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Chapter 19Principles of
Corporate FinanceTenth Edition
Financing and Valuation
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
19-2
Topics Covered
After Tax WACCValuing BusinessesUsing WACC in PracticeAdjusted Present ValueYour Questions Answered
19-3
Capital Project Adjustments
1. Adjust the Discount Rate Modify the discount rate to reflect capital
structure, bankruptcy risk, and other factors.
2. Adjust the Present Value Assume an all equity financed firm and then
make adjustments to value based on financing.
19-5
After Tax WACC
Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?
19-6
After Tax WACC
Example - Sangria Corporation - continued
Balance Sheet (Book Value, millions)Assets 1,000 500 Debt
500 EquityTotal assets 1,000 1,000 Total liabilities
Balance Sheet (Book Value, millions)Assets 1,000 500 Debt
500 EquityTotal assets 1,000 1,000 Total liabilities
19-7
After Tax WACC
Example - Sangria Corporation - continued
Balance Sheet (Market Value, millions)Assets 1,250 500 Debt
750 EquityTotal assets 1,250 1,250 Total liabilities
Balance Sheet (Market Value, millions)Assets 1,250 500 Debt
750 EquityTotal assets 1,250 1,250 Total liabilities
19-8
After Tax WACC
Example - Sangria Corporation - continued
V
Er
V
DTcrWACC ED )1(
Debt ratio = (D/V) = 500/1,250 = .4 or 40%
Equity ratio = (E/V) = 750/1,250 = .6 or 60%
19-9
After Tax WACC
Example - Sangria Corporation - continued
V
Er
V
DTcrWACC ED )1(
%0.9
090.
60.124.40.)35.1(06.
WACC
19-10
After Tax WACCExample - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax.
Given an initial investment of $12.5 million, what is the value of the machine?
19-11
After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?
Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million
Cash FlowsPretax cash flow 1.731Tax @ 35% 0.606After-tax cash flow $1.125 million
19-12
After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?
009.
125.15.12
10
gr
CCNPV
009.
125.15.12
10
gr
CCNPV
19-13
After Tax WACCExample - Sangria Corporation – continued
Perpetual Crusher project
Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt
7.5 EquityTotal assets 12.5 12.5 Total liabilities
Balance Sheet - Perpetual Crusher (Market Value, millions)Assets 12.5 5.0 Debt
7.5 EquityTotal assets 12.5 12.5 Total liabilities
19-14
After Tax WACCExample - Sangria Corporation – continued
Perpetual Crusher project
93.0195.125.1)1(incomeequity Expected
195.5)35.1(06.)1(interestAfter tax
DTrC
DTr
CD
CD
93.0195.125.1)1(incomeequity Expected
195.5)35.1(06.)1(interestAfter tax
DTrC
DTr
CD
CD
19-15
After Tax WACCExample - Sangria Corporation – continued
Perpetual Crusher project
12.4%or 124.5.7
93.0
ueequity val
incomeequity expectedreturnequity Expected
Er
12.4%or 124.5.7
93.0
ueequity val
incomeequity expectedreturnequity Expected
Er
19-16
Capital Budgeting
Valuing a Business or ProjectThe value of a business or Project is usually
computed as the discounted value of FCF out to a valuation horizon (H).
The valuation horizon is sometimes called the terminal value.
19-17
Capital Budgeting
Valuing a Business or Project
HH
HH
r
PV
r
FCF
r
FCF
r
FCFPV
)1()1(...
)1()1( 22
11
PV (free cash flows) PV (horizon value)
In this case r = waccIn this case r = wacc
19-18
Valuing a Business
Latest year0 1 2 3 4 5 6 7
1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.72 Cost of goods sold 63.1 66.2 71.3 76.3 79.9 83.1 87 90.23 EBITDA (1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.54 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.15 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.46 Tax 6 4.7 4.8 5.2 5.2 5.4 5.4 5.47 Profit after tax (5-6) 11.2 8.7 9 9.6 9.7 10 10.1 108 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 16.2 15.99 Investment in working capital 1 0.5 0.8 0.9 0.5 0.6 0.6 0.4
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 20.3 113.4 (Horizon value in year 6)PV Horizon value 67.6PV of company 87.9
Forecast
Example: Rio Corporation
19-19
Valuing a Business
Assumptions
Sales growth (percent) 6.7 7 7 7 4 4 4 375.5 74 74.5 74.5 75 75 75.5 7613.3 13 13 13 13 13 13 1379.2 79 79 79 79 79 79 79
5 14 14 14 14 14 14 14
Tax rate, percent 35%WACC 9%Long term growth forecast 3%
Fixed assets and working capital
Gross fixed assets 95 109.6 125.1 141.8 156.8 172.4 188.6 204.5Less accumulated depreciation 29 38.9 49.5 60.8 72.6 84.9 97.6 110.7Net fixed assets 66 70.7 75.6 80.9 84.2 87.5 91 93.8Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1Working capital 11.1 11.6 12.4 13.3 13.9 14.4 15 15.4
Example: Rio Corporation – continued - assumptions
19-20
Valuing a Business
Example: Rio Corporation – continued
FCF = Profit after tax + depreciation + investment in fixed assets
+ investment in working capital
FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = $3.5 million
19-21
Valuing a Business
Example: Rio Corporation – continued
3.20
1.09
0.6
1.09
1.6
1.09
9.5
1.09
4.3
1.09
2.3
1.09
3.5PV(FCF) 65432
19-22
Valuing a Business
Example: Rio Corporation – continued
6.67$4.113
1.09
1 value)PV(horizon
4.11303.09.
8.6PV ValueHorizon
6
1H
gwacc
FCFH
19-23
Valuing a Business
Example: Rio Corporation – continued
million $87.9
6.673.02
value)PV(horizonPV(FCF)s)PV(busines
19-24
WACC vs. 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.
19-25
WACC vs. Flow to Equity
– The company's cash flows will probably not be forecasted
to infinity. Financial managers usually forecast to a
medium-term horizon -- ten years, say -- and add a
terminal value to the cash flows in the horizon year. The
terminal value is the present value at the horizon of post-
horizon flows. Estimating the terminal value requires
careful attention, because it often accounts for the
majority of the value of the company.
19-26
WACC vs. Flow to Equity
– Discounting at WACC values the assets and
operations of the company. If the object is to
value the company's equity, that is, its common
stock, don't forget to subtract the value of the
company's outstanding debt.
19-27
Tricks of the Trade
What should be included with debt?
– Long-term debt?
– Short-term debt?
– Cash (netted off?)
– Receivables?
– Deferred tax?
19-28
After Tax WACC
Preferred stock and other forms of financing must be included in the formula
EPD r
V
Er
V
Pr
V
DTcWACC )1(
19-29
After Tax WACC
Balance Sheet (Market Value, millions)Assets 125 50 Debt
25 Preferred Equity50 Common Equity
Total assets 125 125 Total liabilities
%04.11
1104.
146.125
5010.
125
2508.
125
50)35.1(
WACC
Example - Sangria Corporation - continuedCalculate WACC given preferred stock is $25 mil of total equity and yields 10%.
19-30
Tricks of the Trade
How are costs of financing determined?– Return on equity can be derived from market data
– Cost of debt is set by the market given the specific rating of a firm’s debt
– Preferred stock often has a preset dividend rate
19-31
WACC & Debt RatiosExample continued: Sangria and the Perpetual Crusher project at 20% D/V
Step 1 – r at current debt of 40%
Step 2 – D/V changes to 20%
Step 3 – New WACC
0984.)6(.124.)4(.06. r
108.)25)(.06.0984(.0984. Er
0942.)8(.108.)2)(.35.1(06. WACC
19-34
Adjusted Cost of Capital
(alternative to WACC)
M&M Formula --> ADR = r (1 - Tc L )
L = Debt / Value
r = Cost of equity @ all equity
Tc = Corp Tax Rate
alternative to WACC (almost same results)
Investment & Financing Interaction
19-35
Adjusted Cost of Capital(alternative to WACC)
Investment & Financing Interaction
Miles and Ezzell
D
AcD r
rTLrrWACC
1
1
D
AcD r
rTLrrWACC
1
1
19-36
Capital Project Adjustments
1. WACC
2. Adjust the Discount Rate Modify the discount rate to reflect capital
structure, bankruptcy risk, and other factors.
3. Adjust the Present Value Assume an all equity financed firm and then
make adjustments to value based on financing.
19-37
Adjusted Present Value
APV = Base Case NPV
+ PV Impact
Base Case = All equity finance firm NPVPV Impact = all costs/benefits directly
resulting from project
19-38
Adjusted Present Value
example:
Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.
19-39
Adjusted Present Value
example:Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.
Project NPV = 150,000Stock issue cost = -200,000Adjusted NPV- 50,000
don’t do the project
19-40
Adjusted Present Value
example:
Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.
19-41
Adjusted Present Value
example:Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.
Project NPV = - 20,000Stock issue cost = 60,000Adjusted NPV 40,000
do the project
19-42
Adjusted Present Value
Latest year0 1 2 3 4 5 6 7
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6Base-case PV of company 84.3
Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97
PV Interest tax shields 5
APV 89.3
Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%
After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79
ForecastLatest year
0 1 2 3 4 5 6 7
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6Base-case PV of company 84.3
Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97
PV Interest tax shields 5
APV 89.3
Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%
After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79
Forecast
Example – Rio Corporation APV