CAPITAL BUDGETING WITH LEVERAGE WACC VS APV WACC 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 7 Recall 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 valuation Example 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 rate to reflect the effect 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 effect of debt tax shield on value Use rA to discount free cash flows Then add cash flows resulting from the debt tax shield Use either rA or rD to discount cash flows from debt tax shield WACC method In the WACC method we discount free cash flows using a discount rate that accounts for tax benefit of debt WACC decreases with leverage Decreasing WACC due to debt tax shield Recall Getting rE and rD for WACC When valuing projects or companies D E rD and rE should reflect the future leverage and risk for the new project or firm not historical values Steps 1 Estimate rD at 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 rE Example 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 flows 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 even Example 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 leverage Pros 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 effects Adjusted Present Value APV Three Steps for Calculating APV 1 Do valuation assuming 100 equity financing 2 Determine additional cash flows from the debt tax shields including terminal value of DTS and discount these cash flows 3 Determine and discount cash flows from other financing effects if any such as costs of financial distress or issuance costs APV NPVall equity PV financing choices Valuing the Debt Tax Shield Cash Flows DTS results in a positive cash flow effect tC x interest Some Comments We usually only consider corporate taxes 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 etc Valuing 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 shields 2 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 In general I recommend using rA when the leverage ratio is fixed and rD when the debt amount is fixed To see why rA is a good choice with fixed D V consider that the debt levels and thus the interest payments and DTS will fluctuate with the same risk as the value of the firm s assets If debt amount is fixed the DTS has the same risk as the debt itself so we can discount them at rD When using rD with a perpetual constant D recall the easy formula PV DTS tCD Example APV of Frozen Treat s Ice Machine Recall we are considering investing 12 5m in a perpetual ice machine generating after tax cash flow of 1 075m We know rD 5 rE 12 D V 40 and tC 30 WACC calculation found NPV 0 What is APV Example APV of Frozen Treat s Ice Machine contd First calculate NPV as if investment is all equity financed rA 12 x 60 5 x 40 9 2 NPVALL E 12 5m 1 075m 9 2 0 82m Value of Debt Tax Shield Each period interest payment is 5 of 5m 25m Tax reduction is 25m x 30 075m PV DTS 105m 9 2 0 82m APV 0 82m 0 82m 0 Same answer as WACC break even Pros and Cons of APV Pros APV separates the value of the assets from the value created by the financing decision Transparent picture of what generates value in a project firm especially if we are considering changing the capital structure APV is for example the best choice for analyzing LBOs with complex capital structures APV can use different discount rates for different cash flow components that have different risks e g assets vs tax shields Cons Requires explicitly deriving schedule of future debt levels and interest payments Other Financing Effects Often we only account for tax benefit of debt when we use APV But unlike the WACC method APV is also allows accounting for other cash flow effects of financing For example financial distress costs agency costs issuance costs etc However the cash flow …