CFP FINAL EXAM NOTES:
Ch18: Capital budgeting & Valuation with leverage;
*Overview of concepts:
* Interest payments are tax deductible as an expense for the corp, debt financing creates valuable ITS for the firm. * Can include value of ITS in several ways:
1. WACC METHOD; discount unlevered free cash flows using the weighted average cost of capital (WACC). Because we calculate the WACC using the effective after-tax interest rate as the cost of debt, therefore this method incorporates the tax benefit of debt implicitly through the cost of capital. 2. ADJUSTED PRESENT VALUE METHOD (APV); first value a projects free cash flows without leverage by discounting them using the unlevered cost of capital. Then separately estimate and add the present value of the ITS from debt. This method we add the value of the ITS to the projects unlevered value. 3. FLOW TO EQUITY METHOD (FTE); Applies the idea that rather than value the firm based on its free cash flows, we can also value its equity based on total payouts to shareholders. So to value incremental payouts to equity associated with a project.
Assessing methods via examples: in which the following assumptions have been made 1. The project has average risk: Assume that the market risk of the project is = to the average market risk of the firm’s investments. Therefore the projects COC can be assessed based on the risk of the firm. 2. The firm’s debt-equity ratio is constant: Assumes that the risk of the firms equity and debt and its WACC will not fluctuate due to leverage change. 3. Corporate taxes are the only imperfection: We assume initially that the main effect of leverage on valuation is due to the corporate tax shield. Ignore personal taxes and insurance costs – assume other imperfections are not significant at the level of debt chosen.
FORMULA 1: pg 596
FORMULA 2: pg 596
SUMMARY OF WACC METHOD:
1. Determine the free cash flow of the investment
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