Capital Budgeting

and
Valuation with Leverage

P.V. VISWANATH

Learning Objectives

The WACC, APV and FTE methods of valuation.

Computation of the unlevered and equity costs of capital,
and their relationship.
Estimation of the cost of capital for a project, even if its risk
is different from that of the firm as a whole.
Estimation of the cost of capital for a project, given the
projects debt-to-value ratio, assuming the firm maintains a
target leverage ratio.
Calculation of the levered value of a project if (1) the firm
has a constant interest coverage policy, or (2) the firm keeps
debt at a constant level.
The effect of issuance costs, personal taxes and financial
distress costs on the assessment of the projects value.

WACC Method with constant D/E ratio

3

When the market risk of the project is the same as the

average risk of the firms investments, the WACC can be

used to value the project.
That is, its cost of capital is simply the cost of capital for a
portfolio of all the firms securities.
We assume, in addition that the firms debt-equity ratio is
constant and that corporate taxes and personal taxes are the
only imperfections.
Since interest payments are tax-deductible, the effective cost
of debt is rD(1-c). This allows us to write the WACC as:

rwacc

E
D

rE
rD (1 c )
E D
E D

WACC Method with constant D/E ratio

4

Personal taxes do not need to be taken into account separately since the cost of

debt will adjust automatically in the marketplace to take personal taxes into
account. Thus, if interest income is taxed at a higher rate than equity income,
firms must pay a higher risk-adjusted cost to obtain debt capital, as compared
to equity capital. In the WACC method, we use the actual market cost of debt
and equity so this penalty for debt capital is already taken into account.
We compute the value of the project by computing the cashflows to the firm if
it were unlevered (EBIT(1-c) adjusted for non-cash items in EBIT) and
discounting them at the WACC.
The tax benefits of debt are taken into account in the discount rate as opposed
to incorporating them in the cashflows directly.
This allows us to undertake a division of labor the cashflow computation is
not impacted by the firms leverage policy and can be calculated by employees
who are only involved in the operations side of the firm.
L
0

FCF3
FCF1
FCF2

L
2
3
1 rwacc
(1 rwacc )
(1 rwacc )

Using the WACC: An example

5

Suppose Avco is considering introducing a new line of packaging, the

RFX Series.
Avco expects the technology used in these products to become
obsolete after four years. However, the marketing group expects
annual sales of $60 million per year over the next four years for this
product line.
Manufacturing costs and operating expenses are expected to be $25
million and $9 million, respectively, per year.
Developing the product will require upfront R&D and marketing
expenses of $6.67 million, together with a $24 million investment in
equipment.

The equipment will be obsolete in four years and will be depreciated via the
straight-line method over that period.

Avco expects no net working capital requirements for the project.

Avco pays a corporate tax rate of 40%.

Expected Free Cashflow from Avco

6

Using the WACC: An Example

7

Avco has $20 of cash and $320 of debt; since the cash

could be used to pay off an equivalent amount of debt, we

reduce debt by the amount of cash to get the net amount
of debt. Hence Avcos debt-value ratio is 300/600.
Avcos WACC can, therefore be computed as
E
D
300
300
rE
rD (1 c )
(10%)
(6%)(1 0.40)
E D
E D
600
600
6.8%

rwacc

Using the WACC: An Example

The value of the project, including the tax shield

from debt, is calculated as the present value of its

future free cash flows.
18
18
18
18

$61.25 million
2
3
4
1.068
1.068
1.068
1.068

L
0

The NPV of the project is $33.25 million

$61.25 million $28 million = $33.25 million

Implementing a Constant Debt-Equity Ratio

9

The WACC method assumed that Avco would keep its debt-equity ratio

constant.
This requires Avco to change the amount of its debt as its market value
changes, as it will if it accepts the Avco project.
How can we compute the additional debt to be issued each year?
To begin with, we note that Avco has a debt-value ratio of 0.5
After Avco takes on the new project, its value will go up by the amount
of the value of the new assets added due to the project, viz. $61.25m.
Hence Avco will have to issue 61.125/2 = 30.625 in net new debt.
We assume that Avco will do that by spending its $20m cash and
issuing $10.625 in new debt.
Since the firm only needs $28m for the RFX project, the additional
$2.625m will be paid out as a dividend.
Its balance sheet will now appears as follows:

Implementing a Constant Debt-Equity Ratio

10

The firms debt capacity is defined as the total amount of debt

required to maintain the firms target debt-value ratio. This equals D

= dVL , where d is the firms debt-value target ratio.
We can now compute the increased debt capacity due to the project at
the different dates in the futureValue
byofworking
backwards:
FCF in year t 2 and beyond

Vt

FCFt 1

}
Vt L 1

1 rwacc

Implementing a Constant Debt-Equity Ratio

11

This is computed as follows. The value at the end of year 3 of the free

cashflow of $18m in year 4 is 18/(1.068) = $16.854.

Hence the debt capacity at that point is 16.854/2 = $8.427m
The value of this project at the end of year 2 is (18+16.854)/1.068 =
$32.635.
Hence the debt-capacity is 32.635/2 = 16.317m.
Using the same procedure, we compute the debt capacity at previous dates.
In order for the WACC answer to be correct, we must assume that AVCO
decreases its debt according to the schedule provided here.
Thus, one year later, it must decrease debt by 30.62 23.71 or 6.91

WACC Method with Changing Debt Levels

12

Suppose we dont want to modify debt levels each year to keep a

constant D/E ratio. How do we apply the WACC method?

Clearly if the D/E ratio is changing, the WACC will be changing
because the WACC depends on the D/E.
However, we cannot compute the D/E ratio for each year without
knowing the value of the project because the equity value depends
on the project value (assuming that were accepting the project).
Hence a trial-and-error method must be used to establish the
WACC for each period.
On the other hand, unless we expect conditions to change
constantly in a predictable fashion, we probably would want to
optimize the amount of debt at a specific debt-equity ratio.
Hence the assumption of a fixed D/E ratio is reasonable.

The APV Method

13

In the APV method, we first value the investment as if it had no

leverage, add the value of the interest tax shield and then deduct any
costs that arise from other market imperfections.

V L APV V U PV (Interest Tax Shield)

PV (Financial Distress, Agency, and Issuance Costs)
We assume that personal taxes are the same on equity income as on

debt income; if this were not so, the relative costs of debt and equity
would be affected and hence we could not compute the unlevered cost of
equity by working backwards from the observed levered cost of equity.
In practice, this theoretical point is often ignored, but as a result, the
estimated values could be grossly in error and could lead to a wrong
decision.
We now see how to implement the APV method.

APV: An Example
14

Let us look again at the Avco example. Since the RFX project has risk

similar to that of the firms other projects, the discount rate to be used in
valuing the RFX project is the required rate of return on the firms assets.
This can be computed by taking a weighted average of the cost of the firms
securities.
We do not take into account the tax shield from debt because we are
initially valuing the project as if there were no debt at all. That is, we use
the pretax WACC:
E
D
rU
rE
rD Pretax WACC
E D
E D
We assume that effective personal taxes on debt income and equity income are the

same; else the pre-tax WACC could not be computed by using the r D that is observed
when there is debt.
Thus, if interest income were taxed at a higher rate than equity income, then the
actual rD would contain a penalty due to the tax disadvantage of debt income for the
investor. Hence in the absence of debt, the unlevered cost of capital would be lower
than the pre-tax WACC.

APV: An example
15

The unlevered cost of equity works out to (0.5)(10) + (0.5)(6) = 8%

We first compute the projects value without leverage:

VU

18
18
18
18

$59.62 million
2
3
4
1.08
1.08
1.08
1.08

Next we find the present value of the firms additional tax

shields due to the project.

Since we have already computed the firms debt capacity
previously, we can compute the tax shields each period as debt
capacity times the interest rate of 6% times the tax rate of 40%:

APV: An example
16

In order to obtain the present value of the tax shields,

we need to know the required rate of return on the

firms tax shields.
In our case, we are assuming that the firm maintains
a constant debt-to-value ratio.
This means that the tax shield at any point equals
(Firm Value) x (target debt ratio) x (int rate) x c
We see from this that the risk of the firms tax shield
is the same as the risk of the firm itself and hence the
appropriate discount rate to value the tax shields is r U.

APV: An Example
17

PV (interest tax shield)

0.73
0.57
0.39
0.20

$1.63 million
2
3
4
1.08
1.08
1.08
1.08

The tax shields, discounted at rU = 8% are worth

$1.63m.
The unlevered project value is $59.62m for a total of
$61.25m.
The present value is $61.25m - $28m = $33.25m as
before.

Flow-to-Equity Method
18

In the WACC method, we compute the value of the firm

and then subtract the value of debt, in order to obtain the

value of equity.
When valuing a project, the WACC method implicitly
assumes that if firm value goes up, so does equity value.
This is true in most cases, but not in all cases.
The FTE method values equity directly by computing the
free cash flows to equity holders (FCFE) and discounting
them at the cost of equity.
We now use Avcos RFX project to show that we get the
same values with the FTE method as with the other
methods.

FTE: An Example
19

FTE: An Example
20

In computing the FCFE, we note that interest payments have to

be deducted.
Furthermore, we have to adjust cashflows by the change in debt.
This is because if money is required to be paid out to debtholders, it is not available to be paid out to equity-holders.
Similarly, if additional debt is issued, that can be used for payouts
to equity-holders.
In our example, debt capacity dropped from $30.625 in year 0 to
$23.71m in year 1. Hence Net Borrowing is 23.71-30.625 = $6.915, i.e. a net payment to debt-holders of $6.915m.
Discounting FCFE at 10%, we get an NPV of $33.25 as before:
NPV (FCFE ) 2.62

9.98
9.76
9.52
9.27

$33.25 million
2
3
4
1.10
1.10
1.10
1.10

Project-Based Cost of Capital

21

If the new project has the same riskiness as the average projects

undertaken by the firm, then the appropriate discount rate for

valuing the project is simply the WACC of the firm, as discussed
above.
What if the new project has a different risk?
In this case, we would need to find other firms whose riskiness is
similar to the riskiness of the new project.
We could then take the average WACC for those firms to estimate
the discount rate for our project.
However, those firms may have leverage ratios different from those
that we propose to have for our project.
In this case, we can still use their unlevered cost of capital, r U.
Consider the following example where Avco wishes to invest in a
plastics project.

Project-Based Cost of Capital

Assume two firms are comparable to the plastics division

and have the following characteristics:

Assuming that both firms maintain a target leverage ratio, the

unlevered cost of capital for each competitor can be estimated

by calculating their pretax WACC.
We then take the average of the two, which in our case works
out to 9.5%.

Competitor 1: rU 0.60 12.0% 0.40 6.0% 9.6%

Competitor 2: rU 0.75 10.7% 0.25 5.5% 9.4%

Project Leverage and the Equity Cost of Capital

23

Suppose the firm desires to fund the project according to a

specific target leverage ratio, since different firms could

have different leverage ratios. In that case, we can compute
rE for our project using the same pre-tax WACC formula,
but with our own target debt leverage ratio:
rE rU

D
(rU rD )
E

Thus if we have a target debt/equity ratio of 1, the cost of

equity capital would be 9.5 +1(9.5-6) = 13%, assuming

that the firm can continue to obtain debt financing at 6%.
We can now compute the WACC as:
rWACC 0.50 13.0% 0.50 6.0% (1 0.40) 8.3%

Project-based Cost of Capital

24

An alternative method for calculating the divisions WACC is:

rW ACC rU d c rD

rwacc 9.5% 0.50 0.40 6% 8.3%

To determine the correct cost of capital for a project, we need to know the

amount of debt to associate with the project.

This is equal to the incremental financing that results if the firm takes on the
project, i.e. the change in the firms total debt (net of cash) with the project
versus without the project.
The target debt ratio and hence the incremental debt capacity will depend
upon the financial asymmetry costs and financial distress costs for the
project.
However, financial distress costs and information asymmetry costs depend
usually on the characteristics of the whole firm. Hence the optimal leverage
for a firm will depend on the characteristics of both the project and the firm.

APV with Constant Interest Coverage Ratio

25

Up to this point, it has been assumed the firm wishes to

maintain a constant debt-equity ratio. Two alternative

leverage policies will now be examined.

Constant interest coverage

Predetermined debt levels

Constant Interest Coverage Ratio

When a firm keeps its interest payments equal to a target fraction, k, of its
free cash flows, then the interest paid in year t = k(FCFt) and the tax shield
in that year is k(FCFt)c.

The present value of the tax shield, then, is ckVU.

Hence the value of the entire project is (1+ck)VU.

That is, we compute the VU as before and then adjust it by multiplying by

(1+ck).

APV with pre-determined debt levels

26

If a firm has pre-determined debt levels that will not

vary according to the cashflows of the firm, then the

riskiness of the tax shields are approximately the same
as the riskiness of the interest payments themselves.
Hence the present value of the tax shield is simply Dc,
where D is the value of the debt, assuming that the
debt is perpetual.
It must be kept in mind that in this case, there is no
target debt ratio!
The value of the levered project is given by

c D

Pros and Cons of the three methods

The FTE method offers some advantages.

It may be simpler to use when calculating the value of equity for the entire
firm, if the firms capital structure is complex and the market values of other
securities in the firms capital structure are not known.
It may be viewed as a more transparent method for discussing a projects
benefit to shareholders by emphasizing a projects implication for equity.

The FTE method has a disadvantage.

One must compute the projects debt capacity to determine the interest and net
borrowing before capital budgeting decisions can be made.

The WACC method is easiest to use if the firm uses a target debt

ratio.
The APV method is easier when using other leverage policies.
However, if personal taxes need to be taken into account explicitly
because of differences between tax rates on equity and bond
income, the procedure is difficult in practice.

Issuance and Other Financing Costs

When a firm raises capital by issuing securities, the banks that

provide the loan or underwrite the sale of the securities charge fees.
These fees should be included as part of the projects required

investment, reducing the NPV of the project.

Financial Distress Costs

29

Financial distress and agency costs also impact the cost of

capital.

For example, financial distress costs tend to increase the sensitivity of the
firms value to market risk, raising the unlevered cost of capital for highly
levered firms.

The free cash flow estimates for a project should be adjusted to

include expected financial distress and agency costs.

In addition, because these costs also affect the systematic risk of

the cash flows, the unlevered cost of capital will no longer be

independent of the firms leverage.
The following example shows how a firm could choose its

optimal leverage ratio taking into consideration that both

cashflows and rU can change with leverage ratio.

Financial Distress Costs

30

APV with financial distress costs

31

Estimating Financial Distress Costs

32

Financial distress occurs when the firm is in default or

close to default. Hence the default premium, i.e. the

difference between the value of the debt if the firm were
default-free and the value of the debt with a non-zero
likelihood of default is related to financial distress costs.
If we can assume that the ratio of financial distress costs
to the default premium is constant, we can estimate the
financial distress costs by looking at the market value of
debt, as in the example below.
However, this method cannot provide estimates of
financial distress costs at other debt levels different
from what the firm actually has, currently.

Valuing Financial Distress Costs

33