Chapter 13 → 16

Corporate Finance
Chapter 19: Financing and Valuation

After-Tax Weighted-Average Cost of Capital (WACC)

The WACC is based on the firm’s current characteristics, but managers use it to
discount future cash flows, which is correct if the firm’s business risk and debt ratio are
expected to remain constant.

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑟𝑑 (1 − 𝑡) 𝑉
+ 𝑟𝑒 𝑉

𝐶𝐹
𝑁𝑃𝑉 =− 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑊𝐴𝐶𝐶

(𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛𝑐𝑜𝑚𝑒)

V = D+E: total market value of the firm

Rd: cost of debt

Re: cost of equity

T: marginal corporate income tax

Assumptions when using WACC to discount CFs:

- The project’s business risks are the same as those of the company’s other assets
and remain so for the life of the project
- The project supports the same fraction of debt to value as in the company’s
overall capital structure, which remains constant for the life of the project.

Valuing Businesses

WACC can also be used to value a company that is financed by a mixture of debt and
equity as long as the debt ratio is expected to remain approximately constant, treating
the company as if it were one big project.

- We forecast the company’s CFs and then discount back to present value

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1. If you discount at WACC, cash flows have to be projected just as you would for a
capital investment project. Do not deduct interest. Calculate taxes as if the
company were all-equity-financed.
2. Unlike most projects, companies are potentially immortal. But that does not
mean that you need to forecast every year’s cash flow from now to eternity.
Financial managers usually forecast to a medium-term horizon and add a
terminal value to the cash flows in the horizon year. The terminal value is the
present value at the horizon of all subsequent cash flows.
3. Discounting at WACC values the assets and operations of the company. If the
object is to value the company’s equity, that is, its common stock, don’t forget to
subtract the value of the company’s outstanding debt

𝐹𝐶𝐹𝑡 𝑃𝑉𝐻
𝑃𝑉 = 𝑡 + 𝐻
(1+𝑊𝐴𝐶𝐶) (1+𝑊𝐴𝐶𝐶)

𝐹𝐶𝐹 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑓𝑖𝑥𝑒𝑠 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑊𝐶

𝐹𝐶𝐹𝐻
𝑃𝑉𝐻 = (𝑊𝐴𝐶𝐶 − 𝑔)

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 − 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

(𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦)

FCF (free cash flow): amount of cash that the firm can pay out to investors after making
all investments necessary for growth. It can be negative for rapidly growing firms, even if
the firms are profitable, because investment exceeds cash flow from operations, which
is normally temporary until growth slows down.

H (horizon)

Free cash flow and net income are not the same.

They differ in several important ways:

● Income is the return to shareholders, calculated after interest expense. Free

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● Income is calculated after various noncash expenses, including depreciation.

The value of the company may not mean everything because it depends on many
assumptions, including:

● The defined time horizon (most of the CFs derive from this period)
● Differences in the long-term growth rate
● Managers must compare it with comparable companies and comparing their
price– earnings multiples and ratios of market to book value.
● Are the revenue figures consistent with what you expect your competitors to do?
Are the costs you have predicted realistic?
● Is the business more worth dead than alive= Sometimes a company’s liquidation
value exceeds its value as a going concern.

Flow-to-equity method:

There’s an alternative to discounting CFs to WACC if the task is to value a firm’s equity:

→ Discount cash flows to equity, after interest and after taxes, at the cost of equity
capital. It should give the same answer as discounting cash flows at the WACC and then
subtracting debt.

Using WACC in Practice

→ How does the formula change when there are more than two sources of financing?

There is one cost for each element. The weight for each element is proportional to its
market value.

𝐷 𝑃 𝐸
𝑊𝐴𝐶𝐶 = 𝑟𝑑 (1 − 𝑡) 𝑉
+ 𝑟𝑝 𝑉
+ 𝑟𝑒 𝑉

𝑉=𝐷 +𝐸 + 𝑃

Carolina Gomes → decc01

→ What about short-term debt?

Short-term debt should always be included in the overall debt value, not only considering
long-term debt. Otherwise, a company will misstate the required return on capital
investments. This is only acceptable when short-term debt is only temporary, seasonal,
or incidental financing or if it is offset by holdings of cash and marketable securities.

→ What about other current liabilities?

Working capital equals current assets subtracted by current liabilities. The sum of
long-term financing on the right is called total capitalization. Since current liabilities
include short-term debt, netting them out against current assets excludes the cost of
short-term debt from the weighted-average cost of capital. This can be an acceptable
approximation, but when short-term debt is an important, permanent source of
financing it should be shown explicitly on the balance sheet.

→ How are the costs of financing calculated?

Estimating the cost of equity in securities that are not on the stock market can be hard.
There is no easy or tractable way of estimating the expected rate of return on most junk
debt issues. The good news is that for most debt the odds of default are small. That
means the promised and expected rates of return are close, and the promised rate can
be used as an approximation in the weighted-average cost of capital.

Common Mistakes when using WACC

● WACC works only for projects that are carbon copies of the firm
● the immediate source of funds for a project has no necessary connection with
the hurdle rate for the project. What matters is the project’s overall contribution
to the firm’s borrowing power.
● You cannot increase the debt ratio without creating financial risk for
stockholders and thereby increasing rE, the expected rate of return they demand
from the firm’s common stock.

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Adjusting WACC when Debt Ratios and Business Risks Differ

The WACC formula assumes that the project or business to be valued will be financed in
the same debt–equity proportions as the company (or industry) as a whole. What if that
is not true? Here are the steps to calculate it correctly:

1. Calculate the opportunity cost of capital by calculating WACC and the cost of
equity at zero debt, which is called unlevering the WACC

𝐷 𝐸
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑟) = 𝑟𝑑 𝑉
+ 𝑟𝑒 𝑉

2. Estimate the cost of debt, rD, at the new debt ratio, and calculate the new cost of
equity.

𝐷
𝑟𝑒 = 𝑟 + (𝑟 − 𝑟𝑑) × 𝐸

3. Recalculate the weighted-average cost of capital at the new financing weights

Unlevering and Relevering Betas

On the previous steps, the cost of equity is unlevered and then relevered. Some financial
managers find it convenient to unlever and then relever the equity beta. Given the beta
of equity at the new debt ratio, the cost of equity is determined from the capital asset
pricing model. Then WACC is recalculated.

𝐷 𝐸
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑖𝑛𝑔 𝑏𝑒𝑡𝑎: β𝐴 = β𝐷 𝑉
+ β𝐸 𝑉

𝐷
𝑅𝑒𝑙𝑒𝑣𝑒𝑟𝑖𝑛𝑔 𝑏𝑒𝑡𝑎: β𝐸 = β𝐴 + (β𝐴 − β𝐷) 𝐸

Rebalancing

The formulas for WACC and for unlevering and relevering expected returns are simple,
but we must be careful to remember underlying assumptions:

Calculating WACC for a company at its existing capital structure requires that the capital
structure not change: the company must rebalance its capital structure to maintain the
same market-value debt ratio for the relevant future.

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The Modigliani-Miller Formula

What if the firm does not rebalance to keep its debt ratio constant? Sometimes other
discount-rate formulas are used, including the Modigliani-Miller formula. It considers
that a company or project generating a level, perpetual stream of cash flows financed
with fixed, perpetual debt, and derived a simple after-tax discount rate:

(𝑇×𝐷)
𝑟𝑀𝑀 = 𝑟(1 − 𝑉
)

Here it’s easy to unlever: just set the debt-capacity parameter (D/V) equal to zero.

Adjusted Present Value (APV)

APV doesn’t attempt to capture taxes or other effects of financing in a WACC or adjusted
discount rate. A series of present value calculations is made instead. The first
establishes a base-case value for the project or firm: its value as a separate,
all-equity-financed venture. The discount rate for the base-case value is just the
opportunity cost of capital.

Once the base-case value is set, then each financing side effect is traced out, and the
present value of its cost or benefit to the firm is calculated. Finally, all the present values
are added together to estimate the project’s total contribution to the value of the firm:

𝐴𝑃𝑉 = 𝑏𝑎𝑠𝑒 − 𝑐𝑎𝑠𝑒 𝑁𝑃𝑉 + 𝑠𝑢𝑚 𝑜𝑓 𝑃𝑉𝑠 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑠𝑖𝑑𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑠

The most important financing side effect is the interest tax shield on the debt
supported by the project. Other possible side effects are the issue costs of securities or
financing packages subsidized by a supplier or government.

→ APV gives the financial manager an explicit view of the factors that are adding or
subtracting value. APV can prompt the manager to ask the right follow-up questions.

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