Chapter 7
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Capital Budgeting
- Valuing a business or project
- The 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
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In this case, r = WACC
Valuing a Business
e.g. Rio Corporation
Latest year
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 66.2 71.3 76.3 79.9 83.1 87 90.2
3 EBITDA (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 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.4
6 Tax 6 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 9.6 9.7 10 10.1 10
8 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 16.2 15.9
9 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 67.6
PV of company 87.9
Forecast
Assumptions Year 0 1 2 3 4 5 6 7
Sales growth (percent) 6.7 7 7 7 4 4 4 3
Costs (percent of sales) 75.5 74 74.5 74.5 75 75 75.5 76
Working capital (percent of sales) 13.3 13 13 13 13 13 13 13
Net fixed assets (percent of sales) 79.2 79 79 79 79 79 79 79
Depreciation (percent of sales) 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 95 109.6 125.1 141.8 156.8 172.4 188.6 204.5
Less accumulated depreciation 29 38.9 49.5 60.8 72.6 84.9 97.6 110.7
Net fixed assets 66 70.7 75.6 80.9 84.2 87.5 91 93.8
Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1
Working capital 11.1 11.6 12.4 13.3 13.9 14.4 15 15.4
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= 8.7 + 9.9 − (109.6 − 95.0) − (11.6 − 11.1) = $3.5???????
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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
- 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.
- 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
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Tricks of the Trade
What should be included with debt?
- How does the formula change when there are more than two sources of financing?
- What about short-term debt?
- What about other current liabilities?
- How are the costs of financing calcualted?
- Company vs. Industry WACCs
After-Tax WACC
Preferred stock and other forms of financing must be included in the formula
= (1 − ) ??
× + ??
× + ??
× ???
Tricks of the Trade
How are costs of financing calculated?
- 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
e.g. Sangria and the Perpetual Crusher project at 20% D/V
Step 1 – r at current debt of 40%
? = 6(0.4) + 12.4(0.6) = 9.84%
Step 2 – D/V changes to 20%
?? = 9.84 + (9.84 − 6)(0.25) = 10.8
Step 3 – New WACC
???? = 6(1 − 0.35)(0.20) + 10.8(0.8) = 9.42%
Investment & Financing Interaction
Adjusted Present Value vs. Adjusted Discount Rate
Adjusted Cost of Capital (alternative to WACC)
Miles and Ezzell
= −
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Alternative to WACC (almost same results)
WACC
- Adjust the discount rate
o Modify the discount rate to reflect capital structure, bankruptcy risk, and other
factors
- Adjust the present value
o Assume an all equity financed firm and then make adjustments to value based on
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Adjusted Present Value
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= −1.067 + 1.75 = $0.683 ???????
Less equity issue cost of $525,000 and debt issue cost of $100,000
= −1.067 + 1.75 − 0.525 − 0.1 = $0.058 ???????
e.g. 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
e.g. Rio Corporation APV
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