###

Note: if you get the error: "Microsoft Excel cannot calculate a formula. Cell references in the formula refer to the
formula's results, creating a circular reference.." when you open this spreadsheet, then click on
Tools/Options/Calculation and then click on the check box marked "Iterations." Usually 100 iterations is plenty.

Chapter 25. Tool Kit for Mergers, LBOs, Divestitures, and Holding Companies
In theory, merger analysis is quite simple. The acquiring firm performs an analysis to value the target company. The acquiring firm
then seeks to buy the firm at preferably below that estimated value. Meanwhile, the target company would only want to accept the
offer is the price exceeds its value if operated independently. In practice, however, the process of merger analysis is much more
involved and raises some difficult issues.

While many valuation techniques exist, we shall focus upon the two most common: the discounted cash flow and market multiple
analysis. Regardless of the method used, it is crucial to recognize that the target company typically will not continue to operate as a
separate entity, but rather it becomes part of the acquiring firm's portfolio of risky assets. This is significant because the operational
changes that may occur will affect the value of the business and must be considered. In addition, it is important to remember that
the goal of merger evaluation is to value the target company's equity, because the business is acquired from the company's owners,
not its creditors. For that reason, our focus will be the value of equity, not total value.

APV ANALYSIS
This process is very much like the process employed in Chapter 15 of the text to value stock. This method operates under the
assumption that the intrinsic value of a firm is determined by the future cash flows that the firm will generate, discounted to the
present. The value consists of two parts: the present value of the free cash flows and the present value of the tax savings due to the
deductibility of interest payments.
The first step in this approach is to create pro forma income statements for the target company as a subsidiary of the acquiring
firm. The purpose of these pro forma statements is to project expected cash flows, because the incremental free cash flows
generated by the merger are one of the key drivers of the valuation. The other driving factor of our valuation will be the discount
rate we use.
Generating Pro Forma Statements
Post merger cash flow forecasts are by far the most important factor in a merger analysis. In this scenario, the target company's
debt ratio is expected to remain at 50%, before and after of the merger. Both the target firm (Tutwiler Corporations) and the
acquiring firm (Caldwell) have a 40% marginal federal-plus-state tax rate. Financial 'analysts for Caldwell have created pro forma
income statements for the Tutwiler subsidiary for the years 2005 to 2009.
Long-term growth rate
Tax rate

6%
40%

Pro Forma Statements (figures in millions of dollars)

.
.
.
.
.
.
.
.
.
.
.

Net sales
Costs of goods sold
Selling & admin. Expense
Depreciation
EBIT
Taxes on EBIT
NOPAT
Plus Depreciation
Operating Cash Flow
Less gross retention for growth
Free Cash Flow

. Interest
. Interest Tax Shield

2005
$105.0
80.0
10.0
8.0
7.0
2.8
4.2
8.0
12.2
9.0
3.2

2006
$126.0
94.0
12.0
8.0
12.0
4.8
7.2
8.0
15.2
12.0
3.2

2007
$151.0
113.0
13.0
9.0
16.0
6.4
9.6
9.0
18.6
13.0
5.6

2008
$174.0
130.0
15.0
9.0
20.0
8.0
12.0
9.0
21.0
15.0
6.0

2009
$191.0
142.0
16.0
10.0
23.0
9.2
13.80
10.0
23.8
17.0
6.8

6.0
2.4

5.0
2.0

4.0
1.6

4.0
1.6

4.0
1.6

TUTWILER'S UNLEVERED COST OF EQUITY

Before the merger, Tutwiler's beta is 1.20, and it has $27 million in debt and $62.5 million in equity. From Equation 1715, rL=rU + (rU -rD) (D/S). Solving for rU gives rU = wS rL + wd rd.
PROBLEM
Calculate Tutwiler's unlevered cost of equity and WACC
rRF
7.0%
Beta
1.2
MRP
5%

rd
S
D
wd

$
$

9%
62.50
27.00
30.168%

rL
rL
rL

=
=
=

WACC
WACC
WACC

=
=
=

rU
rU
rU

=
=
=

rRF
7%
13.00%
wdrd(1-T)
1.63%
10.710%

+
+

Beta
1.2

+
+

9.08%

wS

rL

0.698
0.1179

0.13

*
*

MRP
5%

wSrL

+
+

wd

rd

0.302

0.09

THE HORIZON, OR CONTINUING, VALUE OF THE SUBSIDIARY

In our projections, Tutwiler first experiences growth of about 20%, but that rate slowly dwindles down to the firm's long-term
growth rate of 6%. Now that we have found the cash flows to be generated by Tutwiler, we now seek to find the horizon, or
continuing, value of the firm to the time when growth becomes constant (in 2009). In the long run, Tutwiler will maintain the same
proportion of debt and equity as before the acquisition, so the WACC for the horizon should be equal to the WACC estimated
above.
PROBLEM
Calculate the 2009 horizon value of a firm with Tutwiler's 2009 free cash flow and Tutwiler's WACC and growth rate:
HV 2009

FCF 2009

(1 + g)

HV 2009

=
=

6.8
$153.04

1.060

HV 2009

(WACC
0.1071

g)

0.06

At this point we will reconstruct the proforma statements, only now they will reflect the horizon value as well.
Long-term growth rate
Tax rate

6%
40%

Table 25-2: Projected Postmerger Free Cash Flow Statement (figures in millions of dollars)
2005
$105.0
80.0
10.0
8.0
7.0

2006
$126.0
94.0
12.0
8.0
12.0

2007
$151.0
113.0
13.0
9.0
16.0

2008
$174.0
130.0
15.0
9.0
20.0

2009
$191.0
142.0
16.0
10.0
23.0

2.8
4.2
8.0
12.2

4.8
7.2
8.0
15.2

6.4
9.6
9.0
18.6

8.0
12.0
9.0
21.0

9.2
13.8
10.0
23.8

. Less net retention for growthc

. Free Cash Flow

9.0
3.2

12.0
3.2

13.0
5.6

15.0
6.0

17.0
6.8

. Interesta
. Interest Tax Shield

6.0
2.4

5.0
2.0

4.0
1.6

4.0
1.6

4.0
1.6

$5.6

$5.2

$7.2

$7.6

$161.44

0.60

4.2

7.2

9.6

11.4

.
.
.
.
.

Net sales
Costs of goods sold
Selling & admin. Expense
Depreciation
EBIT

.
.
.
.

Taxes on EBITb
NOPAT
Plus Depreciation
Operating Cash Flow

. Plus terminal valued

$153.0

. FCF and tax shield to Caldwelle

. Net incomef

Notes:
a

Interest payments are estimates based on Tutwiler's existing debt, plus additional debt issued in the acquisition.

Caldwell will file a consolidated tax return after the merger. Thus, the taxes shown here are the full corporate taxers
attributable to Tutwiler's operating profit.

Some of the cash flows generated by the Tutwiler subsidiary after the merger must be retained to finance asset
replacements and growth. The balance will be used to pay interest and principal on any remaining debt within
Tutwiler or transferred to Caldwell to pay dividends on its stock or for redeployment within the corporation.

Tutwiler's available cash flows are expected to grow at a constant 6 prcent rate after 2009. The value of all
post 2009 cash flows as of December 31, 2009, is estimated by use of the constant growth model to be (in
millions--calculations are above):

$153.0

These are the free cash flows plus debt tax shield projected to be available to Caldwell by virture of the acquisition.
The cash flows could be used for interest payments on debt, dividend payments to Caldwell's stockholders, to finance
asset expansion in Caldwell's other divisions and subsidiaries, and so on.

For a company without non-operating income, net income can be calculated as NOPAT - Interest + Interest tax shield.
You would probably be working with complete balance sheets when doing these calculations so net income would be
readily available.

The value of operations including the value of the tax shield can now be derived by finding the NPV of the net cash flow stream in
Row 15 above, discounted at Tutwiler's unlevered cost of equity.
V Ops 2004

$111.66

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is

$111.66
million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.
VEquity
VEquity

V Ops 2004

=
=

VEquity

$111.7
$84.7

Debt2003

27.00

Since Caldwell only has to pay $62.5 million for the equity, it is a good deal for Caldwell.
VALUING THE TARGET WITH A CHANGE IN CAPITAL STRUCTURE
Tutwiler currently has equity worth $62.5 million and debt of $27 million, giving it a capital structure financed with about 30
percent debt: $27 / ($62.5 + $27.0) = 0.30 = 30 percent. If Caldwell decides to increase Tutwilers capital structure to about 50
percent after the acquisition, it will affect the analysis in three ways.
New Target % debt
New interest rate on debt
The Impact on Cash Flows to Caldwell

50%
9.50%

With more debt, the interest payments will be higher than those shown in Table 25-2. Although this does not affect free cash flow or
the unlevered cost of equity, it does affect the interest tax shield during the 5 years of explicit projections. Also, the long run WACC
will be different under a 50% debt level than it was under a 30% debt level. Note that the beauty of the APV method is that it is
easy to incorporate different assumptions about financing.

.
.
.
.
.
.
.
.
.
.
.

Net sales
Costs of goods sold
Selling & admin. Expense
Depreciation
EBIT
Taxes on EBIT
NOPAT
Plus Depreciation
Operating Cash Flow
Less net retention for growth
Free Cash Flow

. Interesta
. Interest Tax Shield

2005
$105.0
80.0
10.0
8.0
7.0
2.8
4.2
8.0
12.2
9.0
3.2

2006
$126.0
94.0
12.0
8.0
12.0
4.8
7.2
8.0
15.2
12.0
3.2

2007
$151.0
113.0
13.0
9.0
16.0
6.4
9.6
9.0
18.6
13.0
5.6

2008
$174.0
130.0
15.0
9.0
20.0
8.0
12.0
9.0
21.0
15.0
6.0

2009
$191.0
142.0
16.0
10.0
23.0
9.2
13.8
10.0
23.8
17.0
6.8

6.0
2.4

6.0
2.4

7.0
2.8

8.0
3.2

8.5
3.4

Note:

Interest is calculated at the higher rate and on the higher level of debt

New Horizon Value Calculation

Free cash flows are the same in 2008 with the different debt level. But the WACC is different.
From Equation 17-15, rL=rU + (rU -rD) (D/S). If the target percentages are 40% debt, 60% equity:
% financed with debt =
% financed with equity =

50%
50%

New levered cost of equity, and WACC

rL
rU
=
rL
=
0.1179
rL
=
14.08%

+
+

rU

0.1179

wDrd(1-T)
WACC
=
+
WACC
=
2.85%
+
WACC
=
9.89%
This WACC is lower than the WACC we obtained with 30% debt.

) D/S
1.00000

(WACC

g)

0.06

wSrL

FCF 2009

(1 + g)

HV 2009
HV 2009

6.8

1.060

$185.30
2005

Free Cash Flow

Interest Tax Shield
Plus Horizon Value
FCF and tax shield to Caldwell

rD
9.5%

7.04%

HV 2009

Cash Flows
.
.
.
.

3.20
2.40

2006
3.20
2.40

2007
5.60
2.80

5.60

5.60

8.40

0.0989

2008
6.00
3.20
9.20

2009
6.80
3.40
$185.30
195.50

The value of operations including the value of the tax shield can now be derived by finding the NPV of the net cash flow stream in
Row 13 above, discounted at Tutwiler's unlevered cost of equity.
V Ops 2003

$133.4

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is

$133.4 million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.
VEquity

VEquity
VEquity

=
=

V Ops 2004

Debt2004

$133.4
$106.4

So with 30% debt, the value of Tutwiler's equity to Caldwell is

So with 50% debt, the value of Tutwiler's equity to Caldwell is

27.00

$84.66
$106.369

Setting the Bid Price

Table 25-3 Analysis of the Tutwiler Acquisition with a Change in Capital Structure
(Millions of Dollars)

Value of equity:
Value of debt:
Total value:

Tutwiler as a Separate Company

Prior to the Acquisition
$62.5
$27.0

Tutwiler as a
Subsidiary with No
Change in Debt
$84.7
$27.0

Tutwiler as a Subsidiary
with a 50% Debt Ratio
$106.4
$27.0

$89.5

$111.7

$133.4

Maximum amount Caldwell

should pay for Tutwiler's
equity:a

$84.7

$106.4

Maximum price per share

Caldwell should pay for
Tutwiler's equity:b

$8.47

$10.64

Notes:

Calculated as the total value as a subsidiary minus the amount of debt as a separate company.

Calculated as the maximum amount divided by the 10 million shares of Tutwiler stock.

ACCOUNTING FOR MERGERS

Firm A will acquire Firm B. Current laws only allow for purchase accounting.

Table 25-3: Accounting for Mergers: A Acquires B

Purchase Accounting

Current assets
Fixed assets
Goodwilld
Total assets
Debt
Common equity
Total claims
Notes:

Postmerger: Firm A
Firm A
(1)

Firm B
(2)

$20 Paida $30 Paida

(3)
(4)

$50 Paida Is price paid equal to NAV?

(5)

$50

$25

$75

$75

$80

50

25

65

75

80

10

$100

$50

$140

$150

$170

$40

$20

$60

$60

$60

60

30

80

80

110

$100

$50

$140

$140

$170

The price paid is the net asset value, that is, total assets minus debt.

In column (3) we assume that Firm B's current and fixed assets are writen down from $25 to $15 before constructing
the consolidated balance sheet.

In column (4) we assume that Firm B's current and fixed assets are both increased to $30.

Goodwill refers to the excess paid for a firm above the apprised value of the physical assets purchased. Goodwill
represents payment both for intangibles such as patents and for "organization" value such as that associated with
having an effective sales force.

In column (3), Firm B's common equity is reduced by $10 prior to consolidation to feflect the fixed asset write-off.
f

In column (5), Firm B's equity is increased to $50 to reflect the above-book purchase price.

Table 25-4 Income Effects of Purchase Accounting

Sales
Operating costs
Operating income
Interest (10%)
Taxable income
Taxes (40%)
Earnings after taxes
Goodwill write-off

Firm A
(1)
$100.0

Firm B
(2)
$50.0

Purchase
(3)
$150.0

72.0
$28.0
4.0
$24.0
9.6
$14.4

36.0
$14.0
2.0
$12.0
4.8
$7.2

109.0
$41.0
6.0
$35.0
14.0
$21.0

0.0

0.0

0.0

Net income

$14.4

$7.2

$21.0

EPSc
Notes:

$2.40

$2.40

$2.33

Operating costs are $1 higher than they otherwise would be to reflect the higher reported costs (depreciation and cost
of goods sold) caused by the physical asset markup at the time of purchase.
Prior to 2001 goodwill was written off over its expected life. Now goodwill is subject to an annual "impairment" test.
If its fair market value has decreased during the year then goodwill is reduced, otherwise it is not.
Firm A had six shares and Firm B had three shares before the merger. A gives one new share for each of B's, so A has
nine shares outstanding after the merger.

Calculations using a nave application of the coporate valuation model

The corporate valuation model may be applied naively to a merger analysis provided the capital structure is not going to change ver
much after the merger. As long as the weighted average cost of capital is consistent with the actual debt level and acutal equity valu
the underlying assumptions for the corporate valuation model are satisfied. Even if the capital structure changes a little during the
immediate post-merger period, a nave implementation of the corporate valuation model will usually be pretty accurate.
Without a change in capital structure: the horizon capital structure will be the same as the pre-merger capital structure.
Data from the APV Model spreadsheet
Long-term growth rate
Tax rate

6.0%
40.0%

11 Free Cash Flow

12 Interest
13 Interest Tax Shield
rRF
Beta
MRP
rd
S
D

2005
3.2
6
2.4

2006
3.2
5
2

2007
5.6
4
1.6

2008
6
4
1.6

2005

2006

2007

2008

2009
6.8
4
1.6

7.00%
1.2
5.00%
9.00%
62.5
27

Corporate valuation model calculations

Pre-merger rL
WACC at pre-merger capital structure
Horizon Value
HV and FCF
Vops
less debt
Value of equity
Value of equity using APV
Difference

13.00%
10.71%

3.2
3.2
5.6
$109.73 discounted at pre-merger WACC
-27
$82.73
$
84.66 from the spreadsheet APV Model
($1.93)

2009
153.0360934
6 159.8360934

This differs a bit from the APV model's answer because the target WACC does not correctly account for the varying
amount of the tax shield in each of the 5 years before the company stabilizes. But since the horizon capital structure and
the pre-merger capital structure are the same, there is not much difference in the answers.

The difference is more dramatic if the capital structure is assumed to change at the horizon:
New Target % debt
New interest rate on debt
Free Cash Flow
Interesta
Interest Tax Shield

50%
9.50%
2005
3.2
6.0
2.4

2006
3.2
6.0
2.4

2007
5.6
7.0
2.8

2008
6.0
8.0
3.2

2009
6.8
8.5
3.4

In a nave application of the corporate valuation model your WACC calculation depends on how nave you are. If you
calculate WACC based on the new target percent of debt but use the old levered cost of equity you are very nave. If you
recalculate the levered cost of equity based on the new target percent of debt you are less naive--but it depends on what you
use to relever the cost of equity. The traditional method has been to use Hamada to relever the cost of equity so we will do
that here, assuming you are somewhat less naive.
rL calculation using Hamada on the pre-merger beta to unlever and lever
pre-merger beta
bU based on Hamada
new beta
New rL using Hamada

1.20
0.95298602 equation 16-8
1.52477764 equation 16-8
14.624%

rL calculation using equation 15-12 to unlever and lever

rU
11.79% From the Model spreadsheet
New rL using equation 17-15
14.08% (equation 17-15)
assumed new rL
WACC at new target using new rL
Free Cash Flow
Horizon Value
FCF and horizon value
Vops
less debt
Value of equity
Value of equity using APV
Difference

14.08% refer to either Hamada's rL or equation 17-15's rL above.

9.890%
2005
2006
2007
2008
2009
3.2
3.2
5.6
6
6.8
185.30
3.2
3.2
5.6
6.0
192.1
$133.77 discounted using WACC at new capital structure
-27.00
$106.77
$ 106.37 From the APV Model spreadsheet
$0.40

Notice that this difference is very large when the Hamada formula is used to relever the equity at the new debt level. The
difference is much smaller if you change the formula in the green cell "assumed new r L to point to rL calculated using
equation 17-15. The remaining smaller difference is due to using an incorrect WACC on the five year's cash flows before
the horizon period.

Modifying the nave corporate valuation model to be consistent with the APV model
In order to make the corporate valuation model correctly deal with a changing capital structure, we need to make several
adjustments.
First, we must calculate the horizon WACC using equation 17-15 to calculate the new levered return to equity. This is just
as in the APV model.
Second, we must calculate a new WACC each period up to the horizon period. This calculation is based on the acutal
percent of debt in each year where the debt level at the end of year t is the amount of debt required to give the assumed
interest payment in year t+1. The debt level at the end of the final year of projections is assumed to be the target debt ratio
multiplied by the horizon value of operations. See the comments in the cells below.
Third, calculate the value of operations each year as the present value of next year's value of operations and next year's free
cash flow, discounted back at the current year's WACC.
Notice that this calculation induces a circularity: the value of operations in year t depends on the WACC at the end of year
t that depends on the debt ratio at the end of year t which in turn depends on the value of operations at the end of year t.
However setting the calculation option to "iterate" allows Excel to solve this circularity.

Notice that this calculation induces a circularity: the value of operations in year t depends on the WACC at the end of year
t that depends on the debt ratio at the end of year t which in turn depends on the value of operations at the end of year t.
However setting the calculation option to "iterate" allows Excel to solve this circularity.
rU
Horizon WACC

11.79% From the APV Model spreadsheet

9.89% From the APV Model spreadsheet

Correcting the WACC each period (this causes a circularity)

Year-end debt implied by interest
Vops at end of year t
Percent debt at year-end
rL at year-end
WACC at year-end
Vops
less debt
Value of equity
Value of equity using APV
Difference

63.16
133.37
47.36%
13.85%
9.99%

2005
63.16
143.49
44.01%
13.59%
10.12%

2006
73.68
154.81
47.6%
13.87%
9.98%

2007
84.21
164.66
51.14%
14.19%
9.85%

2008
89.47
174.88
51.16%
14.19%
9.85%

2009
92.65
185.3
50.00%
14.08%
9.89%

133.369312
-27
$ 106.37
$ 106.37 From the APV Model spreadsheet
$0.00000

The APV and corporate value models give the same answer as long as the WACC is correctly calculated each year.

cture is not going to change very

ebt level and acutal equity value
ture changes a little during the
be pretty accurate.

er capital structure.

calculated at pre-merger capital structure

for the varying

apital structure and

ve you are. If you

e very nave. If you
t depends on what you
f equity so we will do

15's rL above.

calcuated at new capital structure

new debt level. The

calculated using
r's cash flows before

need to make several

to equity. This is just

sed on the acutal

o give the assumed
e the target debt ratio

ons and next year's free

ACC at the end of year

at the end of year t.

ed each year.

Horizon value calculation as above.

uses equation 17-12

Calculations using a nave application of the FCF to equity model

The free cash flow to equity (FCFE) model can be used to value a company whose capital structure is
changing, but only if great care is taken when calculating FCFE. As shown below, a nave implementation of
the FCFE model works reasonably well when the capital structure doesn't change much, but performs very
badly when the capital structure is changing significantly.
Without a change in capital structure: the horizon capital structure will be the same as the pre-merger capital structure.
Data from the APV Model spreadsheet
Long-term growth rate
Tax rate

6.0%
40.0%
2005
3.2
6
2.4

Free Cash Flow

Interest
Interest Tax Shield
rRF
Beta
MRP
rd
S
D
rL

2006
3.2
5
2

2007
5.6
4
1.6

2008
6
4
1.6

2009
6.8
4
1.6

7.00%
1.2
5.00%
9.00%
62.5
27
13.00%

Unlike the corporate valuation model or the APV model, even a nave implementation of the FCFE model
requires knowing the change in debt each period. This is because an increase in debt is a contribution to the
FCFE. In this implementation we will assume that the level of debt at the end of each year is the amount of
debt that would be required to give the assumed interest expense in that year.
FCFE model calculations
Implied debt level
FCF
less interest
plus interest tax shield
plus increase in debt
= FCFE
Horizon Value
HV and FCFE
Value of equity
Value of equity using APV
$
Difference

27.00

2005
66.67
3.2
-6
2.4
39.67
39.27

2006
55.56
3.2
-5
2
(11.11)
(10.91)

2007
44.44
5.6
-4
1.6
(11.11)
(7.91)

2008
44.44
6
-4
1.6
3.60

39.27
(10.91)
(7.91)
3.60
NPV
of
HV
and
FCFE
discounted
at
r
$61.48
L
84.66 from the spreadsheet APV Model
(23.18)

2009
44.44
6.8
-4
1.6
4.40
66.63
71.03

This differs from the APV model's answer because the return to equity does not correctly account for the fact that the
debt level increases substantially from the pre-merger level--so the cost of equity should increase as well. This happens
even though at the horizon the target percent debt is the same as the percent debt before the acquisition. The fact that
the cost of equity is wrong during the five years immediately after the acquisition causes this naive implementation of the
cash flow to equity model to give incorrect answers. In addition, the assumption that the last year's FCFE will continue
to grow at a constant rate is only consistent with FCF growing at a constant rate if the company is already at it's target
capital structure the year BEFORE the last projected year. It is incorrect to assume that the last year's FCFE will grow
at a constant rate unless the firm already happens to be at the target capital structure.

This differs from the APV model's answer because the return to equity does not correctly account for the fact that the
debt level increases substantially from the pre-merger level--so the cost of equity should increase as well. This happens
even though at the horizon the target percent debt is the same as the percent debt before the acquisition. The fact that
the cost of equity is wrong during the five years immediately after the acquisition causes this naive implementation of the
cash flow to equity model to give incorrect answers. In addition, the assumption that the last year's FCFE will continue
to grow at a constant rate is only consistent with FCF growing at a constant rate if the company is already at it's target
capital structure the year BEFORE the last projected year. It is incorrect to assume that the last year's FCFE will grow
at a constant rate unless the firm already happens to be at the target capital structure.
The difference is more dramatic if the capital structure is assumed to change at the horizon:
Data from the APV Model spreadsheet
New Target % debt
New interest rate on debt
Free Cash Flow
Interesta
Interest Tax Shield
FCFE calculation
Implied debt level
FCF
less interest
plus interest tax shield
plus increase in debt
= FCFE

50%
9.50%

27.0

2005
3.2
6.0
2.4

2006
3.2
6.0
2.4

2007
5.6
7.0
2.8

2008
6.0
8.0
3.2

2009
6.8
8.5
3.4

63.2
3.2
-6.0
2.4
36.2
35.8

63.2
3.2
-6.0
2.4
0.0
-0.4

73.7
5.6
-7.0
2.8
10.5
11.9

84.2
6.0
-8.0
3.2
10.5
11.7

89.5
6.8
-8.5
3.4
5.3
7.0

Of course a new rL must be calculated since the capital structure at the horizon will be different. You could use Hamada
to do this (see the worksheet tab Corporate Valuation Model for an example of this) but that would be wrong for reasons
discussed in the text. We will assume you correctly use equation 17-15 to re-lever the equity.
New rL calculation:
ru
new rL
Horizon Value
FCFE
HV and FCFE
Value of equity
Value of equity using APV
Difference

11.79% equation 25-4

14.09% equation 17-15
2005
35.8
35.8

2006

2007

2008

-0.4
-0.4

11.9
11.9

11.7
11.7

2009
91.3
7.0
98.2

96.817
106.4
-9.6

Even though we have the correct discount rate at the horizon, this gives a different answer from the APV. The reason is
first, that the discount rate for the five projected years is incorrect, and second, that the FCFE in the last year is not
consistent with the capital structure we assumed at the horizon. The firm will have to recapitalize at the horizon to get to
its target debt ratio, and we haven't taken this required change in debt into account. Neither the corporate valuation
model nor the APV model require knowing the dollar value of debt in the year after the horizon, and this makes using
either model much easier than the FCFE model. Below we will show how to correctly calculate FCFE and the discount
rate in order to make the FCFE model consistent with the other two models.

Modifying the FCFE model to be consistent with the APV model

In order to make the FCFE calculation consistent with the APV and corporate valuation calculations we need to do
several things:

In order to make the FCFE calculation consistent with the APV and corporate valuation calculations we need to do
several things:
First, we need to extend the projections out one more year so we can see what must happen to the debt level so that the
assumption of a horizon capital structure is satisfied.
Second, we must specify the implied end of year debt level to be the amount of debt that would give the assumed interest
expense in the NEXT year.
Third, in the last year of projections there is no debt level (because we don't know the interest expense in our extended
year of projections--the year in blue). This is what makes implementing the FCFE model correctly difficult. For now,
just enter the previous year's debt.
Fourth, in the extended (blue) year's projections, project FCF and debt level to have grown at the assumed long term
growth rate (see the comments in the cells).
Fifth, calculate new levered equity required returns each year using equation 17-15 based on the current year's debt and
equity levels. This induces circularity, just like it did with the corporate valuation model, because the end of year equity
depends on the end of year rL which depends on the end of year debt ratio, which depends on the end of year equity level.
Unfortunately, as you will see, there is one more circularity to be dealt with and this combination makes it difficult for
Excel to reliably find a solution.
Finally, notice the green cell. It has an arbitrary debt level in it. In reality, for the company to be at its target capital
structure by the end of the projection period, as assumed, it will likely have to change its debt level. Here is what makes
the FCFE calculation difficult. You must MANUALLY through trial and error select a debt level that sets the yellow cell
to the target debt ratio. Excel's Goal Seek can sometimes be used, but because there are other circularities embedded in
the construction, it does not always converge even though there is a solution.
2005
2006
2007
2008
2009
Free Cash Flow
3.2
3.2
5.6
6.0
6.8
Interesta
6.0
6.0
7.0
8.0
8.5
Tax shield
2.4
2.4
2.8
3.2
3.4
Debt level implied by
63.2
63.2
73.7
84.2
89.5
92.6
change in debt
0.0
10.5
10.5
5.3
3.1
FCFE
-0.4
10.1
11.9
6.5
4.8
Horizon E
Value of Equity
70.092
80.207
80.988
80.302
85.241
92.569
D/E
0.901069544 0.787439003 0.909819 1.048667 1.049658 0.999794288
D/(D+E)
47.40%
44.05% 47.64% 51.19% 51.21%
49.99%
rl
13.86%
13.60% 13.88% 14.20% 14.20%
14.09%
Actual debt level
Increase in debt
VE
V eq from APV
difference

27
36.2
106.3
106.369312
-0.119

The difference between the FCFE value of equity and the APV value of equity is minimal, provided the green cell is
chosen to be consistent with the assumed horizon capital structure.

erger capital structure.

Calculated as FCFE(1+g)/(rL-g)

for the fact that the

s well. This happens
sition. The fact that
implementation of the
s FCFE will continue
already at it's target
ear's FCFE will grow

You could use Hamada

d be wrong for reasons

e APV. The reason is

he last year is not
at the horizon to get to
orporate valuation
nd this makes using
CFE and the discount

ns we need to do

debt level so that the

e the assumed interest

ense in our extended

difficult. For now,

assumed long term

urrent year's debt and

he end of year equity
nd of year equity level.
makes it difficult for

at its target capital

. Here is what makes
hat sets the yellow cell
ularities embedded in

2009
7.21
8.8
3.5
98.1
5.6
7.5
98.1
98.123
0.999798
49.99%
14.09%

d the green cell is

The value for debt in the green cell must be chosen so

the actual percent of debt (in the yellow cell) is equal
to the target percent of debt. Excel has difficulty
solving this problem.
Target for yellow cell
50%

Reconciliation of free cash flow to equity model, corporate valuation model and APV model for
constant growth.
The corporate valuation model, the APV model, and the cash flow to equity model will all give the same value if
applied using the same assumptions. This spreadsheet shows what is required for these three models to give the same
answer in the simplest case of a constant growth firm.
Consider a company with a specified target debt ratio and required returns below. It has NOPAT and net retentions as
assumed and a perpetual growth rate of g.
Tax rate
Target % debt
Target % equity
rd
rsL
WACC
rU
g = growth rate
Nopat
- net retentions
= FCF

40%
30.17%
69.83%
9%
13%
10.71%
11.79% Note: ru must be calculated using formula 25-4, NOT Hamada.
6%
4.2
1
3.2

Corporate valuation model

The corporate valuation model discounts the growing free cash flow at the target WACC.
Vops
72.059 = FCF(1+g)/(WACC - g)
Vdebt
21.73843 = VOps x target % debt
Value of Equity
50.320 = VOps x target % equity

Important note for the corporate valuation model: This example assumes a constant percent of debt. If the percent of
debt is changing over time then the only way the corporate valuation model will give the correct answer for the value of
operations is for the WACC to change as the percent of debt changes. If you know the percent of debt in each year,
then the changing levered cost of equity can be calculated using equation 17-15 and 25-4 and hence the WACC
calculated. Unfortunately, this induces a circularity: you must know the value of operations to calculate the percent of
debt, which you need in order to calculate the WACC, which you use to calculate the value of operations. Excel can
resolve this circularity, but the programming is more difficult than the programming for the APV, which does not
involve circularities.

Cash flows to equity model

In order to implement the cash flow to equity method we need to know the projected interest expense. This requires
knowing the debt level. If we also need to know the target capital structure this gives the value of the firm without
having to resort to any valuation techniques at all since VOps = debt level / target % debt. So the cash flow to equity
model is circular if its calculations require knowing both the debt level and the target capital structure. However, if
you make the (perhaps heroic) assumption that you know the interest payment and the required return to equity at the
target capital structure, but don't you don't know the target capital structure itself, then the model isn't circular. We'll
make that assumption for the purpose of this example.
interest

1.846 To be consistent with the assumptions in the corporate valuation model above,
assume that the interest expense is rd x (Vdebt/(1+g)) from above.

interest tax shield

FCF to equity calcuation:
FCF
- Interest Expense
+ Interest tax shield

+ Change in debt
FCF to Equity
Value of Equity
Assumed Debt
Total Value

0.738 assume that the interest expense is rd x (Vdebt/(1+g)) from above.

3.2
-1.846
0.738 This is just the tax shield for the current year.
In the FCFE calculation, an increase in debt is a cash flow to equity. Here debt
1.230 must increase at a rate of g. This is the increase in debt in the current year.
3.323
50.320 = FCFE(1+g)/(rL-g)
21.738
72.059

Important note for FCFE model: This example assumes a constant percent of debt (even if you don't know what the
percent is). If the percent of debt is changing over time then the only way the FCFE model will give the correct answer
for the value of equity is for the discount rate to change as the percent of debt changes. If you know the percent of debt
in each year, then the changing levered cost of equity can be calculated using equations 17-15 and 25-4. Unfortunately,
this induces a circularity: you must know the value of equity to calculate the percent of debt, which you need in order
to calculate the discount rate, which you use to calculate the value of equity. Excel can resolve this circularity, but the
programming is more difficult than the programming for the APV, which does not involve circularities.

APV Method
The APV method requires knowing the target debt level. You don't need the target % debt since ru is used to discount
cash flows.
Vu
58.550 = FCF(1+g)/(ru-g)
Vts
13.508 = (Tax shield)(1+g)/(ru-g)
Total Value
Assumed Debt
Value of Equity

72.059
21.738
50.32

Important note for the APV model: The same discount rate is applied to the free cash flow and the tax shield in every
period, even if the percent of debt is changing. This means that there is no inherent circularity in programming the
APV model, unlike the corporate valuation model and the FCFE model. As discussed above, when properly
implemented all three models give the same answer. However the extra steps required to program Excel to resolve the
circularities induced when the discount rate changes over time due to a changing capital structure make the APV a
simpler and more logical choice.

d APV model for

he same value if
dels to give the same

T and net retentions as

da.

debt. If the percent of

answer for the value of
debt in each year,
ce the WACC
alculate the percent of
erations. Excel can
V, which does not

ense. This requires

f the firm without
ash flow to equity
ucture. However, if
return to equity at the
del isn't circular. We'll

ation model above,

bove.

o equity. Here debt

he current year.

don't know what the

ve the correct answer
now the percent of debt
d 25-4. Unfortunately,
ich you need in order
is circularity, but the
arities.

ru is used to discount

he tax shield in every

n programming the
en properly
m Excel to resolve the
re make the APV a