Chapter 19

FINANCING AND VALUATION

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Edition
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
19-1 THE AFTER-TAX WEIGHTED-AVERAGE COST OF
CAPITAL
• MM World Assumption: Assumption of separating
investment from financing in chapter 6 is MM world
(capital structure is irrelevant to value). The four step
process we considered in valuing investment project:
Forecast after-tax cash flows, assuming all equity financing.
Assess the projects risk.
Estimate the opportunity cost of capital
Calculate the NPV using the opportunity cost as discount
rate.
• Interaction of investment & financing: In reality,
investment and financing decisions interact and
cannot be wholly separated in capital budgeting
decision. So we extend the 4 steps to include value
contributed by financing decision for adjustment. 13-2
19-1 THE AFTER-TAX WEIGHTED-AVERAGE COST OF
CAPITAL
• Adjusting Projects including Financing Decision:
1. Adjust the discount rate
2. Adjust the present value
• Adjusting the discount rate: One reason for the
interaction of investment and financing is taxes. In
reality interest is tax deductible expense. So the
after-tax weighted-average cost of capital (WACC) is
given as:
D E
WACC  rD (1  Tc )  rE
V V
• This WACC captures the value of interest tax shields.
rD(1-Tc) is the after-tax cost of debt. WACC captures
the financing state (capital structure) of the firm.
13-3
AFTER TAX WACC
• WACC: It is the expected weighted average
rate of return on a portfolio of firm’s
outstanding debt and equity. The portfolio
weights depends on the market values. It
reveals the expected rate of return demanded
by investors for committing their hard-earned
money to the firm’s assets and operations.
• When estimating the WACC, you are
interested in the current values and
expectations for the future, not in the past
investments. 13-4
AFTER TAX WACC
• Illustration 2: Calculating tax adjusted WACC:
• For Sangria corporation, the cost of debt is 6% where as the
cost of equity is 12.4%. The corporate marginal tax rate is
35%. The balance sheet is given as:

Debt ratio = D/V = 500/1250 = 0.4

Equity ration = E/V = 750/1250 = 0.6

• After tax WACC: D E

WACC  rD (1  Tc )  rE
V V
 0.06(1  0.35) * 0.4  0.124 * 0.6  0.09  9%
13-5
AFTER TAX WACC
• Illustration 2: Sangria’s enologists have proposed investing
$12.5 million the construction of a perpetual crushing machine.
It is expected that the stream of earning cash flow of
$1.731milllion per year pretax. The project has average risk.
Tax rate is 35%. (a) find the after-tax cash flow. (b) Calculate
the NPV. Remember there is no depreciation & time is infinity.
• (a) After-tax cash flow:
Pretax cash flow 1.731
(Tax@35% = Tax rate*Pretax CF) (0.35*1.731 = 0.606)
After-tax cash flow = 1.125 Million

• (b) NPV=
CF1 1.125
NPV   I 0   12.5  0
WACC - g 0.09 - 0

Note: Barely acceptable investment 13-6

AFTER TAX WACC
• Sangria’s Perpetual Crusher Machine Project:
• Value Balance Sheet Considering it as a mini-firm:
Balance Sheet – Perpetual Crusher (Market Value, Millions)
Assets 12.5 5.0 (0.4*12.5) Debt
7.5 (0.6 * 12.5) Equity
Total assets 12.5 12.5 Total liabilities

• Expected return to shareholders:(show that rE=0.124

Aftertax interest income  rD (1  Tc )D  0.06 * (1  0.35) * 5  0.195
Expected equity income  CF  rD (1  Tc )D  1.125  0.195  0.93
Expected equity income 0.93
Expected equity return  rE    0.124  12.4%
Equity value 7.5
CF 1.125
Note : For perpetuity : annual rate of return    0.09  9%  WACC
I0 12.5 13-7
AFTER WACC
• Review of assumptions of Sangira’s project:
• The project’s business risks are the same as
those of Sangira’s other assets and remains so for
the life of the project.
• The project supports the same fraction of debt to
value as in Sangira’s overall capital structure,
which remains constant for the life of the project.

13-8
19-2 VALUING BUSINESSES
• Valuation: Financial manager should value projects.
• Investors and financial analysts value the whole
business. So should the financial manager. Financial
manager has to decide on what the entire business or a
part is worth. Examples:
• In case of takeover offer, it is vital to know the know the
combined value of the businesses.
• If a company wants to sell one of its divisions, it is vital to
know what the division is worth in order to negotiate with
buyer.
• When a firm goes public, the investment bank must evaluate
how much the firm is worth in order to set an issue price.
• If a mutual fund owns shares in a firm that is not traded, so
the fund managers should estimate a fair value for them.
13-9
VALUING BUSINESSES
• Important points in valuing businesses:
1. WACC is used to discount the free cash flows to the present
value treating the company as if it were a big project. After-tax
cost of debt is accounted for in WACC, so interest is not
deducted in projecting the cash flows as a capital budgeting
project. Tax is deducted from pretax profit.
2. Companies are potentially immortal (going concern). Instead of
forecasting CFs to eternity, financial managers usually forecast to
a medium-term horizon (10 years) and add a terminal value to
the CFs in the horizon year. This terminal (horizon) value is the
PV at the horizon of all subsequent CFs to infinity. Estimating
the terminal value requires careful attention because it often
accounts for the majority of the value of the company.
3. If the object is to value the company’s equity (i.e., common
stock), subtract the value of the company’s outstanding debt.
13-10
VALUING BUSINESSES
• Forecasting FCF: In valuation of business, we
forecast the free cash flow (FCF).
• FCF is the amount of cash that the firm can pay out
to investors after making all investments necessary
for growth. It is calculated assuming that the firm is
all-equity financed.
• We forecast each year’s FCF out to a valuation
horizon (H) and predict the horizon value (PVH) of
the business at that horizon, which is also discounted
back to the present.
FCF1 FCF2 FCF3 FCFH PVH

0 1 2 3 H H+1
C0 = I0
13-11
VALUING BUSINESSES
• Calculation of Business or Project Value:
Discounting the FCF at the after-tax WACC gives the
total value of the firm (debt plus equity).
• FCF:

FCF  Profit after tax  Depreciation  investment in fixed asets

 investment in working capital

• Business value:
FCF1 FCF2 FCFH PVH
PV    ....  
1 2 H
(1  WACC) (1  WACC) (1  WACC) (1  WACC) H

FCFH 1
Where : PVH 
(WACC - g) 13-12
VALUING BUSINESS
• Illustration: The projected forecasted FCF of Rio
Corporation is given in Table 19.1. The FCF forecast
is for first 6 years. The sales are expected to settle
down to stable with a 3% long-term growth starting
from year 7. The WACC of Rio Corporation is 9%.
Tax rate is 35%. Debt value is $36 million.
• (a) Calculate the PV of the first 6-year FCFs.
• (b) Calculate the horizon value (PVH).
• (c) Calculate the PV of horizon value.
• (d) Calculate the PV of the Business.
• (e) Calculate the Total Value of Equity.
• (f) Calculate the value of 1 share if the number of
outstanding shares is 1.5 million shares. 13-13
VALUING BUSINESS
• FCF Projection & Company Value of Rio ($million)
Forecast
0 1 2 3 4 5 6 7
1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.7
2 Cost of goods sold 63.1 6.2 71.3 76.3 79.9 83.1 87.0 90.2
3 EBTIDA (=1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.5
4 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1
5 Pretax Profit (EBIT=3-4) 17.2 8.7 9.0 9.6 9.7 10.0 10.1 10.0
6 Tax 6.0 4.7 4.8 5.2 5.2 5.4 5.4 5.4
7 Profit After tax (5-6) 11.2 8.7 9.0 9.6 9.7 10.0 10.1 10.0

8 Investment in fixed assets 11.0 14.6 15.5 16.6 15.0 15.6 16.2 15.9
9 Investment in WC 1.0 0.5 0.8 0.9 0.5 0.6 0.6 0.4
10 FCF (=7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6.0 6.8

13-14
VALUING BUSINESS
• (a) PV of FCFs:
3.5 3.2 3.4 35.9 6.1 6.0
PV        $20.3 million
1 2 3 4 5 6
1.09 1.09 1.09 1.09 1.09 1.09

• (b) Horizon Value (PVH):

FCFH 1 6.8
PVH    113.4 million
(WACC - g) (0.09 - 0.03)

• (c) PV of horizon value:

PVH 113.4
PV(PVH )    $67.6 million
6 6
(1  WACC ) (1  0.09)

13-15
VALUING BUSINESS
• (d) PV (Business):

PV(Business)  PV(FCFyears1  6)  PV(Horizonvalue)

 20.3 million  67.6 million  $87.9 million

• (e) Value of Equity (Given Debt is 36.0 million):

Equity Value  PV(Business)  Debt Value
 87.9 million  36.0 million  $51.9 million

• (f) Value per share (Rio has 1.5 million shares):

Equity Value 51.9

Value per share    $34.6
1.5 shares 1.5

13-16
VALUING BUSINESS
• WACC versus Flow to Equity:
• If you discount at WACC, cash flows have to be
projected just as you would for a capital investment
project. Do not deduct interest. Calculate taxes as
if the company were all-equity financed. The value
of interest tax shields is picked up in the WACC
formula.
• To find the value of total equity, we subtract the
value of debt from the total firm value.

13-17
19-3 USING WACC IN PRACTICE
• What is WACC if The Value Balance Sheet Has
More than 2 Entries?
Net Working Capital: Long-term debt (D)
-Current Assets
-Current Liabilities Preferred stock (P)
Property, plant, and equipment
Growth Opportunities Equity (E)
Total Assets Total Value (V)

• WACC if the company has more than 2 financing

sources: Including preferred stock (P).
D P E
WACC  rD (1  Tc )  rP  rE
V V V

13-18
USING WACC IN PRACTICE
• WACC & Short-term Debt & Current Liabilities:
• Short-term debt: If short-term debt is temporary, seasonal,
or incidental financing, and this could be offset by short-term
lending (investing in marketable securities), there is no point
of including short-term debt in the WACC because company
is not a net short-term borrower.
• Current liabilities: It may include short-term debt.
• Netting out against current assets excludes the cost of
short-term debt from the WACC. This can be an
acceptable approximation.
• When short-term is an important or permanent source
of financing, it should not be netted out of current asset
but shown on liability side and the interest cost on short-
term debt should be an element of WACC.
13-19