Valuation Lecture I: WACC vs. APV and Capital Structure DecisionsFinancial Decisions

Timothy A. Thompson

Market value balance sheet

Market value assets Market value claims

Total enterprise value Total enterprise value

Notation

Asset or claimC = excess cashA = value of projects

(unlevered)D = mkt value debtE = mkt value equityTS = debt tax shieldsNet debt = D’ = D – CTEV = D – C + E

Required return, betarc, βc

ra, βa,reu,βeu

rd,βd

reL,βeL

rTS,βTS

Balance sheet mathematics

Logic: LHS and RHS of B/S must be equal Assume that TS refers to the present value of tax shields net

of costs of financial distress

EDTSACV

ECDTSATEV )()(

DCTSAE )(

Calculating the equity value of the firm Equity method

Present value of all future cash flows to equity Discounted at the required return on the levered equity

of the firm, reL, (based on levered equity beta, βeL) reL is greatly affected by differences in leverage Method buries future net debt payments into the equity

cash flow Valuation by components

E = TEV + C – D

Valuation by components method Value the total enterprise value of the firm by

discounting all the operating asset cash flows Discounted at either

WACC (using the WACC method) Or at

The unlevered cost of equity reU (APV method)

What is the difference between WACC and reU? TAX SHIELDS

Equity = Total enterprise value + Excess Cash – Market Value of Financing Obligations

Value of investment is the present value of the investment’s cash flows (DCF) Cash flows are measured as free cash flows from

operations From operations means no financing-related cash flows are

included Free cash flows means after expected new investments

When financial structure matters either Discount operating free cash flow at WACC

WACC incorporates tax benefits of debt into the valuation by reducing the discount rate relative to reU , WACC method

Discount operating free cash flow at reU (gives VU) Then add the present value of tax benefits of debt financing

explicitly (VL = VU + PVTS), APV method

What about costs of financial distress? Theoretically, whatever costs of financial

distress (COFD) have not been subtracted off in the operating cash flows should be subtracted from either method (WACC or APV)

Often difficult to estimate COFD Good to develop intuition about what COFD are Understand what business likely to suffer from

large/small COFD

Capital Structure

Tradeoff theory of the capital structure Value of the firm is a function of capital structure

(in particular, the debt/value ratio) As firm levers up (from zero leverage, holding

investments fixed) value increases due to PVTS (and perhaps for other reasons)

As firm levers up, the value decreases due to COFD

Want to find the happy medium!

Tradeoff Theory of the Capital Structure

Debt

Mar

ket V

alue

of T

he F

irm

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

How do you calculate PVTS?

Simple model, Fin II For example in the 40% debt scenario

Assume that the level of debt in the scenario is perpetual debt

How do you calculate COFD?

Difficult COFD is the present value of all future

expected costs associated with financial distress If you did a method in Fin II, you can go ahead

and attempt it You would need inputs that are not in the case, and you

would have to look them up If you didn’t learn a method in Fin II

You can try to figure out a good guess from Chapter 17/18 of BM

Structure of COFD

COFD is a function of The probability of financial distress The cost of financial distress conditional on the

firm becoming financially COFD could be small even if distress is likely, if the firm

would not likely incur large costs in distress However, if we are pretty certain that the probability of

distress is very small, then the above “product” is likely to be very small and PVTS is likely to exceed COFD

Bond Ratings

Investment Grade Ratings AAA, AA, A, BBB (S&P)

Junk Bond Ratings BB, B, CCC, etc.

If proforma bond rating (based on a certain capital structure) is high investment grade

AAA or AA, maybe even high A Then probability of subsequent bankruptcy is very low

(see BM) – these would very likely be safe capital structures