Topics Covered

1
Topics Covered

• After Tax WACC
• Tricks of the Trade
• Capital Structure and WACC
• Adjusted Present Value

2
Alternative Specifications

• Tax-adjusted required rate
• where t marginal corporate tax rate
• D/V virtual debt ratio
• r r F ? (rM rF)

3
After Tax WACC

• The tax benefit from interest expense
  deductibility must be included in the cost of
  funds.
• This tax benefit reduces the effective cost of
  debt by a factor of the marginal tax rate.

Old Formula
4
After Tax WACC
Tax Adjusted Formula
5
After Tax WACC

• Example - Sangria Corporation
• The firm has a marginal tax rate of 35. The
  cost of equity is 14.6 and the pretax cost of
  debt is 8. Given the book and market value
  balance sheets, what is the tax adjusted WACC?

6
After Tax WACC

• Example - Sangria Corporation - continued

7
After Tax WACC

• Example - Sangria Corporation - continued

8
After Tax WACC

• Example - Sangria Corporation - continued

Debt ratio (D/V) 50/125 .4 or 40 Equity
ratio (E/V) 75/125 .6 or 60
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After Tax WACC

• Example - Sangria Corporation - continued

10
After Tax WACC

• Example - Sangria Corporation - continued
• The company would like to invest in a perpetual
  crushing machine with cash flows of 2.085
  million per year pre-tax.
• Given an initial investment of 12.5 million,
  what is the value of the machine?

11
After Tax WACC

• Example - Sangria Corporation - continued
• The company would like to invest in a perpetual
  crushing machine with cash flows of 2.085
  million per year pre-tax. Given an initial
  investment of 12.5 million, what is the value of
  the machine?

12
After Tax WACC

• Example - Sangria Corporation - continued
• The company would like to invest in a perpetual
  crushing machine with cash flows of 2.085
  million per year pre-tax. Given an initial
  investment of 12.5 million, what is the value of
  the machine?

13
After Tax WACC

• Preferred stock and other forms of financing must
  be included in the formula.

14
After Tax WACC

• Example - Sangria Corporation - continued
• Calculate WACC given preferred stock is 25 mil
  of total equity and yields 10.

15
Adjusted Present Value

• APV Base Case NPV
• PV Impact
• Base Case All equity finance firm NPV.
• PV Impact all costs/benefits directly resulting
  from project.

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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.

17
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 150,000
• Stock issue cost -200,000
• Adjusted NPV - 50,000
• dont do the project

18
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
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 - 20,000
• Stock issue cost 60,000
• Adjusted NPV 40,000
• do the project

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Topics Covered

• Leveraged Buyouts
• Spin-offs and Restructuring
• Conglomerates
• Private Equity Partnership
• Control and Governance

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Definitions

• Corporate control -- the power to make investment
  and financing decisions.
• Corporate governance -- the role of the Board of
  Directors, shareholder voting, proxy fights, etc.
  and the actions taken by shareholders to
  influence corporate decisions.
• Financial architecture -- the financial
  organization of the business.

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Leveraged Buyouts

• The difference between leveraged buyouts and
  ordinary acquisitions
• 1. A large fraction of the purchase price is debt
  financed.
• 2. The LBO goes private, and its share is no
  longer trade on the open market.

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Leveraged Buyouts

• The three main characteristics of LBOs
• 1. High debt
• 2. Incentives
• 3. Private ownership

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Leveraged Buyouts
10 Largest LBOs in 1980s and 1997/98 examples
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Private Equity Partnership
Investment Phase
Payout Phase
General Partner put up 1 of capital
General Partner get carried interest in 20 of
profits
Mgmt fees
Limited partners get investment back, then 80 of
profits
Limited partners put in 99 of capital
Partnership
Partnership
Company 1
Company 2
Investment in diversified portfolio of companies
Sale or IPO of companies
Company N