By

Arpit amarCorporate Finance – 2011Georg Simon Ohm University of applied Science, Nuremberg

Introduction

Finance manager

Takes two decision

Investment or capital budgeting

decision

Where to invest or purchase of real assets

Financing decision

How to raise money or sale of financial

assets

Investment decision

Finance manager

Explores good investment

projects

Analyse NPV (net present

value)

The difference between Projects value and its cost

Takes opportunity cost

of capital as discount rate

Assumes all cost of financing is

equity financed

And calculates NPV

Financing decision

When Investment project is financed with equity capital as well as debt capital

Then this will represent the capital structure of the firm

Equity capital requires return to be paid to

shareholders or investors

The return should be more then the

opportunity cost of capital

Debt capital requires fixed interest to be paid

to the creditors

Interest is tax-deductible expense, so we calculate

after tax cost of debt

The weighted average of cost of debt and cost of equity taken together is called weighted average of capital

(WACC)

WACCAnalyse the cost of raising the equity and debt

capital

Takes the weighted average of cost

And value’s project

WACC = Rd( 1-Tc) D/V + RE E/V

Rd = cost of debtRe = cost of equity

D= market value of debtE= market value of equity

Tc = corporate tax rate

The formula of WACC works for average projects, where business risk from equity and debt ratio

remains constant

The managers use WACC to discount future cash flows but when equity and debt ratios are expected to change , then WACC may not give exact results

Calculating Sangria’s WACCSangria is a U.S.-based company whose products aim to promote happy ,

low stress lifestyles. The book value and market value are :

Assetsvalue

$1000 $500 Debt

$500 Equity

$1000 $1000

Assetsvalue

$1250 $500 Debt

$750 Equity

$1000 $1250

Book values , $million

Market values , $million

In book value : the value of debt and equity are equal

In market values : the value of debt remains same and value of equity changes from $ 500

to $750

The given cost of debt is 6%.This represent interest

paid on existing and on new borrowing debt

The given cost of equity is 12.4%.

This represent the expected rate of return demanded by investors

Sangria’s WACC

Taking market values for the calculation of

debt and equity ratios

Debt ratio = 500/1250 = .4

Equity ratio = 750/1250 = .6

The market share price changes from $5 to $7.5.This is the current market price and when it is multiplied by number of its outstanding

shares , then it increases the equity capital and changes equity ratio in overall capital structure. Sangria is constantly profitable and pays taxes

at the marginal rate of 35%

Therefore:Cost of debt (rd) = .06

Cost of equity (re)=0.124

Marginal tax rate (Tc) = .35

Debt ratio (d/v) = .4Equity ratio (e/v) = .6

The company’s after- tax WACC is:

WACC= .06*(1-.35)*.4 +.124*.6 =.090

OR 9%

Using Sangria’s WAAC for the valuation of project

Suppose there is an investment in the firm of $12.5 million in perpetual crushing machine. The machine never depreciates and generates a cash flow of $1.731 million

per year pre-tax. And overall the project is average risk

If the risk involved in project is average then we use WACC as a discount rate

that is 9%

Pre tax cash flow = $1.731 millionTax at 35% of $1.731 million = .606

After tax cash flow (c) = $1.125 million

NPV= -12.5 + 1.125 / .09NPV = 0

NPV= Initial investment + cash flow / discount rate of WACC

When NPV is zero then the project is barely acceptable as an investment.This states that return from investing $12.5 million in project generates the cash flow of $1.125 million which is equals to Sangria’s WACC OF 9%. That is: cash flow / investment =1.125/12.5*100 =9% Therefore return on investment is equal to cost

Assumptions about WACC

•When NPV is zero then project is barely acceptable stating that the cost of capital and return from investment are equal

•Pre tax cash flows are converted into after tax cash flows as if the project were all equity financed.

•The project cash flow’s are then discounted by WACC in order to capture the effect from tax shield

•When business risk and debt ratios are not constant or expected change ,then use of WACC is not exactly correct.

•The formula works for average projects where business risk and debt ratios are expected to be constant

•WACC formula uses after tax cost of debt thereby capturing the value of interest shield

WACC and financial crisisCost of capital assumes risk free rate of return but in practice its not risk

free

Cost of equity capital

Return investors expects

Cost of debt capital

Interest to be paid by company

High cost of equity capital makes it compulsory for

company to pay risk premium rate of return which has to

be more than its beta

High Cost of debt capital creates inflation , increase investors expectations to cover this inflation rate

Incapacity to pay back huge debt may lead to defaults and

so credit institution will not lend more money, investors

loose faith and may invest in government bonds, there will

be refinancing problems

Need to analyse good investment projects.

Zero NPV or low NPV projects may not be able pay high returns to shareholders.Share price and valuation of company may get affected

Valuing Businesses

When valuing a business as a whole is necessary:

• Mergers & Acquisition• Selling of a business unit• Going Public

WACC can be used to value businesses that are financed by debt & equity

Assumption: constant debt ratio

Present Value (free cash flow) Present value (horizon value)

Valuing Businesses

Example: Valuing Rio Corporation

Input data:• Rio Corporation is a similar corporation like Sangria• Same line of business like Sangria (Assumption: same proportion of debt like

Sangria)

Sangria's WACC can be used – 9%

Goal: Calculating the present value of Rio Corporation

Steps to do:1. Calculation of free cash flows (FCF)2. Estimating horizon value3. Calculation of present value

Valuing Businesses

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: Valuing Rio Corporation

Valuing Businesses

Example: Valuing Rio Corporation

Valuing BusinessesExample: Valuing Rio Corporation

Determination of free cash flows:

FCF = profit after tax + depreciation – investment in fixed assets – - investment in working capital

FCF1= 8,7 + 9,9 – (109,6 - 95,0) – (11,6 -11,1) = 3,5 (million $)FCF2 = …

Calculation of PV (FCF)

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

Valuing Businesses

Example: Valuing Rio Corporation

Determination of horizon value:

•Long run growth rate: 3%

6.67$4.113

1.09

1 value)PV(horizon

4.11303.09.

8.6PV ValueHorizon

6

1H

gwacc

FCFH

million $87.9

6.673.02

value)PV(horizonPV(FCF)s)PV(busines

Value of equity = PV(business) – value of debt = 87,9 – 36,0 = $51,9 million

Valuing BusinessesTricks of the Trade

More than two sources of financing:

EPD r

V

Er

V

Pr

V

DTcWACC )1(

Valuing BusinessesTricks of the Trade

What about short term debt?

• Leaving short term debt out of calculation is an error• No serious error if debt is only temporary or compensated by holdings of cash

and marketable securities

What about other current liabilities?

• Usually "netted out" (Net working capital = current assets – current liabilities)• Net working capital is entered on the left hand side of balance sheet

Valuing BusinessesTricks of the Trade

How are the costs of financing calculated?

• Interrest rate for equity can be retrieved by looking at the stock market (typical demand by investors)

• Getting borrowing rate and D/V and E/V is not difficult• Convertible, junk debt,

Valuing BusinessesImpact of the Euro Crisis on valuing businesses

• Inflation leads to increasing interest rates• WACC is increasing with increasing interest rates

•Present value decreases with increasing WACC

•Key interest rate may increase higher interest rates (like mentioned above)•Influence of rating agencies•Influence of currency exchange rates Increase / decrease of FCF

EPD r

V

Er

V

Pr

V

DTcWACC )1(

APV -Adjusted present value

APV = Base Case NPV + sum of PV Impact

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

PV impact : Interest rate tax shields (plus) Issuing cost of securities ( minus) Financing packages subsidized ( plus)

Estimating the firm or project base case value assuming it is all equity financed and then adjust this base case value to account for the financing side effects .

APV- Base case Example : Sangria Perpetual crusher project

Cost of capital r = 9.84% Investment = $ 12.5 million Project cash flow = $ 1.125 million (perpetual).

Base –case NPV= -12.5 + 1.125 = -$1.067 million .0984Project is not worthwhile with all equity financing.

APV-PV (interest tax shield)Condition I The project support with debt of $ 5 million 6% borrowing rate rD =.06

35 % tax rate ( Tc=.35)

Annual tax shield = .35 X.06 X 5 = .0105 or $ 105,000.

Tax shields are constantly rebalanced with debt and with discount rate r =9.84% PV ( interest tax shields, debt rebalanced) = $ 105, 000 = $ 1.067 million .0984APV = sum of base –case value and PV( interest tax shield)APV = -1.067 million + 1.067 million = 0

APV-PV (interest tax shield)Condition IISuppose sangria plans to keep project debt fixed at $5 million The risk of tax shield is the same of the risk o the debt and we discount at the

rate of 6% rate on debt.PV( tax shields, debt fixed) = – 105,000 = $ 1.75 million. .06APV = -1.067 + 1.75 =$ .683 millionNow the project is more attractive with fixed debt , the interest tax shields

are safe and therefore worth more .( if perpetual crusher project fails , the $ 5 million of fixed debt may end up as a burden on sangria’s other asset)

APV -Other financial side effects Suppose finance by issuing debt and equity $ 7.5 million equity with issue cost of 7% = $ 525.000 $ 5 million of debt issue cost of 2% = $ 100,000 Assume debt s fixed once is issued and tax shield worth $1.75 million

APV = -1.067+ 1.75- 0.525 -0.100 = 0.58 million

Note : other financial side affects Leasing ( plus) with base case NPV subsidies loan from government ( plus)

APV for business

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 64.6 horizon value 6 year 113.4Base-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 64.6 horizon value 6 year 113.4Base-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

Rio corporation APV valuation

APV for business

Opportunity cost of capital= 9.84%APV = base –case NPV + PV ( interest tax shields)If the debt levels are taken as fixed and tax shield discounted by 6% borrowing

rate

=$ 84.3 + 5.0 = $ 89.3 million. There is an increase of $1.4 million from NPV , this increase is higher early debt

levels. APV explore financial strategies with out looking the fixed debt ratio or having

to calculate the WACC for every scenario. APV useful when debt for a project is tied to book value or has to repaid on

fixed schedule. Leverage buyouts( LBO) – generating cash by selling assets , shaving cost and

improving profit margins APV works fine for LBOs but for WACC can’t use the discount rate to evaluate

an LBOs because its debt ratio will not be constant.

APV for international investments Custom tailored project financing, special contracts with suppliers,

customers and governments. When debt ratio will not be constant , turn to APV Example1- In project ,if the competing supplier offers low interest rate project loans

or lease of the plant in their bids, then NPVs of this loans or lease should be included in project analysis

2- A manufacture agrees a guarantee to provide in minimum price this value is also addition to project APV –if the market price varies

3- if the government impose cost or restriction such as the investors should park their part of incoming money in non interest bearing accounts e.g 2 years, then this period calculate the cost of this requirement and subtract it from APV.

Thank you