Capital Budgeting

1
Lecture 17

• Capital Budgeting
• for Levered Firm

2
Three approaches
1. Adjusted Present Value (APV) approach
2. Flow to Equity (FTE) approach
3. Weighted Average Cost of Capital (WACC)
approach
3
Adjusted Present Value (APV) approach
Calculate NPV ignoring financing, then add NPV of
financing (NPVF) APV NPV NPVF
4
Example
Suppose bankruptcy and financial distress costs
are irrelevant.
1. All-equity value
5
Example (Continued)
2. Additional financing side-effect
6
Example (Continued)
3. Including Personal Taxes
With personal taxes, the PV of the tax shield
would change
4. Subsidized Financing
7
Example (Continued)
5. Floating Costs
8
Example (Continued)
6. Costs of financial distress
9
Flow to Equity (FTE) Approach
(Equitys contribution) (Initial investment) -
(debt)
10
Applying the FTE Approach to the Previous Example
11
Example (Continued)
Equity contribution is 5m, so NPV is 1.7m. The
1.7m debt tax-shield raises equity market value
to 6.7m.
Simultaneity in the FTE approach
12
Weighted Average Cost of Capital (WACC) Approach
13
WACC Approach (continued)

• S and B are publicly available
• depends on the assets beta coefficient,
  the return on the market index, and the SML
• can be found using bond betas,
  and the SML, or as yield to maturity on a
  similar risk bond
• also can be found using a weighted beta

14
Applying the WACC Approach to the Previous Example
15
Comparison of the APV, FTE and WACC
16
Comparison of APV, FTE and WACC (Continued)
APV, FTE and WACC give the same valuation in an
MM world.

• WACC reflects tax benefits of debt in a lower
  discount rate
• APV adds the PV of tax shield

• APV and WACC use unlevered cash flows, so the
  full cost of investment is subtracted to obtain
  NPV
• FTE uses levered cash flows, so only the equity
  contribution to investment is subtracted.

17
Comparison of APV, FTE and WACC (Continued)

• APV is needed when there are interest subsidies
  or floatation costs, or the level of debt changes
  over the life of the project.
• FTE and WACC assume a constant debt-equity ratio.

WACC is most widely used in practice, although
FTE is popular with financial analysts since it
focuses on the equity effects.
18
Example Finite lived project with floatation
costs and interest subsidy
(Depreciation tax shield) 0.34 2m 0.68M
for 5 years
19
Example (continued)
Interest of 10 (757,576) is paid on the gross
loan, yielding (tax benefits) 0.34 757,576
257,576 (net interest) 500,000
20
Example (continued)
The loan is repaid at date 5, with the principal
payment not tax deductible
21
Example (continued)
Suppose a government pays the floatation costs
(so the firm borrows only 7.5m) and enables the
firm to borrow at 8.
(Interest) 0.08 7.5m 0.6m for 5 years
(APV) -0.5140 1.342 0.8280