Transcript 0324782918_179578

Chapter 14:
The Link Between Capital
Structure and Capital Budgeting
Corporate Finance, 3e
Graham, Smart, and Megginson
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
M&M, Capital Budgeting, and the
WACC
 When
calculating project NPVs using the
WACC…
use unlevered project cash flows (ignoring
financing effects).
 We capture the effect of financing choices by
discounting cash flows at the WACC.
 We
 This
1.
2.
is fine as long as two conditions hold:
The business risk of the project under
consideration is similar to that of the firm’s
existing assets.
The project does not materially alter the firm’s
long-run target debt-to-equity ratio.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
M&M, Capital Budgeting, and the
WACC
 Two
other approaches analysts can use to
calculate project values when firms use
both debt and equity:
 The
adjusted present value (APV) method
calculates an investment’s value as if it were
financed only with equity, then adds back the
present value of any financing side effects.
 The flow-to-equity (FTE) method uses the
firm’s cost of equity to discount levered
project cash flows.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Adjusted Present Value Method

Calculates the project’s unlevered cash flows,
just as the WACC does.

APV discounts these cash flows using the
discount rate that applies if the firm is financed
only with equity.

Analysts using the APV technique must add (or
subtract) the PVs of any financing side effects
that arise because the firm uses leverage.
APV = NPV(Unlevered) + NPV(Financing effects)
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The Flow-to-Equity Method

FTE method differs from WACC and APV
approaches by focusing exclusively on cash flows
to shareholders.

WACC and APV project cash flow calculations
ignore interest expense, while an FTE analysis
deducts interest costs and taxes from project
cash flows.

This type of cash flow calculation is referred to
as levered cash flow.
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Interactions Between Investment
and Financing Decisions
1.
Under certain conditions, all three methods (WACC,
FTE, and APV) generate estimates of an investment’s
value that agree. In such cases, choose the method
that is easiest to apply given the available data.
2.
When the firm plans to maintain a constant target
debt-to-equity ratio in the long run, use the WACC or
FTE methods.
3.
When the firm’s debt-to-equity ratio varies over a
project’s life, but the amount of debt outstanding at
any given time is known, use the APV method.
4.
When financing side effects beyond the interest tax
shield are an important part of the investment project
under consideration, use the APV method.
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© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.