress costs the firm will pay if prod fails
PV(fin distress cost) = 9.52380952381

A Who Pays for Financial Distress Costs?

 example - ARMIn

shares o/s = 10
debt 100
yr 1

debt to repurchase shares

Rf 5%

Vu = 109.523809524
share price 10.9523809524

VL = 100
share price 10

due to bankruptcy cost, the new debt is worth 76.1904761905

no of shares repurchase at 104 7.61904761905

BALANCE NO OF SHARES = 2.38095238095

VALUE OF LEVERED EQUITY = 23.8095238095

SHARE PRICE AFTER TRANSACTION = 10

THIS RECAPITALIZATION WILL COST S/H 0.952 PER SHARE OR 9.52 IN TOTAL
THIS IS SAME AS THE pv OF FINANCIAL DISTRESS COSTS COMPUTED ABOVE = 9.52380952381

16.3 OPtimal Capital Structure: The Tradeoff Theory

Debt tax shield + cost of financial distress----> tells how much leverage firm should take to maximize its value
this is known as Trade-off theory

Vl = Vu + PV(inttax shield) - PV(distress cost)

A The Present Value of Financial Distress Costs

3 key factors n determining ---->

probability of Fin distress
magnitude of cost if firm is in distress
 appropriate discount rate depends on firms market risk

higher firm beta---> higher chances of distress in economic turndown----> more negative beta of distress cost

B OPTIMAL LEVERAGE

PERMANENT DEBT---->
VL = VU +(T*D)

NO DEBT , FV = VU

LOW DEBT LEVELS----> NO RISK OF DEFAULT----> MAIN EFFECT IS INCREASE IN TAX SHIELD(T*D)
T---> EFFECTIVE TAX RATE
IF THERE IS NO CASE OF FINANCIAL DISTRESS---> FV WILL KEEEP ON INCREASEING TILL INTEREST <EARNINGS BEFO

COST OF FINANCIAL DISTRESS REDUCE THE VALUE OF LEVERED FIRM

AMT OF REDUCTIN = PV(FIN DISTRESS COST)
AMT IF REDUCTION INCREASES WITH INC IN PROB OF DEFAULT---> WHICH INCREASES WITH INC N DEBT

DEBT FOR WHICH VL IS MAXIMISED---> (T*D) - PV(DISTRESS COST)>0 AND MAX

EXAMPLE: Choosing an Optimal Debt Level

T=15% 15%
MAX DEBT 35
 16.5 Exploiting Debt Holders:The Agency Costs of Leverage

AGENCY COSTS
most likely when cost of financial distress is high

Exampe - baxter---> loan of 1mn-->

without change in strat--> value of assets at the end of year = 900000
and baxter will default on its debt

several types of agency costs

A Excessive Risk-Taking and Asset Substitution

executives considering new strategy---> no oinitial cost

but success probability = 50%
if suceeds, FV 1300000
if fails, FV 300000

expected FV = 800000
old strat 900000
decline 100000

some executives, despite decline in FV have suggested to go ahead with new strat---why?
to benefit s/h--- how?

if baxter continues old strategy---> equity holders will not get anything
risky strategy---> nothing to loose for S/H
if succeeds--->after repaying debt, S/H will get = 300000
if fails---> S/H will get = 0
Expected payoff for S/H in new strat = 150000

clear gain for S/H innew strat even with negative expeced payoff

B Debt Overhang and Under-Investment

sometimes when in distress---> S/H prefer not to oinvest innew positive NPV projects
this is DEBT OVERHANG
its costly for debt holders and overall value of firm
coz its giving up the NPV of missed opportunity

cashing out
when in financila distress
s/h have incentive to withdraw cash if possible
suppose baxter has equipment it cansell for 25000 at beginning of year
without it baxter has to shut some opertions resulting in decline of FV to 800000
this will cause a decline of 100000 in FV
anf if the fiem is likely to default then this cost will be borne by D/H

so S/H gain if baxter seell equip now and uses this proceed to pay immediate cash dividend

this incentive to liquidate assets below their actual value to firm is extreme form of DEBT OVERHANG

Estimating the Debt Overhang

how much leverge a firm must have to have debt overhang problem

amount invested = I
NPV, D,E, Beta-d and Beta-e

if Beta-d or D = 0
NPV/I>0

but if debt is risky

S/H will reject positive NPV proj with profitability indicies below cutoff

Example-Estimating the Debt Overhang

Sears - from 12.7
equity beta 1.36
debt beta 0.17
D/E 1

Saks
equity beta 1.85
debt beta 0.31
D/E 1
 min NPV for s/h benefit
initial invest 100000

NPV/I (Sears) = 0.125

NPV/I (Saks) = 0.168

min NPV sears = 12500

min NPV saks = 16757

saks has more debt overhang

C Agency Costs and the Value of Leverage

new shares
ith nothing

150
80
 ownership and Valueof firm remains same

firm's creditors and the firm ceases to exist

eived on firm shut down/liquidation

o file bankruptcy by first negotiating directly with creditors

will receive <80

take to maximize its value
nds on firms market risk

gative beta of distress cost

SHIELD(T*D)

TILL INTEREST <EARNINGS BEFORE INT AND TAX

SES WITH INC N DEBT

DEBT OVERHANG
QUIZ 2
problem 1
CoC 10%
0 1
-10000 12000
-10000 10909.09

NPV = 909.0909
IRR = 20%
Max deviation allowed = 10%

problem 3

Expected
COST
sale
proj today(mn y1 y2 y3 y4 Disc Rate
pricein
)
year 5
Sea Breeze -6 0 0 0 0 35.5 8%
West ranch -9 0 0 0 0 46.5 8%
Mount Ridge -3 0 0 0 0 18 15%
Lake vew -9 0 0 0 0 50 15%
Ocean Park -15 0 0 0 0 75.5 15%
green hills -3 0 0 0 0 10 8%

problem 3

expected pizza sales (mn) 20

% sales from previous cust
who switch 40%
sales from previous cust
who switch (mn) 8

a. if price of earlier and new pizza are same

incremental sales 12

b. if no healhier pizza introduced

% those who wish to switch

to another brandif
healthier pizza not
introduced (of those who
want helthier pizza) 50%
%those who wish to switch
to another brandif
healthier pizza not
introduced (ofTOTAL) 20.0%

those who wish to switch to

another brandif healthier
pizza not introduced
(ofTOTAL) 4

incremental sales 16

problem 2

0 1 2 3 4 5 6
-10 0 5 2 2 2 2
pv -10 0 4.1322314 1.502629601803 1.366027 1.241843 1.128948
PAYBACK PERIOD 5
CoC 10%
NPV -0.628322

problem 5

INITIAL INVEST 5
GROSS PROFIT MARGIN
0 1 GROSS PROFIT MARGIN AVG
-5 CORP TAX
9 7
PV

0 1 2 3
2 2 2 2
sales1 9 7
sales 2 2 2 0.138
COGS1 5.85 4.55 0.0414
COGS2 1.5 1.5
COGS 7.35 6.05

Gross profit 3.65 2.95

SGA 5 0
dep 0 0
ebit -1.35 2.95 -0.4725
tax 0.4725 -1.0325
inc earnings -0.8775 1.9175

problem 6

georgia
S. carolina

problem 7

current price 350 yr 1 yr 2

next year price 300 price 350 300
units 20000 25000
cogs 200 sales 7000000 7500000
sales(units) this yr 20000 cogs 4000000 5000000
% inc sales next yr 25% addl sales (cart) 75 75
sales(units) next yr 25000 cogs(cart) 22.5 22.5

incrementa limpact in sales ( 500000

gross profit 3000000 2500000
4050000 3812500
sales cart 1500000 1875000
cogs cart 450000 562500
gross profit cart 1050000 1312500

tot gross pro 4050000 3812500

problem 8

NI 250
DEP 100
INT 0
CAPEX 200
DELTA WC 10
OCF 350
FCF 140

problem 9
 YR1 YR2
REVENUE 125 160
COGS 40 60
DEPRECIATIN 25 36
INC IN WC 5 8
CAPEX 30 40
CORP TAX RATE 20% 20%

GROSS PROFIT 85 100

EBIT 60 64
PAT 48 51.2

FCF 38 39.2

problem 10

INITIAL EXP 15
LIFE 5
TAX RATE 20%
PER YR DEP 3

YR BV DEP
0 15 3
1 12 3
2 9 3
3 6 3
4 3 3
5 0
A 3
B. ANNUAL DEP TAX SHIELD 0.6 3
C. MACRS
YR DEP RATE DEP DEP TAX SHIELD DEP
0 20% 3 0.6 15
1 32% 4.8 0.96
2 19.20% 2.88 0.576
3 11.52% 1.728 0.3456
4 11.52% 1.728 0.3456
5 5.76% 0.864 0.1728
problem 11

YR 5
REVENUE 1200
OPERATING INC 100
NI 50
FCF 110
BV OF EQUITY 400

GROWTH RATE 2%
COC 12%
FCF IN YR 6 112.2
CV IN YR 5 1122

P/E 30
CV IN YR 5 1500

Market/book 4
CV IN YR 5 1600
IRR NPV NPV pi

42.70% 18.16 18160703 3.03 -3+(18/(1+irr)^5) =0

38.88% 22.65 22647119 2.52
43.10% 5.95 5949181 1.98
40.91% 15.86 15858837 1.76
38.16% 22.54 22536844 1.50
27.23% 3.81 3805832 1.27

1.98
1.50
1.76
3.03

1.27

2.52
OFIT MARGIN 35%
OFIT MARGIN AVG 25%
35%

2
-500000
-237500

262500
problem 3
shares Price/share Tot equity debt
alpha (all equity) 10 22 220
omega 20 x 20x 60

A x= 8

B
shares Price/share Tot equity debt
alpha (all equity) 10 22 220
omega 20 11 220 60

SELL 20MN SHARES OF OMEGA 220

BUY 10 MN SHARES OF ALPHA 220
BORROW 60MN

problem 4

CASH 5000
shares 5000
share price 12
MV TE 60000

no of shares to be repurchased 416.66667

MV emp stock option 8000

TOT ASSETS = 68000

NON CASH ASSETS 63000

MV EQUITY AFTER REPURCHASE 55000

SHARE PRICE 12

problem 5

cost of capital, Re = Ru = Ra = 12%

A. BRROWS
D/E 0.5
D/V 0.3333333
E/V 0.6666667

DEBT COST OF CAPITAL, Rd = 6%

EQUITY COC, Re X
WACC = 12%

12 = (X*2/3)+(6*1/3)

X= 15

B. BORROWS
D/E 1.5
D/V 0.6
E/V 0.4
DEBT COST OF CAPITAL, Rd = 8%

EQUITY COC, Re X
WACC = 12%

12 = (X*0.4)+(8*0.6)

X= 18%

problem 6 -GLOBALPISTONS

MV EQUITY 200
MV DEBT 100

Re 15%
Rd 6%
E/V 0.6666667
D/V 0.3333333

WACC = Ru 12%

A. NEW STOCK ISSUES

NEW STOCK ISSUED = 100
MV EQUITY 300
MV DEBT 0
Re X
Rd 6%
E/V 1
D/V 0

Ru 12%
 12 = (X*1)+(6*0)

X= 12%

B. i. NEW STOCK ISSUES

MV DEBT 150
MV EQUITY 150
Re X
Rd 6%
E/V 0.5
D/V 0.5

Ru 12%
12=(X*1/2)+(6*1/2) 13.2

X= 18.00%

X= 23.94

B. ii. NEW STOCK ISSUES

MV DEBT 150
MV EQUITY 150
Re X
Rd 8%
E/V 0.5
D/V 0.5

Ru 12%
12=(X*1/2)+(6*1/2)

X= 16.00%

problem 7 - PELAMED PHARMA

EBIT 325
INTEREST EXPENSE 125
CORP TAX RATE 25%
TAX 50

A. PAT 150
B. NI+INT 275
C. IF INT = 0
EBIT 325
INTEREST EXPENSE 0
CORP TAX RATE 25%
TAX 81.25

PAT 243.75
NI+INT 243.75

INT TAX SHIELD 31.25

problem 8 - GROMMIT ENGG

NI 20.75
FCF 22.15
TAX RATE 20%

A. INCREASE IN INT EXPESE 1

INC IN TAX SHIELD 0.2

NEW NI 19.95

B. FCF WILL REMAIN SAME

problem 9 - ARNELL INDUSTRIES

Debt, D 10
tax rate 21%
int rate 6%
1 yr int 0.6
int tax shield 0.126

pv of int tax shield 2.1

c.
Debt, D 10
tax rate 21%
int rate 5%
1 yr int 0.5
int tax shield 0.105

pv of int tax shield 2.1

problem 10 - bay transport

MV DEBT 30
Rd 7%
TAX RATE 25%
ADITIONAL PAYMENT 5%

INT 1.95
INT TAX SHIELD 0.4875
PV OF INT TAX SHIELD 4.24

problem 11 - SAFECO

D 0
CASH 10
TAX RTE 21%

EQUITY E
Re R
D-C -10
PV OF INT TAX SHIELD -2.1

problem 12 - ROGOT

D 1
E 2
D/V 0.3333333
E/V 0.6666667

TAX RATE 21%

Re 12%
Rd 7%

PRE TAX WACC 10.33%

EFFECTIVE WACC 9.84%

problem 13 - SUMMIT BUILDERS

D/E 0.65
D/V 0.3939394
E/V 0.6060606
TAX RATE 25%
Rd 7%

DEC IN WACC 0.69%

problem 14 - MILTON

TAX RATE 21%

Ru 15%
D 19.05
FCF 5

VALUE OF FIRM W/O LEVERAGE 33.333333

VALUE OF FIRM WTH LEVERAGE 37.333833

problem 15 - KURZ
ALL EQUITY
SHARES 20
SHARE PRICE 7.5
MV OF E 150
TAX RATE 25%

BORROW TO REPURCHASE SHARE

MV DEBT 50
NEW MV EQUITY 100
D/V 0.3333333
E/V 0.6666667

A. MV OF ASSETS B4 REPURCHAS 150

B. MV ASSETS AFTER BORROWING 212.50

C. SHARE PRICE JUST BEFORE REPURCHASE

E 162.50
SHARE PRICE 8.13
NO OF SHARES TO BE REPURCHASED 6.15

D.
ASSETS 162.50
E 112.50
SHARE PRICE 8.125
Rwacc 7.25%

0 1 2 3 4
FCF -29.0025 21 21 21 21
V (Levered) $70.73 $54.86 $37.84 $19.58
Debt $35.37 $27.43 $18.92 $9.79
 2004 2005 2006

Interest Expense 10568 8028 11081

PBT 17910 32723 30447

TAX 7414 12830 11747
PAT 10496 19893 18700
Tax rate 41% 39% 39%

Current portion of LT Debt 26534 20767

Tax payable 5723 5462
Deferred tax 14179 14179
Long term debt 82414 81078

Equity beta Equity beta

d/e tax rate
(levered) (unlevered)
Jackson 11.20% 40% 0.89 0.833958021
Wide 85.40% 40% 1.21 0.800052896
Corsicana 15.20% 40% 1.11 1.017228739
Worthington 47.50% 40% 1.39 1.081712062
85% 1.15 0.93323793

1.409189274
 Spread to Beta debt
Credit Rating Target D/V Target D/E treasury (as per credit
[E(rm)- rf] ratings)

Consolidated A+ 42.20% 73.01% 1.62% 0.05

E&P A+ 46% 85.19% 1.60% 0.05

R&M BBB 31% 44.93% 1.80% 0.1
Petrochemicals AA- 40% 66.67% 1.35% 0.05

Yield to maturity for US Treasury

Bonds (rf)
Maturity Rate
1-yr 4.54%
10-yr 4.66%
30-yr 4.98%

E&P R&M

rd 5.060% rd 5.160%

rf 4.98% rf 4.98%
[E(rm)- rf] 1.60% [E(rm)- rf] 1.80%
Beta debt 0.05 Beta debt 0.1

re 11.030% re 10.980%
rf 4.98% rf 4.98%
[E(rm)- rf] 5% [E(rm)- rf] 5%
Beta Equity 1.21 Beta Equity 1.2

Unlevered cost of Unlevered cost of

capital for E&P capital for R&M
D/V 46% D/V 31%
E/V 54% E/V 69%
rd 5.060% rd 5.160%
re 11.030% re 10.980%
Ru (E&P) 8.28% Ru (R&M) 9.18%
beta unlevered
beta unlevered (E&P) 0.6764 0.859
(R&M)
Asset Risk
Unlevered
Assets weight of assets
Beta
E&P 0.6764 140100 0.533960416039393
R&M 0.859 93829 0.357608650082514
Petrochemical 1.24446971 28450 0.108430933878092

Beta d
Rd(Midland) 5.061% 0.05
(Midland)

Beta equity
Re(Midland) 11.230% 1.25
(Midland)

Beta
Ru(Midland) 8.934% unlevered 0.803
(midland)

Midland
rd 5.061%
rf 4.98%
[E(rm)- rf] 1.62%
Beta debt 0.05

re 11.230%
rf 4.98%
[E(rm)- rf] 5%
Beta Equity 1.25

Unlevered cost of
capital for Midland
D/E 59.30%
D/V 37%
E/V 63%
rd 5.061%
re 11.230%
Ru (Midland) 8.93%

Petrochemical
Unlevered beta 1.24
Beta debt 0.05
beta Equity 2.041
D/V 40%
E/V 60%
rd(Petrochemical) 5.048%
rf 4.98%
[E(rm)- rf] 1.35%
Beta debt 0.050

re(Petrochemical) 15.184%
rf 4.98%
[E(rm)- rf] 5.00%
Beta equity 2.041

Unlevered cost of
capital for petrochem

D/V 40%
E/V 60%
rd 5.048%
re 15.184%
Ru (E&P) 11.13%

R wacc (consol) 8.081%

R e (consol) 11.030%
R d (consol) 5.060%
D/E 59.30%
D/V 0.37225361
E/V 0.62774639
tax rate 39%
 Beta equity
(as per
Actual D/V Actual D/E
comparable
firms)
45.46% 83.34% 1.25

1.21
1.2
Tax rate 40%

Equity Beta
Equity MV Net debt D/E
(Levered)

E&P
Jackson Energy Inc 57931 6480 11.2% 0.89
Wide Plain petroleum 46089 39375 85.4% 1.21
Corsicana energy Corp 42263 6442 15.2% 1.11
Worthington petroleum 27591 13098 47.5% 1.39
Average 40% 1.15

R&M
Bexar Energy 60356 6200 10.30% 1.7
Kirk Corp 15567 3017 19.40% 0.94
White Point Energy 9204 1925 20.90% 1.78
Petrarch Fuel services 2460 -296 -12% 0.24
Arkana Petroleum Corp 18363 5931 32.30% 1.25
Beaumont Energy 32662 6743 20.60% 1.04
Dameron Fuel 48796 24525 50.30% 1.42
Average 20% 1.196

Midland Energy 134114 79508 59.30% 1.25

Spread to
Target
Credit Rating Target D/E treasury
D/V
[E(rm)- rf]

Consolidated A+ 42.20% 73.01% 1.62%

E&P A+ 46% 85.19% 1.60%

R&M BBB 31% 44.93% 1.80%
Petrochemicals AA- 40% 66.67% 1.35%

Yield to maturity for US Treasury Bonds

(rf)
Maturity Rate
1-yr 4.54%
10-yr 4.66%
30-yr 4.98%

E&P R&M
Equity Beta (Levered) Equity Beta (Levered)
Asset Beta 0.933 Asset Beta 1.050
Target D/V 46% Target D/V 31%
Target E/V 54% Target E/V 69%
Equity Beta (Levered) 1.41 Equity Beta (Levered) 1.33

Cost of Debt (E&P) Cost of Debt (E&P)

Rf 4.98% Rf 4.98%
E(Rm) - Rf 1.60% E(Rm) - Rf 1.80%
Debt beta 0.05 Debt beta 0.1
Debt Cost of capital 5.06% Debt Cost of capital 5.16%

Cost of Equity (E&P) Cost of Equity (E&P)

Rf 4.98% Rf 4.98%
E(Rm) - Rf 5.00% E(Rm) - Rf 5.00%
Equity Beta 1.41 Equity Beta 1.33
Equity Cost of capital 12.03% Equity Cost of capital 11.64%

Unlevered Cost of capital Unlevered Cost of capital

Debt Cost of capital 5.06% Debt Cost of capital 5.16%

Equity Cost of capital 12.03% Equity Cost of capital 11.64%
Target D/V 46% Target D/V 31%
Target E/V 54% Target E/V 69%

Unlevered Cost of capital 8.824% Unlevered Cost of capital 9.633%

 Equity Beta
LTM Revenue LTM earnings (UnLevered) Or
Asset Beta

18512 4981 0.834

17827 8495 0.800
14505 4467 1.017
12820 3506 1.082
0.933

160708 9560 1.601

67751 1713 0.842
31682 1402 1.582
18874 112 0.259
49117 3353 1.047
59989 1467 0.926
58750 4646 1.091
1.050

251003 18888 0.922

Beta equity
Beta debt
(as per
(as per credit Actual D/V Actual D/E
comparable
ratings)
firms)
0.05 45.46% 83.34% 1.25

0.05 1.21
0.1 1.2
0.05

Petrochemicals
Asset beta
Asset Beta (Midland) 0.922
Asset Beta (E&P) 0.933
Asset Beta (R&M) 1.050
Asset Beta (petrochemicals) x
Assets (E&P) 140100
Assets (R&M) 93829
Assets (Petrochemicals) 28450
weight of assets (E&P) 0.534
weight of assets (R&M) 0.358
weight of assets (Petrochemicals) 0.108
Asset Beta (Petrochemicals) (x) 0.45

Equity Beta (Levered)

Asset Beta 0.430
Target D/V 40%
Target E/V 60%
Equity Beta (Levered) 0.60

Cost of Debt (E&P)

Rf 4.98%
E(Rm) - Rf 1.35%
Debt beta 0.05

Debt Cost of capital 5.05%

Cost of Equity (E&P)

Rf 4.98%
E(Rm) - Rf 5.00%
Equity Beta 0.60
Equity Cost of capital 7.99%

Unlevered Cost of capital

Debt Cost of capital 5.05%
Equity Cost of capital 7.99%
Target D/V 40%
Target E/V 60%
Unlevered Cost of capital 6.813%

Unlevered beta (Petrochemicals)

Equity Beta (Levered) 0.60
Debt beta 0.05
Target D/V 40%
Target E/V 60%
Unlevered beta (Petrochemicals) 0.3812
Exhibit 1: Summary Financial Information on Sampa Video, Inc., 2000 (in thousands of dollars)

FY 2000
Sales 22500
EBIDTA 2500
Depreciaion 1100
Operating Profit 1400
Net Income 660

Exhibit 2: Projections of Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-
2006 (in thousands of dollars).
2002E 2003E 2004E 2005E
Sales 1200 2400 3900 5600

EBIDTA 180 360 585 840

Depreciaion -200 -225 -250 -275
EBIT -20 135 335 565
Tax Expense 8 -54 -134 -226
EBIAT -12 81 201 339

CAPX 300 300 300 300

Investment in WC 0 0 0 0

OCF 188 306 451 614

FCF -112 6 151 314

Exhibit 3: Additional Assumptions

Risk free Rate (Rf) 5%

Project Cost of Debt (Rd) 6.80%
Market Risk Premium 7.20%
Marginal Corporate Tax Rate (t) 40%
Project Debt Beta (Bd) 0.25
Asset Beta for cramer.com and cityretrieve.com 1.5
Ru 15.800%

Exhibit 2: Projections of Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-
2006 (in thousands of dollars).
0 1 2 3
2001 2002E 2003E 2004E
Sales 1200 2400 3900

EBIDTA 180 360 585

Depreciaion -200 -225 -250
EBIT -20 135 335
Tax Expense 8 -54 -134
EBIAT -12 81 201

CAPX 1500 300 300 300

Investment in WC 0 0 0

OCF 0 188 306 451

FCF -1500 -112 6 151

What is the value of the project assuming the firm was entirely equity financed? What are the
annual projected free cash flows? What discount rate is appropriate?

if the firm is all equity financed, Rwacc = Re = Ru = 15.800%

i.e the discount rate = 15.800%
growth rate 5%

TV or CV IN YEAR 2006 = 4812.5

0 1 2 3
2001 2002E 2003E 2004E
Unlevered FCF -1500 -112 6 151
PV (T=0) -1500 -96.71848 4.474393 97.241415
NPV 1228.4851
Value of unlevered Firm = 2728.4851

Value the project using the Adjusted Present Value (APV) approach assuming the firm raises
$750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity.

D (million)= 750
Using the AVP Method
VL = AVP = VU + PV(Interest Tax Shield)
value of unlevered firm = 2728.4851

PV(tax shield) = PV(future interest payments) = t x D = 300

VL (Value of Levered Firm) = 3028.4851

Value the project using the Weighted Average Cost of Capital (WACC) approach assuming
the firm maintains a constant 25% debt-to-market value ratio in perpetuity

Debt 25%
Beta Debt 0.25
Cost of Debt 6.80%
Equity 75%
Beta Equity 1.9166667
Cost of Equity 18.80% 18.800%

Rwacc 15.1200% 15.800%

using the WACC Method

VL0 = FCF1/(1+Rwacc) + FCF2/(1+Rwacc)2 + FCF3/(1+Rwacc)3 +...

new TV or CV at year 2006 = 5135.8696

0 1 2 3
2001 2002E 2003E 2004E
Unlevered FCF -1500 -112 6 151
PV (at Post tax Rwacc) -1500 -97.289785 4.5274086 98.974794

Value of Levered Firm, VL0 2969.9722

What are the end-of-year debt balances implied by the 25% target debt-to-value ratio?

0 1 2 3
NEW FCF 2001 2002E 2003E 2004E
NEW FCF -1500 -112 6 151
V(Levered) 2969.97 3531.03 988.49 4521.63
Debt / Value 25% 25% 25% 25%
Debt balances 742.49 882.76 247.12 1130.41
Interest rate 7% 7% 7% 7%
Interest Amount 50.489528 60.027544 16.804284

Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value
the project.
0 1 2 3
2001 2002E 2003E 2004E
Sales 1200 2400 3900

EBIDTA 180 360 585

Depreciaion 200 225 250
EBIT -20 135 335
Tax Expense -8 54 134
EBIAT -12 81 201

CAPX 1500 300 300 300

Investment in WC 0 0 0 0

OCF 0 188 306 451

FCF -1500 -112 6 151
TAX SHIELD 20.195811 24.011018 6.7217135
CCF -1500 -91.804189 30.011018 157.72171
pv(CCF) -79.278229 22.380182 101.57008
V(ccf) 2981.0631
Levered FCF #REF! #REF! #REF! #REF!
DISCOUNT RATE (Pre WACC) 15.800% 15.800% 15.800% 15.800%
PV #REF! #REF! #REF! #REF!
Value of levered Firm (levered) = #REF!

AVP METHOD FOR FIXED D/E

D 25%
E 75%
0 1 2 3
2001 2002E 2003E 2004E
Debt Balances 742.49 882.76 247.12 1130.41
Interest Paid 50.489528 60.027544 16.804284
Tax rate 40% 40% 40%
tax shield 20.195811 24.011018 6.7217135
PV(tax shield) 17.543269 18.117948 4.4058292
PV (tax shield) 222.28882

Value of levered firm = 2950.7739

for D/V = 25%

Value of Levered Firm (APV) 2950.7739 pv(tax shield) =
Value of Levered Firm (WACC) 2969.9722
Value of Levered Firm (CCF) #REF!

2981.0631
-11.09085
-23.09444
s)

Delivery Project 2002-

2006E
7500

1125
-300
825
-330
495

300
0

795
495

Delivery Project 2002-

4 5 5
2005E 2006E 2006E CV
5600 7500

840 1125
-275 -300
 565 825
-226 -330
339 495

300 300
0 0

614 795
314 495

4 5 5
2005E 2006E 2006E CV
314 495 4812.5
174.62057 237.71818 2311.149 2311
237.7
 PV(t=0)
4 5 5 V0
2005E 2006E 2006E CV 244.8 D
314 495 5135.8696 2540 PV(t=1)
178.78313 244.82248 2540.1542 v1
D
pv(t=2)
v2

4 5 6 6 pv(t=3)
2005E 2006E 2007E 2007E CV v3
314 495 519.75 5392.663 D
4891.30 5135.87 pv (t=4)
25% 25% v4
1222.83 1283.97 12483.016 D
7% 7% 7% pv (t=5)
76.867767 83.152174 936.15489 v5
D

4 5 5
2005E 2006E 2006E CV
5600 7500

840 1125
275 300
565 825
226 330
339 495

300 300
0 0

614 795
314 495 4812.5
30.747107 33.26087 374.46196 351
344.74711 528.26087 5186.962
191.71955 253.69134 2490.9801
 #REF! #REF! #REF!
15.800% 15.800% 15.800%
#REF! #REF! #REF!

4 5
2005E 2006E 2006E cv
1222.83 1283.97
76.867767 83.152174 862.74489
40% 40% 40%
30.747107 33.26087 345.09795
17.506573 16.450522 148.26468

241.48714
167.46299
Rwacc 15.12%
1 2 3 4 5 6 6
2001 2002E 2003E 2004E 2005E 2006E 2007E 2007E CV
-1500 -112 6 151 314 495 519.75 5392.663
-97.28978 4.5274086 98.974794 178.78313 244.82248 223.30056 2316.8536
2969.9722
742.49306
5.2119527 113.93978 205.81513 281.83964 257.0636 2667.1619
3531.032
882.75801
131.16748 236.93438 324.45379 295.93162 3070.4368
988.48727

247.12182

272.75886 373.51121 340.67648 3534.6868

4521.6334
1130.4083
429.9861 392.18677 4069.1315
4891.3043
1222.8261
451.48541 4684.3842
5135.8696
1283.9674

519.75 5392.663

0.7545681
Exhibit 1: Summary Financial Information on Sampa Video, Inc., 2000 (in thousands of dollars)

FY 2000
Sales 22500
EBIDTA 2500
Depreciaion 1100
Operating Profit 1400
Net Income 660

Exhibit 2: Projections of Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-
2006 (in thousands of dollars).
2002E 2003E 2004E 2005E
Sales 1200 2400 3900 5600

EBIDTA 180 360 585 840

Depreciaion -200 -225 -250 -275
EBIT -20 135 335 565
Tax Expense 8 -54 -134 -226
EBIAT -12 81 201 339

CAPX 300 300 300 300

Investment in WC 0 0 0 0

OCF 188 306 451 614

FCF -112 6 151 314

Exhibit 3: Additional Assumptions

Risk free Rate (Rf) 5%

Project Cost of Debt (Rd) 6.80%
Market Risk Premium 7.20%
Marginal Corporate Tax Rate (t) 40%
Project Debt Beta (Bd) 0.25
Asset Beta for cramer.com and cityretrieve.com 1.5
Ru 15.800%

Exhibit 2: Projections of Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-
2006 (in thousands of dollars).
0 1 2 3
2001 2002E 2003E 2004E
Sales 1200 2400 3900

EBIDTA 180 360 585

Depreciaion -200 -225 -250
EBIT -20 135 335
Tax Expense 8 -54 -134
EBIAT -12 81 201

CAPX 1500 300 300 300

Investment in WC 0 0 0

OCF 0 188 306 451

FCF -1500 -112 6 151

What is the value of the project assuming the firm was entirely equity financed? What are the
annual projected free cash flows? What discount rate is appropriate?

if the firm is all equity financed, Rwacc = Re = Ru = 15.800%

i.e the discount rate = 15.800%
growth rate 5%

TV or CV IN YEAR 2006 = 4812.5

0 1 2 3
2001 2002E 2003E 2004E
Unlevered FCF -1500 -112 6 151
PV (T=0) -1500 -96.71848 4.474393 97.241415
NPV 1228.4851
Value of unlevered Firm = 2728.4851

Value the project using the Adjusted Present Value (APV) approach assuming the firm raises
$750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity.

D (million)= 750
Using the AVP Method
VL = AVP = VU + PV(Interest Tax Shield)
value of unlevered firm = 2728.4851

PV(tax shield) = PV(future interest payments) = t x D = 300

VL (Value of Levered Firm) = 3028.4851

Value the project using the Weighted Average Cost of Capital (WACC) approach assuming
the firm maintains a constant 25% debt-to-market value ratio in perpetuity

Debt 25%
Beta Debt 0.25
Cost of Debt 6.80%
Equity 75%
Beta Equity 1.9166667
Cost of Equity 18.80% 18.800%

Rwacc 15.1200% 15.800%

using the WACC Method

VL0 = FCF1/(1+Rwacc) + FCF2/(1+Rwacc)2 + FCF3/(1+Rwacc)3 +...

new TV or CV at year 2006 = 5135.8696

0 1 2 3
2001 2002E 2003E 2004E
Unlevered FCF -1500 -112 6 151
PV (at Post tax Rwacc) -1500 -97.289785 4.5274086 98.974794

Value of Levered Firm, VL0 2969.9722

What are the end-of-year debt balances implied by the 25% target debt-to-value ratio?

0 1 2 3
NEW FCF 2001 2002E 2003E 2004E
NEW FCF -1500 -112 6 151
V(Levered) 2969.97 3531.03 988.49 4521.63
Debt / Value 25% 25% 25% 25%
Debt balances 742.49 882.76 247.12 1130.41
Interest rate 7% 7% 7% 7%
Interest Amount 50.489528 60.027544 16.804284

Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value
the project.
0 1 2 3
2001 2002E 2003E 2004E
Sales 1200 2400 3900

EBIDTA 180 360 585

Depreciaion 200 225 250
EBIT -20 135 335
Tax Expense -8 54 134
EBIAT -12 81 201

CAPX 1500 300 300 300

Investment in WC 0 0 0 0

OCF 0 188 306 451

FCF -1500 -112 6 151
TAX SHIELD 20.195811 24.011018 6.7217135
CCF -1500 -91.804189 30.011018 157.72171
pv(CCF) -79.278229 22.380182 101.57008
V(ccf) 2981.0631
Levered FCF #REF! #REF! #REF! #REF!
DISCOUNT RATE (Pre WACC) 15.800% 15.800% 15.800% 15.800%
PV #REF! #REF! #REF! #REF!
Value of levered Firm (levered) = #REF!

AVP METHOD FOR FIXED D/E

D 25%
E 75%
0 1 2 3
2001 2002E 2003E 2004E
Debt Balances 742.49 882.76 247.12 1130.41
Interest Paid 50.489528 60.027544 16.804284
Tax rate 40% 40% 40%
tax shield 20.195811 24.011018 6.7217135
PV(tax shield) 17.543269 18.117948 4.4058292
PV (tax shield) 222.28882

Value of levered firm = 2950.7739

for D/V = 25%

Value of Levered Firm (APV) 2950.7739 pv(tax shield) =
Value of Levered Firm (WACC) 2969.9722
Value of Levered Firm (CCF) #REF!

2981.0631
-11.09085
-23.09444
s)

Delivery Project 2002-

2006E
7500

1125
-300
825
-330
495

300
0

795
495

Delivery Project 2002-

4 5 5
2005E 2006E 2006E CV
5600 7500

840 1125
-275 -300
 565 825
-226 -330
339 495

300 300
0 0

614 795
314 495

4 5 5
2005E 2006E 2006E CV
314 495 4812.5
174.62057 237.71818 2311.149 2311
237.7
 PV(t=0)
4 5 5 V0
2005E 2006E 2006E CV 244.8 D
314 495 5135.8696 2540 PV(t=1)
178.78313 244.82248 2540.1542 v1
D
pv(t=2)
v2

4 5 6 6 pv(t=3)
2005E 2006E 2007E 2007E CV v3
314 495 519.75 5392.663 D
4891.30 5135.87 pv (t=4)
25% 25% v4
1222.83 1283.97 12483.016 D
7% 7% 7% pv (t=5)
76.867767 83.152174 936.15489 v5
D

4 5 5
2005E 2006E 2006E CV
5600 7500

840 1125
275 300
565 825
226 330
339 495

300 300
0 0

614 795
314 495 4812.5
30.747107 33.26087 374.46196 351
344.74711 528.26087 5186.962
191.71955 253.69134 2490.9801
 #REF! #REF! #REF!
15.800% 15.800% 15.800%
#REF! #REF! #REF!

4 5
2005E 2006E 2006E cv
1222.83 1283.97
76.867767 83.152174 862.74489
40% 40% 40%
30.747107 33.26087 345.09795
17.506573 16.450522 148.26468

241.48714
167.46299
Rwacc 15.12%
1 2 3 4 5 6 6
2001 2002E 2003E 2004E 2005E 2006E 2007E 2007E CV
-1500 -112 6 151 314 495 519.75 5392.663
-97.28978 4.5274086 98.974794 178.78313 244.82248 223.30056 2316.8536
2969.9722
742.49306
5.2119527 113.93978 205.81513 281.83964 257.0636 2667.1619
3531.032
882.75801
131.16748 236.93438 324.45379 295.93162 3070.4368
988.48727

247.12182

272.75886 373.51121 340.67648 3534.6868

4521.6334
1130.4083
429.9861 392.18677 4069.1315
4891.3043
1222.8261
451.48541 4684.3842
5135.8696
1283.9674

519.75 5392.663

0.7545681
Tax rate 34%
Proforma INC Statement
0 1 2 3 4 5
EBIT 22.7 29.8 37.1 40.1 42.1
INTEREST 21.6 19.1 17.8 16.7 15.8
EBT 1.1 10.7 19.3 23.4 26.3
TAX @ 34% 0.374 3.638 6.562 7.956 8.942
NI 0.726 7.062 12.738 15.444 17.358

Supplement Data
0 1 2 3 4 5
DEPRECIATION 21.5 13.5 11.5 12.1 12.7
CAPEX 10.7 10.1 10.4 11.5 13.1
CHANGE IN NWC -12.3 1.9 4.2 5.2 6.1
CHANGE IN ASSETS 9 6.9 3.4 0 0

PROFORMA BALANCE SHEET

ASSETS 0 1 2 3 4 5
NWC 60 47.7 49.6 53.7 59 65.1
NET FIXED ASSETS 221 210.3 206.9 205.7 205.1 205.5
OTHER ASSETS 26 17 10.1 6.7 6.7 6.7
TOTAL ASSETS 307 275 266.6 266.1 270.8 277.3

LIABILITIES AND EQUITY

Revolver @ 7.5% 13 0.2 4.8 11.7 20.9 20
Bank loan @ 8% 80 60 40 20 0 0
subordinated debt @ 9.5% 150 150 150 150 150 0
LT debentures @ 9% 0 0 0 0 0 140
TOTAL DEBT 243 210.2 194.8 181.7 170.9 160
EQUITY 64 64.7 71.8 84.5 99.9 117.2
TOTAL LIABILITIES AND EQUITY 307 274.9 266.6 266.2 270.8 277.2

SUPPLEMENT DATA
Interest paid 0 21.6 19.1 17.8 16.7 15.8
principal repaid 0 32.8 15.5 13.1 10.8 10.9
dividends 0 0 0 0 0 0

Base case cash flows 0 1 2 3 4 5

EBIT 22.7 29.8 37.1 40.1 42.1
LESS: tax 7.718 10.132 12.614 13.634 14.314
EAT 14.982 19.668 24.486 26.466 27.786
ADD: DEPRECIATION 21.5 13.5 11.5 12.1 12.7
OCF 36.5 33.2 36.0 38.6 40.5
LESS: CHANGE IN NWC -12.3 1.9 4.2 5.2 6.1
LESS: CHANGE IN ASSETS -9 -6.9 -3.4 0 0
LESS: CAPEX 10.7 10.1 10.4 11.5 13.1
FCF 47.1 28.1 24.8 21.9 21.3

Re D/v E/V Unlevered Re

COMPANY 1 24% 50% 50% 48.0%
COMPANY 2 13.50% 0 100% 13.5%

Rf 5%
Re 35%
Rwacc (pretax) 13.50%
g 5.00%
0 1 2 3 4 5
FCF 0 47.082 28.068 24.786 21.866 21.286
PV 0 41.48194 21.78812 16.95192 13.17607 11.30094
V(unlevered) 244.30

Cost of debt = 10%

0 1 2 3 4 5
Interest tax shield 0 7.344 6.494 6.052 5.678 5.372
8.9% 9.1% 9.1% 9.2% 9.2%
 Rwacc 12.80%
g 3%
Ru 14%
FCF 2536
Unlevered TV 23746.182

LEVERED TV 26653.878

value of tax shield at year end 1993 2908

value of tax shield at year end 1988 1543.724
1 2 3 4
Tax shields 1151 1021 1058 1120
PV 1014.0969 792.5634109 723.59921 674.8925
5 PV of tax shields from 1989-1993 3833.7491
262.9447
139.5999 TV of interest tax shield 5377.5

Tax shield in terminal value = 2907.6957

5
125.3467 107.44
22.78481
0.046083
0.096083
 5
1184
628.5971