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Corporation Finance Tony Marciano

Lecture 4: Project Valuation with Financing Effects

1 Introduction
2 Adjusted Present Value
3 Weighted Average Cost of Capital
4 Summary

I. Introduction
When evaluating projects, we have thus far assumed all equity financing -- ignoring the effects
of capital structure on the attractiveness of a project. However we will show that the terms for
funding a project can have an impact on the project's total value. In this section, (as in BM 19),
we will incorporate the financing of a project in the determination of the value of the project.
We can summarize the effect of financing on the value of the firm in the following equation:
VL = VU + PV(Tax Benefits) + Corporate Benefits(Debt) – Costs of Financial Distress
where VL is the value of the firm with leverage and VU is the value of the all-equity firm.

The latter two effects are difficult to quantify; consequently, most bankers capture these effects
in the projected cash flows or possibly by slapping on some type of discount percentage on their
final value. The tax effect, on the other hand, is generally quantified in the Valuation process.

The purpose of this section is to determine how to value a project, (or a firm), by adjusting for
the quantifiable tax benefit of debt. The steps are exactly the same as we discussed previously
for Valuation – except we now must make a tax adjustment. The other effects of financial
structure are ignored here, and are generally embedded in other parts of the analysis performed
by practitioners. So overall, this section discusses the Valuation techniques recommended, as
well as used, to incorporate tax benfits. There are basically two methods used to adjust our
previous valuation techniques to incorporate tax benefits. The first one we will discuss is called
the Adjusted Present Value method, (APV). The other is called the Weighted Average Cost of
Capital method, (WACC). We will discuss each in turn, and then compare the two.

For a thorough analysis of valuation techniques employed – primarily in the context of valuing a
firm – please refer to the Kaplan handout (Note on Discounted Cash Flow Valuation Methods)
that is posted on Blackboard.
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II. Adjusted Present Value (APV)

Whether you use APV or WACC, the steps in performing your valuation are very similar.
Remember that the steps for performing a valuation which ignores capital structure requires that
you start by projecting cash flows in the way described in the first few weeks of the course. The
second step is to estimate a discount rate which accounts for risk. Finally, you perform the
mechanics of the third step to arrive at a final valuation. Both APV and WACC essentially
follow this format with an additional adjustment for the benefit of debt. The main difference
between APV and WACC is at which step the adjustment is made. They both start by projecting
out free cash flows in exactly the same way. However, they diverge at that point. In the case of
APV, the tax advantage of debt is incorporated in the cash flows to generate a total cash flow
with the tax shields added in. Then the remaining steps are identical since the tax shield cash
flows are simply added in. On the other hand, WACC does not incorporate the tax benefit of
debt in the cash flows but rather by adjusting downwards the discount rate used in the
mechanical step. Theoretically, they are both supposed to get you to the same final answer.
They simply differ in the manner by which you get there: higher cash flows in the case of the
APV method while the WACC method uses a lower discount rate. Let us now describe the two
methods in detail.

In order to calculate the capital structure-adjusted NPVor APV, we will employ the concept that
NPV is additive to give:
APV = NPVbase + NPVfinancing
where NPVbase is the NPV of the project in the all-equity case (the method in the first half of the
course).
In order to calculate NPVfinancing, take the present value of all the financing effects and sum them
up:

Some guidelines to performing this task include:

• Subtract issue costs at time zero.
• To adjust for the key issue of the tax benefit of debt, take the present value of the debt tax
shields:
- First, use the debt capacity of the project not the debt chosen to finance the project
- Run out interest payments (basically Debt * Debt rate or D*Rd) and consequential
tax savings in a pro-forma giving essentially D*Rd*Tc
- If you add the figure calculated in the previous bullet point (the Interest Tax
Shield) to the Free Cash Flow calculated earlier in the course you get a cumulative
cash flow available to all investors – known as the Capital Cash Flow. I
recommend discounting this capital cash flow as you would the free cash flow
earlier in the course. You will get a higher value because the capital cash flow is
higher than the free cash flow by the amount of the interest tax shield.

• Incorporate any other effects in the cash flows when calculating NPV base
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Examples of APV as well as WACC as described below are in the Valuation note document by
Steve Kaplan. The practice questions also have valuation questions like the ones on the midterm
but that now require this single adjustment.

Unlevering Beta (with Taxes)

In this course, we will keep unlevering the same as before since we will assume that the firm
keeps a constant leverage RATIO and so the tax shields move in synch with the firm. (Method 1
in the Kaplan handout.)

The Kaplan paper on the course’s Blackboard site also describes a method 2 which assumes a
constant debt LEVEL. This assumption results in the following:

where tc is the Corporate Tax Rate and represents the only change to our original unlevering
formula that we used in the first few weeks of the course. Notice that when we can assume that
the debt beta is zero, this reduces to:

The derivation of these formulas flows from the following realization:

VL = VU + t*D = D + E and VU = D *(1-t) + E.

III. Weighted Average Cost of Capital (WACC)

There is a very popular alternative to the APV method called the WACC method. They both are
valuation methods which incorporate tax effects and that start and end in the same place. They
start by projecting free cash flows. They end by applying the mechanics of valuation. As a
result, they are supposed to generate the same result, theoretically. The key difference between
the two is that APV adjusts for taxes by increasing the cash flows due to the tax benefit whereas
WACC adjusts by decreasing the discount rate.

Overall, we will discount the same project cash flows as before, but we will use a different
(lower) discount rate to take into consideration the tax benefit of debt. This formula is called the
weighted average cost of capital and is a simple adjustment to MM II incorporating the tax
beneift of debt:

WACC =

where r* is the WACC which is used to discount project cash flows. Note that the WACC is
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lower than the discount rate implied by MM II since it incorporates the fact that debt has a
corporate tax advantage. Also, note that the corporate tax rate is the proper variable here since
we don't have to adjust for personal taxes (rd and re are pretax interest rates ).

IV. Summary
A key element for valuing a project or firm that is financed with debt is to add in the tax benefit
of debt. The two major approaches to do this are APV and WACC. They are very similar
methods which give similar results, primarily differing in that APV values the tax benefit by
increasing the cash flows whereas WACC captures the benefit via decreasing the discount rate.
The key advantage of APV is that it gives you the flexibility to incorporate unorthodox tax
issues such as non-static leverage ratios and other special tax issues including NOLs (net
operating losses). The key advantage of WACC is that it is easier to use and explain and relies
on rates that can be observed in the marketplace. Academics generally recommend APV due to
its flexibility advantages whereas practitioners generally favor WACC, at least currently, due to
its clean simplicity. I certainly recommend APV when valuing firms with special tax
circumstances, un-smooth leverage ratios, or financial distress possibilities. For stable, low risk
firms without any special tax issues, it certainly seems that WACC is fine. Personally, I would
employ WACC in these cases. I recommend that you are familiar with both, knowing how to do
a valuation using either method – APV for flexibility and WACC for convention.

By the way, there are other methods. One such method requires valuing firms or projects by
determining cash flows to equity holders. Remember if you perform this method, that the
appropriate discount rate is the levered equity discount rate. This method is common when debt
is a very instrumental part of the deal -- as in financial institutions. For large public
corporations, it is usually not used.

Also, people like combining this approach with a multiples or relative value approach to get a
valuation from different perspectives as we mentioned earlier in the course. The focus in this
course is on DCF valuation.

Overall, not much has changed here from the previous course content. Unlevering betas, cash
flow projecting, and discounting mechanics are the same. The only difference is capturing the
frictions – with taxes the one incorporated in the mechanism. In the case of APV, the tax cash
flows are projected while in the WACC method, the only change is that the discount rate is
adjusted for the tax benefit of debt. So,

APV: Increase each annual Cash Flow by Debt capacity * Debt Rate * Corporate Tax
Rate

WACC: Decrease discount rate via the following calculation:

WACC = %Equity * Re + %Debt * Rd (1-Tc) with capital structure done on a MV basis.
Note this generally requires that the equity beta adjusts for the new leverage ratio (a
process that is the opposite of “Unlevering” and is thus called “Relevering”) as we will see
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in the American Chemical case .

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DCF Valuation Cookbook Final Version:

1) Set up
a) Get projections information
b) Choose Horizon
c) Choose Long Term Growth
i) I often assume inflation
d) Determine methodology (WACC,APV,FCF to Equity)
i) More on this later
2) Cash Flow Projections
a) Project Earnings
i) Project Sales
ii) Multiply by historical ratio to get to Gross Profit
iii) Project Depreciation
(1) CAPX straight-lined over proper time
iv) EBIT = Gross Profit – Operating Expense (Depr, SGA)
v) EBIAT = EBIT * (1-TaxRate)
b) Convert Earnings to FCF (Free Cash Flow)
i) Project Inc NWC w/ NWC = % of Sales
ii) FCF = EBIAT + DEPR – CAPX – IncNWC
c) Remember these are cash flows in expectation
d) If APV, then add interest tax shield ITS
i) ITS = D * Rd * Tc unless special circumstances
3) Determine Discount Rate
a) Get Beta
i) Find Comps with Equity betas
ii) Unlever their equity betas to get to asset beta = B(equity)*%Equity
(1) Use their leverage ratio
(2) Book debt but Market Equity (P*#shares)
iii) Take median (or mean) to get to Asset Beta
b) Get Risk-free Rate
i) Treasury rate of the maturity that matches the investment’s maturity
c) If APV
i) Plug into CAPM
ii) Discount Rate = Rf + MRP*Beta
iii) MRP = 6 now and 7 for older cases
iv) Discount at this rate the capital cash flows
v) Where Capital Cash Flow = Free Cash Flow + ITS
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d) If WACC
i) Estimate leverage ratio %D through capital; structure analysis
ii) Estimate Debt interest rate Rd given this capital structure
iii) Estimate Equity Discount Rate
(1) Calculate the Equity Beta
(a) Relever the equity beta from the Asset Beta of above
(b) Bequity = Basset / %E
(c) Where %E is percentage equity that is proposed
(2) Plug into CAPM as above
(a) Re = Rf + MRP * Be
iv) Plug into WACC formula
(1) WACC = %E * Re + %D * Rd *(1-Tc)

4) Mechanics => Enterprise Value

a) Discount Cash Flows at the Discount Rate
b) If there is an infinite horizon where a terminal value (TV) needs to be calculated
then take the last cash flow and divide over (r-g). Note that the result needs to be
placed one period before the final cash flow.

5) If valuing firm, convert Enterprise Value to Stock Price

a) Firm Value = Enterprise Value + Cash
b) Equity Value = Firm Value – Debt
i) Or Equity Value = Enterprise Value – Net Debt
ii) Where Net Debt s Debt – Cash
c) Stock Price = Equity Value / #Shares Outstanding