Slide 1IntroductionThe Weighted Average Cost of Capital MethodValuing a Project with WACCValuing a Project with WACCExpected Future Free Cash Flow“Market Value” Balance SheetValuing a Project with WACCValuing a Project with WACCSummary of the WACC MethodImplementing a Constant Debt-Equity RatioImplementing a Constant Debt-Equity RatioNew Market Value Balance SheetImplementing a Constant Debt-Equity RatioImplementing a Constant Debt-Equity RatioImplementing a Constant Debt-Equity RatioDebt CapacityThe Adjusted Present Value MethodThe Unlevered Value of the ProjectThe Unlevered Value of the ProjectThe Unlevered Value of the ProjectValuing the Interest Tax ShieldInterest Tax ShieldValuing the Interest Tax ShieldValuing the Project with LeverageSummary of the APV MethodSummary of the APV MethodThe Flow-to-Equity MethodFree Cash Flow to EquityValuing the Equity Cash FlowsProject-Based Costs of CapitalEstimating the Unlevered Cost of CapitalEstimating the Unlevered Cost of CapitalEstimating the Unlevered Cost of Capital using BetasProject Leverage and the Equity Cost of CapitalProject Leverage and the Weighted Average Cost of CapitalAn Alternate ApproachAn Alternate ApproachEstimating the Unlevered Cost of CapitalProject Leverage and the Equity Cost of CapitalProject Leverage and the Weighted Average Cost of CapitalCAPITAL BUDGETING WITH LEVERAGEIntroductionDiscuss three approaches to valuing a risky project that uses debt and equity financing.Initial AssumptionsThe project has average risk. For convenience the betas or costs of capital used will be for the existing firm rather than being project specific.The firm’s debt-equity ratio is constant. This simplifies the application in that we don’t need to worry about changing costs of capital and fixes the adjustment of our risk measure for leverage.Corporate taxes are the only imperfection.No agency, bankruptcy or issuance costs to quantify.The Weighted Average Cost of Capital MethodBecause the WACC incorporates the tax savings from debt, we can compute the levered value (V for enterprise value, L for leverage) of an investment, by discounting its future expected free cash flow using the WACC. (1 ) wacc E D cE Dr r rE D E Dt= + -+ +31 202 3 1 (1 ) (1 )Lwacc wacc waccFCFFCF FCFVr r r= + + ++ + +LValuing a Project with WACCRalph Inc. is considering introducing a new type of chew toy for dogs.Ralph expects the toys to become obsolete after five years when it will be discovered that chew toys only encourage dogs to eat shoes. However, the marketing group expects annual sales of $40 million for the first year, increasing by $10 million per year for the following four years.Manufacturing costs and operating expenses (excluding depreciation) are expected to be 40% of sales and $7 million, respectively, each year.Valuing a Project with WACCDeveloping the product will require upfront R&D and marketing expenses of $8 million. The fixed assets necessary to produce the product will require an additional investment of $20 million. The equipment will be obsolete once production ceases and (for simplicity) will be depreciated via the straight-line method over the five year period. Ralph expects no incremental net working capital requirements for the project.Ralph has a target of 60% Equity financing.Ralph pays a corporate tax rate of 35%.Expected Future Free Cash Flow“Market Value” Balance SheetThe firm is currently at its target leverage:Equity to Net Debt plus Equity ratio is:$510.00/($510.00 + $390.00 - $50.00) = 60.0%Valuing a Project with WACCRalph intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the project. Thus, Ralph’s WACC is: (1 ) 510 340 (12%) (5%)(1 0.35)850 850 8.5%wacc E D cE Dr r rE D E Dt= + -+ += + -=Valuing a Project with WACCThe value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows discounted at the WACC.The NPV (value added) of the project is $52.10 million$77.30 million – $25.20 million = $52.10 millionIt is important to remember the difference between value and value added.02 3 4 512.45 16.35 20.25 24.15 28.05 + 1.085 1.085 1.085 1.085 1.085 $77.30 millionLV = + + +=Summary of the WACC Method1. Determine the free cash flow of the investment.2. Compute the weighted average cost of capital.3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.4. The WACC can be used throughout the firm as the companywide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.Implementing a Constant Debt-Equity RatioBy undertaking the project, Ralph adds new assets to the firm with an initial market value $77.30 million. Therefore, to maintain the target debt-to-value ratio, Ralph must add $30.92 million in new debt.40% × $77.30 = $30.9260% × $77.30 = $46.38 (compare to $52.10)Implementing a Constant Debt-Equity RatioRalph can add (net) debt in this amount either by reducing cash and/or by borrowing and increasing actual debt. Suppose Ralph decides to spend $25.20 million (cover the negative FCF in year 0) in cash to initiate the project. This increases net debt by $25.20 millionNew Market Value Balance SheetWe need an increase in net debt of $30.92.Spend $25.20 million on the project and pay a $5.72 million dividend so $30.92 million in cash goes out (this further increases net debt and reduces equity by the required amount).Implementing a Constant Debt-Equity RatioThe market value of Ralph’s equity increases by $46.38 million.$556.38 − $510.00 = $46.38 (60% of $77.30)Adding the dividend of $5.72 million into the mix, the shareholders’ total gain is $52.10 million.$46.38 + 5.72 = $52.10Which is exactly the NPV calculated for the projectAlternatively: without the dividend the equity increased by the project’s NPV of $52.10 = $562.10 - $510.00. This is too large an increase in equity, given the increase in debt of $25.20, if Ralph is to maintain 60% equity.Implementing a Constant Debt-Equity RatioDebt CapacityThe amount of debt at a particular date that is required to maintain the firm’s target debt-to-value