CAPITAL BUDGETING WITH LEVERAGE:WACC VS. APVWACC vs. APV• When we value a project or firm that’s financed with leverage, we have thus far used the following method:—Calculate unlevered cash flows—Discount these cash flows using the Weighted Average Cost of Capital (WACC)• Now we will look at another method, APV, to achieve the same goal, and compare this method to using WACC• Main readings: BD 18.2‐18.3, 18.5, 18.7Recall: Tax Effect of Borrowing• If we issue debt to finance our project, we have to make interest payments• Interest (unlike dividends) is tax deductible—It is paid out of before‐tax earnings• The resulting debt tax shield (DTS) is valuable• WACC and APV are the two primary ways to account for the value of the tax shield in the valuationExample: Tax Deductibility of Interest• Firm ”Levered” has borrowed $5M at 7%. Interest expense is $350k• Firm ”Unlevered” has no debt• Without leverage, the assets return $1202 to investors• With leverage, the same assets return $1325• The $123 difference represent additional cash flows to investors when financing with leverage, i.e. the “Debt Tax Shield” (DTS)Comparison of WACC vs. APV methods• Both methods involve discounting free cash flows• WACC method adjusts the discount r ate to reflect the eff ect of debt tax shield on value—Use the weighted average cost of capital (WACC) to discount free cash flows, where the effective cost of debt is lower than rD• APV method adjusts the cash flows to reflect the eff ect of debt tax shield on value—Use rAto discount free cash flows—Then add cash flows resulting from the debt tax shield—Use either rAor rDto discount cash flows from debt tax shieldWACC method• In the WACC method, we discount free cash flows using a discount rate that accounts for tax benefit of debt௪௔௖௖ ௘ ௗ ௖WACC decreases with leverag eDecreasing WACC due to debt tax shieldRecall: Getting rEand rDfor WACC• When valuing projects or companies, D/E, rD, and rEshould reflect the future leverage and risk for the new project or firm, not historical va lues• Steps:1. Estimate rDat new D/E (often we use old rD)2. To get new rE, first determine rA(often by unlevering an appropriate rE)3. Then relever rA, using future capital structure, to get new rEExample: Frozen Treat• The Frozen Treat Co. makes premium hand‐made ice cream—Cost of debt (rD) = .05—Cost of equity (rE) = .12— Marginal tax rate (tC) = .3—Debt ratio (D/V) = 500/1,250 = .4— Equity ratio (E/V) = 750/1,250 = .6• WACC = 12% x .6 + .5% x .4 x (1‐0.3) = 8.6%Example: Frozen Treat (cont.)• Frozen Treat considers investing $12.5m in a perpetual ice machine • Ice machine will generate perpetual cash flow s of $1.535m before tax each period —FCF = $1.075m after tax—(We assume no Capex, Depreciation, NWC)• Project has same risk as Frozen Treat’s other operations and it would be financed with the same leverage —(E = $7.5m and D = $5m)• NPV = ‐$12.5m + $1.075m / 8.6% = 0• Project just exactly breaks evenExample: Frozen Treat (cont.)• Note the assumptions in this example—Project has same business risk (asset beta) as the rest of firm—Project supports the same D/E ratio as the rest of the firm• Then, we can use firm’s WACC to discount project cash flows• Otherwise, we must adjust WACC for differences in risk (rA) or leveragePros and Cons of WACC• Pros:—Simple method to account for DTS. Also the most used method in practice• Cons—To be accurate, WACC requires that the firm or project targets a constant future debt ratio —Not as flexible or transparent as APV• Does not assign a separate value to the tax shield• Cannot account for other (non ‐tax) financial effectsAdjusted Present Value (APV)• Three Steps for Calculating APV:1. Do valuation assuming 100% equity financing2. Determine additional cash flows from the debt tax shields (including terminal value of DTS) and discount these cash flows3. Determine and discount cash flows from other financing eff ects (if any), such as costs of financial distress or issuance costsAPV = NPVall equity+ PV(financing choices) Valuing the Debt Tax Shield: Cash Flows• DTS results in a positive cash flow eff ect:tCx interest Some Comment s:• We usually only consider corporate tax es —We could also consider our investors’ personal tax rates, but we rarely do so in practice• Debt Tax Shield is only valuable if EBIT is positive (and only to the extent EBIT is higher than the interest payments)—Alternatively, we must keep track of loss carrybacks, etcValuing the Debt Tax Shield: Discount Rate• Two candidates for discount rates:1. We can use rD, because this reflects the risk of the debt that is creating the tax shields2. We can use rA, because this reflects the risk of the assets that generate profits, and we need profits to benefit from the tax shields•