The firm pays out all earnings as dividends.
The project has average risk.
Corporate taxes are the only market imperfection.
The firm’s debt-equity ratio is constant.
Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, which is its value including the benefit of interest tax shields given the firm's leverage policy, by discounting its future free cash flow using the WACC.
The WACC incorporates the benefit of the interest tax shield by using the firm's before-tax cost of capital for debt.
When the market risk of the project is similar to the average market risk of the firm's investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the firm's securities; that is, the project's cost of capital is equal to the firm’s weighted average cost of capital (WACC).
A project's cost of capital depends on its risk.
The WACC can be used throughout the firm as the company wide 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.
A disadvantage of the WACC method is that you need to know how the firm's leverage policy is implemented to make the capital budgeting decision.
The intuition for the WACC method is that the firm's weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after-tax basis.
To be profitable, a project should generate an expected return of at least the firm's weighted average cost of capital.
Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.
Compute the weighted average cost of capital.
Determine the free cash flow of the investment.
Adjust the WACC for the firm's current debt/equity ratio.
Deducting costs arising from market imperfections
Calculating the unlevered value of the project
Calculating the after-tax WACC
Calculating the value of the interest tax shield
The firm's unlevered cost of capital is equal to its pretax weighted average cost of capital–that is, using the pretax cost of debt, rd , rather than its after-tax cost, rd (1 - τc ).
A firm's levered cost of capital is a weighted average of its equity and debt costs of capital.
When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project's cash flows, so they should be discounted at the project's unlevered cost of capital.
The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage.
To determine the project's debt capacity for the interest tax shield calculation, we need to know the value of the project.
To compute the present value of the interest tax shield, we need to determine the appropriate cost of capital.
Because we don’t value the tax shield separately, with the APV method we need to include the benefit of the tax shield in the discount rate as we do in the WACC method.
A target leverage ratio means that the firm adjusts its debt proportionally to the project’s value or its cash flows.
The APV approach explicitly values the market imperfections and therefore allows managers to measure their contribution to value.
We need to know the debt level to compute the APV, but with a constant debt-equity ratio we need to know the project's value to compute the debt level.
The WACC method is more complicated than the APV method because we must compute two separate valuations: the unlevered project and the interest tax shield.
Implementing the APV approach with a constant debt-equity ratio requires solving for the project's debt and value simultaneously.
In the flow-to-equity valuation method, the cash flows to equity holders are then discounted using the weighted average cost of capital.
In the WACC and APV methods, we value a project based on its free cash flow, which is computed ignoring interest and debt payments.
In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders taking into account all payments to and from debt holders.
The first step in the FTE method is to determine the project’s free cash flow to equity (FCFE).
The project's free cash flow to equity shows the expected amount of additional cash the firm will have available to pay dividends (or conduct share repurchases) each year.
The value of the project’s FCFE should be identical to the NPV computed using the WACC and APV methods.
The value of the project’s FCFE represents the gain to shareholders from the project.
Because interest payments are deducted before taxes, we adjust the firm's FCF by their before-tax cost.
Determine the equity cost of capital, rE.
Ompute the equity value, E, by discounting the free cash flow to equity using the equity cost of capital. C
Determine the free cash flow to equity of the investment.
Determine the before-tax cost of capital, rU.
In the real world, specific projects should differ only slightly from the average investment made by the firm.
We can estimate rU for a new project by looking at single-division firms that have similar business risks.
The project's equity cost of capital depends on its unlevered cost of capital, rU, and the debt-equity ratio of the incremental financing that will be put in place to support the project.
Projects may vary in the amount of leverage they will support–for example, acquisitions of real estate or capital equipment are often highly levered, whereas investments in intellectual property are not.
For capital budgeting purposes, the project’s financing is the incremental financing that results if the firm takes on the project.
Projects with safer cash flows can support more debt before they increase the risk of financial distress for the firm.
If the positive free cash flow from a project will increase the firm's cash holdings, then this growth in cash is equivalent to a reduction in the firm’s leverage.
The incremental financing of a project corresponds directly to the financing that is directly tied to the project.
Rather than set debt according to a target debt-equity ratio or interest coverage level, a firm may adjust its debt according to a fixed schedule that is known in advance.
When we relax the assumption of a constant debt-equity ratio, the equity cost of capital and WACC for a project will change over time as the debt-equity ratio changes.
When we relax the assumption of a constant debt-equity ratio, the APV and FTE methods are difficult to implement.
If a firm is using leverage to shield income from corporate taxes, then it will adjust its debt level so that its interest expenses grow with its earnings.
When we relax the assumption of a constant debt-equity ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies.
When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt cost of capital, rD.
With a constant interest coverage policy, the value of the interest tax shield is proportional to the project's unlevered value.
When the firm keeps its interest payments to a target fraction of its FCF, we say it has a constant interest coverage ratio.
As a general rule, the WACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the life of the investment.
The FTE method is typically used only in complicated settings for which the values of other securities in the firm’s capital structure or the interest tax shield are themselves difficult to determine.
For alternative leverage policies, the FTE method is usually the most straightforward approach.
When used consistently, the WACC, APV, and FTE methods produce the same valuation for the investment.
With perfect capital markets, all securities are fairly priced and issuing securities is a zero-NPV transaction.
The fees associated with the financing of the project are independent of the project's required cash flows and should be ignored when calculating the NPV of the project.
When a firm borrows funds, a mispricing scenario arises if the interest rate charged differs from the rate that is appropriate given the actual risk of the loan.
The WACC, APV, and FTE methods determine the value of an investment incorporating the tax shields associated with leverage.
Sometimes management may believe that the securities they are issuing are priced at less than (or more than) their true value. If so, the NPV of the transaction, which is the difference between the actual money raised and the true value of the securities sold, should not be included in the value of the project.
An alternative method of incorporating financial distress and agency costs is to first value the project ignoring these costs, and then value the incremental cash flows associated with financial distress and agency problems separately.
When the debt level—and, therefore, the probability of financial distress—is high, the expected free cash flow will be reduced by the expected costs associated with financial distress and agency problems.
If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for the existing shareholders.