FIRM VALUATION

Firm Valuation
Assumptions:
 Corporate taxes - individual taxe rate is zero
 Capital markets are frictionless
 Individuals can borrow and lend at the
risk-free rate
 There are no costs to bankruptcy
 Firms issue only two types of claims:
risk-free debt & (risky) equity
 All firms are in the same risk class

CFi  CFj
 No other taxes than corporate taxes
 All cash flow streams are perpetuities
 Everybody has the same information
 No agency costs
  The value of an unlevered firm is
E(FCF)(1  t c )
V 
U

r
,where
E(FCF)  Expected future cash flow
r  Discount rate for an all - equity firm
of equivalent risk
t c = Corporate tax rate
 If the firm issues debt, then
E(NOI)(1  t c ) k dDt c
V 
L

r kb
,where
k dDt c = The amount paid to the
lenders, kd = interest rate,
kb D = amount of debt
k b  rf
=interest on debt. If the debt is risk-free
then .
 k dD
If B
kb
then
V  V  t cB
L U

In other words
L
V = Value of an unlevered firm + the
PV of the tax shield provided by
debt.
Notice that if t c  0 then V  V
L U

(The famous Modigliani-Miller

hypothesis)
This implies that
“The market value of any firm is
independent of its capital structure and
is given by capitalizing its expected
return at the rate r appropriate to its risk
class”
(Modigliani-Miller, American Economic Review, 1958 june)
 When the firm makes an investment I,
its value will change according to
(source)
V L
(1 t c ) E(NOI) B
  tc
I r  I I
 The above investment will affect the
value of the levered firm:

V  S  S   B  B
L 0 n 0 n

Note that Equity = old + ds0+dsn

 Because the project has the same risk
as those already outstanding, the value
of the outstanding debt stays the same
(B 0  0) .
 Because new project is financed with
new debt, equity or both

I  S  B
n n

 Inserting  I into the above formula (),

V L
S S  B
0 n n
 
I I I
VL
S 0
 1
I I
 This means that the project has to
increase the shareholders’ wealth, so
that

S V
0 L
  1 0
I I

V L
S 0
1 and 0
I I
The Weighted Average Cost of Capital

 Recall the formula

V L
(1 t c ) E(NOI) B n
  tc 1
I r  I I
as shown it should be greater than 1, so
(1 t c )E(NOI) B
 r (1 t c )
I I
 This results in what is called “the Weighted
Average Cost of Capital”, WACC, source.

 B 
WACC  r 1  t c
 I 
 If there are no taxes the cost of capital is
independent of capital structure.
 B
What does mean ?
I
B*
 “IfV* denotes the firm’s long run target
debt ratio ...then the firm can assume,
that for any particular investment
dB B * “

dI V * .
 An alternative definition of the
weighted average cost of capital
 Definition by Haley and Shall [1973]
 Target leverage ratio

 B 
WACC  r 1 t c
 V 
Reproduction
value
Reproduction value = PV of the stream of goods
and services expected from the project.
 How to calculate the cost of the two
components in WACC (debt & equity)
 Assumptions:
 The cost of debt =
 The cost of equity capital is the return on
S  S
0 n

NI
S  S
0 n
This can be written as (C-W, p. 449):
NI B
 r  (1 t c )(r  k b ) 0
S  S
0 n
S  Sn

Since the total change in equity is

S  S  S
0 n

NI
, the cost of equity k s 
S
can be written as
B
k s  r  (1 t c )(r  k b )
S
  If the firm has no debt in its capital
structure, then k s  r
It can be shown that (C-W, 451) WACC
can be written as:
B S
WACC  (1 t c )k b  ks
B S B S

tax shield Percentage Percentage

cost
of debt in cost of equity in
of debt the capital of equity the capital
structure structure
 This formula is the same as the
Modigliani-Miller definition


WACC  r 1  t c
B 
 B  S

The M-M and the traditional definition

are identical !