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CAPITAL STRUCTUREVALUATION & CAPITAL BUDGETING
FEUI Program Studi Maksi – PPAK
Manajemen Keuangan
Kuliah II 13.04.2009
RWJ CH. 17Sugeng Purwanto Ph.D, FRM
Note: Submit a summary of Chapter 15&16.
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CAPITAL STRUCTURE AND FIRM VALUE
PV of tax shield
Zero leverage firm value
Leveraged firm value
PV of financial distress costsValueofthe firm(V = S + B)
Debt RatioB/S orB/V
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CAPITAL ASSET PRICING MODEL (CAPM)
“Common method to determine the cost of equity of risky assets”
ExpectedReturnE[R]
Β (Systematic Risk)
Security Market Line :”SML”E[Ri] = Rf + β (E[Rm] – Rf)
E[Ri] Expected return stock “I”E[Rm] Expected market returnRf Risk-free rate (T-Bill rate, SBI rate)β Systematic risk (non-diversiable risk, market tisk)E[Rm]-Rf Risk Premium
Rf
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CAPITAL BUDGETINGReview
METHODS
(1) Pay back period (PBP)(2) Discounted pay back period (DPBP)(3) NPV (net present value)(4) IRR (internal rate of return)
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CAPITAL BUDGETING
3 APPROACHES:
(1) ADJUSTED PRESENT VALUE
(2) FLOW TO EQUITY (FTE)
(3) WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Note:All of the above approaches are using NPV method.
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ADJUSTED PRESENT VALUE APPROACH
APV = NPV + NPFVAPV = Adjusted Present ValueNPV = Value of the project to an unlevered firmNPVF = Net Present Value of the financing side effect
NPVAF Side Effects. There are 4 side effects (can be “+” or “-”:
1). The tax subsidy to debt (tax benefits from debt)2). The costs of issuing new securities3). The costs of financial distress4). Subsidies to debt financing
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TAX SUBSIDY (BENEFITS FROM TAX)Example I.A. APV APPROACH. FOR UNLEVERED FIRM
Consider a project of the P.B. Singer Co. with the following characteristics:Cash inflows: $500,000 per-year for the indefinite futureCash costs: 72% of salesInitial investment: $475,000TC (Corporate Tax): 34%R0 (the cost of capital for a project of an all-equity firm) : 20%
Calculate the Net Present value (NPV) of project!
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Answer: I.A.Cash inflows $500,000Cash costs = 72%x$500,000 -$360,000Operating income $140,000Corporate Tax: 34%x$140,000 -$47,600Unlevered Cash Flow (UCF) $92,400
Present Value of annuity of $92,400 with a discount rate R0 of 20% is:
PV = $92,400/20% = $462,000
NPV = PV – Initial Investment = $462,500 - $475,000 = - $13,000 Zero Debt B = 0 ---- NPVF = 0APV = NPV + NPVF APV = -$13,000 + 0 = -$13,000The project is not feasible! 8
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Example continue: Example I.B. APV APPROACH FOR LEVERED FIRM
Now assume that the firm finances the project with US$126,229.50 in debt. So that the remaining investment of $475,000 - $126,229.50 = $348,770.50 is financed with equity.Evaluate the project feasibility!
Answer:APV = NPV + NPVF
= NPV + TC x B
APV = -$13,000 + 34% x $126,229.50= -$13,000 + $42,918= $29,918
The APV IS POSITIVE. THE PROJECT IS FEASIBLE. 9
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Example II.Evaluate the project feasibility with FLOW TO EQUITY (FTE) Approach.
Answer:FTE Approach steps.
Step 1.Calculating Levered Cash Flow (LCF)
Step 2.Calculating the Discount Rate of Leverage Equity RsRs = R0 + B/S (1 – Tc) (R0 – RB)
Step 3.ValuationNPV = LCF/Rs
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Step 1. Calculating LCF
Cash Inflows $500,000Cash costs: 72% x $500,000 -$360,000Interest: 10% x $126,229.50 -$12,622.95Income after interest $127,377.05Corporate Tax: 34%x$127,377.05 -$43,377.20Levered Cash Flow (LCF) $84,068.85
Note:You can calculate LCF with a formula:LCF = UCF – (1 – Tc) x RB x B
UCF = Unlevered Cash Flow = $92,400RB = 10%B = $126,229.50
LCF = $92,400 – (1-34%)x10%x$126,229.50 = $84,068.,8511
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Step 2. Calculating Discount Rate of Levered Equity Rs
Rs = R0 + B/S (1 – Tc) (R0 – RB)
Rs = 20% + 1/3 x (1-34%) (20% - 10%)= 22.2%
Note:Target Debt-to-Equity ratio is 1/3Target Debt-to-Value ratio is 1/4
B/S = 1/3 Debt-to-Equity ratio
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Step 3. VALUATION OF PROJECT
The Present Value of the project levered cash flow (LCF) is
PV = LCF/Rs
= $84,068.85/22.2%
= $378,688.50
Initial Investment $475,000Debt $126,299.50Equity = $475,000 - $126,299.50 = $348,770.50
NPV = PV – Equity Invested= $378,688.50 - $348,770.50= $29,918. ---- NPV Positive! The project is feasible!
The same result with APV approach. 13
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Example III.Evaluate the project feasibility with WEIGHTED AVERAGE COST OF CAPITAL METHOD (WACC)
Answer:RWACC = S/(S+B) x Rs + B/(S+B) x RB (1 – Tc) S Equity
B DebtTc Corp
Tax∞ UCF
NPV = ∑ - Initial Investment
t=1 (1 + RWACC)t
UCF = UNLEVERED CASH FLOW
PERPETUITY OF UCF :
NPV = UCF/RWACC - Initial Investment
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Example III continue
RWACC = 3/4 x 22.2% + ¼ x 10% (1 – 34%)= 18.3%
PV of project = UCF/RWACC
= $92,400/ 18.3%
= $504,918
NPV = $504,918 - $475,000
= $29,918 NPV Positive, the project is feasible
The same result with APV Approach or FTE Approach.15
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WHICH APPROACH TO BE USED?
Suggested guideline
USE WACC OR FTE IF THE FIRM’s TARGET DEBT-TO-EQUITY RATIO APPLIES TO THE PROJECT OVER ITS LIFE.
USE APV IF THE PROJECT’s LEVEL OF DEBT IS KNOWN OVER THE LIFE OF THE PROJECT.
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ESTIMATION OF DISCOUNT RATE
Procedure to calculate Discount Rate
Step 1. Determining of Cost of Equity Capital of industryRs = Rf + β (Rm – Rf) CAPM MethodTo find Rs
Step 2. Determining Cost of Capital if ALL EquityRs = R0 + B/S (1-Tc) (R0 – RB)To find R0
Step 3. Determining Rs for the firm evaluated
Step 4. Determining RWACC for the firm evaluated
DO EXERCISES!! Example 17.1 17
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EXERCISES (AND/OR HOMEWORK)
RWJ Text Book page 496 – 500
Example 17.1Determination of Cost of capital.
Example 17.2APV Example.
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BETA AND LEVERAGE
The No-Tax Case
βEquity = βAsset [1 + Debt/equity]
The Corporate Tax Case
βEquity = [1 + (1-Tc)xDebt/Equity] βUnlevered firm
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Example 17.3.BETA AND LEVERAGE
C.F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is considered riskless. The corporate tax rate is 34%. Regression analysis indicates that the beta of the firm’s equity is 2. the risk-free rate is 10%, and the expected market premium is 8.5%. What would the project’s discount rate be in the hypothetical case that C.F.Lee Inc is all equity?
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Example 17.3.Answer
Beta of hypothetical all-equity firm.
βEquity = [1 + (1-Tc)xDebt/Equity] βUnlevered firm
Unlevered Beta:βUnlevered firm = βEquity / [1 + (1-Tc)xDebt/Equity]βUnlevered firm = 2/ [1 + (1-34%)x$100m/$200m] = 1.5
Discount Rate:Rs = R0 +β (Rm – Rf)Rs = 10% + 1.5 x 8.5% = 22.75% 21
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Example 17.3.
The J.Lowers corp which currently manufacture staples is considering a $1 million investment in a project in the aircraft adhesive industry. The corporation estimates unlevered aftertax cash flows (UCF) of $300,000 per year into perpetuity from the project. The firm will finance the project with a debt-to-value ratio of 0.5 (or equivalently a debt-to-equity ratio of 1:1).The three competitors in this new industry are currently unlevered with betas of 1.2, 1.3, and 1.4. assuming a risk-free rate of 5%, a market risk premium of 9% and a corporate tax of 34%, what is the net present value of the oproject?
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Example 17.3. Answer1.Calculating the average unlevered beta in the industry.
Avg unlevered beta = (1.2 + 1.3 + 1.4)/3 = 1.3
2.Calculating the levered beta for J.lower’s new projectβEquity = [1 + (1-Tc) Debt/Equity] βUnlevered firm
= [1 + (1-34%) 1/1] = 2.16
3. Calculating the cost of levered equity for the projectRs = Rf + β (Rm – Rf) = 5% + 2.16x9% = 24.4%
4. Calculating the WACC for the projectRWACC = B/V RB (1-Tc) + S/V Rs
= 1/2x5% (1-34%)+1/2x24.4% = 13.9%
5. The project Val ue.NPV = UCF/RWACC – Initial Investment
= $300,000/13.9% - $1million = $1.16 million
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THE END