Corporate Finance: Ch 18 - Financing and Valuation

Managers tend to think about financial choices that lower

their cost of capital

Maximizing value is equivalent to

minimizing the cost of capital

Unlevered Cashflows

cash flows that would accrue to shareholders if firm only uses EQUITY

Levered Cash Flow

cash flows that accrue to shareholders under current capital structure (with some debt)

r₀

cost of equity capital if a firm uses only equity financing

r_E

cost of equity capital under current capital structure (with some debt)

r_WACC

weighted average cost of capital

NPV

net present value of a project calculated assuming no debt

NPVF

net present value of financing side effects

Components of NPVF

• tax benefits from debt financing. the benefit is T_C x r_D x D each year

• costs of issuing new securities: investment banking costs, legal fees, etc.

• Expected financial distress costs from taking on project

Flow to equity approach basic ideas

• calculate expected cash flow that will accrue to equityholders after taxes and interest payments — levered cash flow (LCF)

• calculate cost of equity r_E including the effect of leverage

• Calculate NPV to equityholders

when debt ratios are expected to change over a project’s life, rE and rWACC will…

change over time, thus WACC and FTE methods will be prone to errors

when debt levels in the future are uncertain…

value of tax shields is hard to predict, thus APV method prone to errors

Use APV if

debt levels are known over project’s life

Use WACC and FTE if

target debt ratio is known for project life

rWACC < r0

• rWACC decreases with leverage

• project value increases with leverage