CF Session 11 - Valuing a Levered Firm

Avijit Bansal
Indian Institute of Management Calcutta

February 1, 2023

1
Summary and implications of M-M propositions

Financial leverage has no impact on the cashflow or the risk of the firm. As a
result, the market value of a firm remains unimpacted

Debt increases the risk for the shareholders and they get compensated for that
by higher expected returns on their equity investment (redistribution of risk)

▶
D
RE = RA + (RA − RD ) ×
E
Since the capital structure is irrelevant, security type within debt and equity are
also irrelevant

2
Real world with taxes
Weighted Average Cost of Capital

D E
cost of capital = rD + rE
V V

However, recall that the interest paid by a company is tax deductible

Hence, the tax saved on interest enhances the value of the firm

D E
After tax weighted average cost of capital = (1 − T )rD + rE
V V

When managers refer to weighted average cost of capital (WACC), they are
referring to after-tax weighted average cost of capital. We will also adopt the
same nomenclature

3
WACC
Important Points

WACC is project specific

Same company can value different projects at different WACCs. Why?

If one is using company’s WACC for valuing a project. The inherent

assumptions are

▶ Project’s business risk are the same as those of the company

▶ Project’s has the same leverage ratio as that of the company, which will
remain constant for the life of the project

4
WACC Inputs
Leverage Ratio

D
should be the the target capital structure (always in market value terms) for
V
project under consideration

Common mistake while computing leverage ratio

D
▶ Using ratio of the firm
V
D
If one is using company’s for valuing a project. The inherent assumption is
V
▶ Project’s has the same leverage ratio as that of the company, which will
remain constant for the life of the project

5
WACC Inputs
Leverage Ratio

How to get the target leverage ratio?

Use the data of the comparable firms (pure-plays) in the same business as that
of the project

D
A company may internally decide upon the target ratio for a project. If this
V
information is available then it should be preferred over company’s debt ratio

Note: Target debt ratio is assumed to be constant. If the debt ratio of the
project is not constant, then better to use the APV method.

6
WACC Inputs
Cost of debt

The interest rate the would be charged to the company to raise debt at the
target capital structure

If multiple loans are taken to finance the project then, respective rD should be
D
multiplied at the respective ratio.
V
The assumption again is that the target debt ratio consists of multiple sources
of debt

7
WACC Inputs
Marginal tax rate

Use the firm’s marginal tax rate (after including the project)

Do not use effective/average tax rate

What is the difference between marginal and effective tax rate?

8
Marginal versus effective tax rate

Assume your annual income is 12 lakhs. What is your effective and marginal tax rate?

Tax rate Income Range (lakhs) Tax owed (lakhs)

10% 0−5 0.5
20% 5 − 10 1
30% > 10 0.6
Total tax 2.1

2.1
Effective tax rate is = 17.5%
12

Marginal tax rate is 30%

9
WACC Inputs
Cost of equity

Discussed at length in Session 9

Refer to our discussion of the Walmart case on estimating division-wise cost of

equity

10
Value of a levered firm

FCF1 FCFT
VL = + ··· +
(1 + WACC )1 (1 + WACC )T

As discussed earlier, we compute FCF assuming that the firm is all-equity

financed

The impact of the interest tax shield is taken care of in the computation of
WACC

11
Cash flows to equity holders

Cash flow to equity holders:

FCFE = (EBIT − Interest) × (1 − T ) +Dep − ∆NWC − CAPEX + ∆Debt

| {z }
PAT

FCFE
VE =
rE

FCFE discounted at rE gives the market value of equity

∆Debt = New Debt - Principal Repaid

12
Cash flows to debt and equity holders

Collective cash flows = Cash flows to equity holders + Cash flows to debt holders

CCF = FCFE + Interest − ∆Debt

| {z }
Cash flows to debt holders

CCF = (EBIT − I) × (1 − T ) + Dep − ∆NWC − CAPEX + ∆Debt + Interest − ∆Debt

| {z } | {z }
FCFE Cash flows to debt holders

CCF = (EBIT ) × (1 − T ) + Dep − ∆NWC − CAPEX − I × (1 − T ) + I

| {z }
FCFF

CCF = FCFF + IT

IT is also referred to as Interest Tax Shield

13
 D
Levered firm with constant
V

Risk of the collective cash flows is the same as the risk of the asset (rA )

D
If a firm has constant , then ITS and firm value are exposed to the same
V
level of risk (rA )

Intuition: Interest Tax shield = Tax × rD × D

D
For constant , Interest tax shield moves up/down with V
V

14
 D
Value of a firm with constant ratio
V

Let VL0 be the value of the levered firm at t = 0

FCF1 be the free cash flow during t = 1

rD be the cost of debt

D0 be the debt at time t = 0

T be the marginal tax rate

Let VL1 be the value of the levered firm at t = 1

FCF1 + rD × D0 × T +VL1
| {z }
ITS1
VL0 =
(1 + rA )
D
Note: For a firm with constant , D0 depends on VL0 , which itself is being valued
V

15
 D
Value of a firm with constant ratio
V
D0
Let D0 = VL0 × d, where d =
VL0
FCF1 + rD × d × VL0 × T +VL1
| {z }
ITS1
VL0 =
(1 + rA )
Then,

VL0 (1 + rA − rD × d × T ) = FCF1 + VL1

FCF1 + VL1
VL0 =
(1 + rA − rD × d × T )
E0 D0
Substitute rA = rE0 × + rD 0
VL0 VL
FCF1 + VL1 FCF1 + VL1
VL0 = =
E0 D0 1 + WACC
(1 + rE 0 + rD 0 − rD × d × T )
VL VL
| {z }
WACC

16
 D
Value of a firm with constant ratio
V

FCF1 + VL1
VL0 =
1 + WACC
Recursively, substituting for VL1

FCF1 FCF2 FCF3

VL0 = + + + ...
(1 + WACC )1 (1 + WACC )2 (1 + WACC )3

FCF discounted at WACC is the same as FCF and ITS discounted at rA

Hence, you can value a company using two approaches

Free cash flows to firm Collective Cash flows to Equity and Debt holders
VL = =
WACC rA

17
Equivalence between FCFF and CCF approach
D
Note: Only valid when ratio is constant
V

Free cash flows to firm Collective Cash flows to Equity and Debt holders
VL = =
WACC rA

FCFF FCFF + I × T
VL = =
D E D E
(1 − T )rD + rE rD + rE
V V V V
| {z } | {z }
WACC rA

In the FCFF approach, the tax advantage is acknowledged in the denominator

(WACC)

In the CCF approach, the tax advantage is acknowledged in the numerator

(Interest tax shield)

18
Approaches for valuing a company

Weighted average cost of capital (WACC)

▶ Discount FCFF using WACC

Adjusted Present Value

▶ Step1: Value of unlevered firm (FCFF discounted at rA )

▶ Step 2: Add PV of the tax shield of debt

▶ Step 3: Add/subtract PV of any other side effects

Flow to equity method

19
Adjusted Present Value
Step 1: Value of unlevered firm (as if 100% equity financed)

APV = NPV (All Equity) + PV (Tax Shield) + PV (Other factors)

Forecast free cash flows to firm (FCFF)

Discount the cash flows at the risk of the asset (rA )

D E
rA = rD × + rE ×
V V
Risk of the asset remains unaffected by the capital structure

D
If you know WACC, rA can be obtained by adding back rD × ×T
V
D
rA = WACC + rD × × T = Pre-tax WACC
V
FCFF1 FCFF2 FCFF3
VU = + + + ...
(1 + rA )1 (1 + rA )2 (1 + rA )3

20
Adjusted Present Value
Step 2: Add PV of Tax Shield of debt

Compute the tax shield, rd × D × T

Ask whether the company will maintain constant debt of constant debt ratio.
Note: Very important

For constant debt, discount interest tax shield at the cost of debt

rD × D × T
▶ PV (ITS) = =D×T
rD

D
For constant debt ratio ( ), discount the interest tax shield at the cost of
V
capital (rA )

rD × D × T
▶ PV (ITS) =
rA
▶ Intuition: rD × D × T moves up/down with V , hence risk of the tax
shield is same as risk to the company

21
Extending the APV method

APV method can easily be used to add value of subsidized debt by adding the
PV of the interest savings

Impact of the change in capital structure can be easily incorporated

22
Flow to Equity Method

Computes the value of the equity holders of the company

Step 1: Compute FCFE

▶ FCFE = PAT + Depreciation − ∆NWC − CAPEX + ∆Debt

Discount FCFE at rE to get VE (value of equity holders)

Also, VE = VL − D provides the same value

23
Valuing a company using APV

Table: Tax savings using debt

Table: Firm details
All equity 50% leverage
Assets 2000
RA 15% EBIT 400 400
RD 10% Interest 0 100
Tax rate 25% PBT 400 300
EBIT 400 Tax 100 75
PAT 300 225

Assume the firm maintains a constant D/V ratio (market level)

FCF is 300

Compute value of un-levered firm

Compute the value of tax shield

VL = VU + PV (ITS)

24
Valuing a company using APV

FCF 300
VU = = = 2000
rA 15%
ITS = rd × D × Tax = 10% × 1000 × 25% = 25
ITS 25
PV (ITS) = = = 166.67
rA 15%

To whom does the benefit of PV (ITS) accrue to? Debt holders or shareholders?

25
Balance Sheet - Market Value

Assets Liabilities
Assets 2000 1000 Debt
PV (ITS) 166.67 ? Equity

26
Balance Sheet - Market Value

Assets Liabilities
Assets 2000 1000 Debt
PV (ITS) 166.67 1166.67 Equity

VL = 2000 + 166.67 = 2166.67

VD = 1000

VE = VL − VD = 2000 + 166.67 − 1000 = 1166.67

D 1000
= = 0.462
V 2166.67
E 1166.67
= = 0.538
V 2166.67
D
= 0.857
E
D
rE = rA + (rA − rD ) × = 19.29%
E
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Valuing a company using WACC
Computing WACC

D E
WACC = rD × × (1 − Tax ) + rE ×
V V
WACC = 10% × 0.462 × (1 − 25%) + 19.29% × 0.538 = 13.85%

Is there another way to compute WACC?

28
Valuing a company using WACC
Computing WACC

D
WACC = rA − rD × × Tax
V
WACC = 15% − 10% × 0.462 × 25% = 13.85%

29
Valuing a company using WACC
Value of a levered firm

FCF
VL =
WACC
300
VL = = 2166.67
13.85%

VL = VU + PV (ITS)

Hence, WACC and APV can both be used to value a firm

30
Valuing a company using Flow to Equity

VL = VE + D
FCFE 225
VE = = = 1166
rE 19.29%
VD = 1000

VL = 1166 + 1000 = 2166

31
APV versus WACC
Advantages and disadvantages of WACC

Advantages

▶ Computationally easier

Disadvantages

▶ Separate impact of asset and liabilities not visible

▶ Distress cost of debt cannot be incorporated

▶ Works best for a firm maintaining constant leverage ratio

▶ Not flexible enough to incorporate the impact of distress cost of debt,

subsidized debt, hybrid securities (convertibles)

Note: If leverage ratio is not constant, then one has to compute WACC for each year

32
APV versus WACC
Advantages and disadvantages of APV

Advantages

▶ Contribution of assets, liabilities can be observed separately

▶ Benefits and distress cost of debt can be computed

▶ Flexible enough to incorporate the impact of hybrid securities, subsidized

debt

▶ Easier for valuing companies with complex capital structure

Disadvantages

▶ Computationally more nuanced

Note: If leverage ratio is not constant, then one has to compute WACC for each year

33
Value of Company
Partially funded with subsidized debt

Table: Firm details

Assets 2000
RA 15%
RD 10%
Tax rate 25%
EBIT 400

The company has a debt of 1000 raised at a cost of 10% and plans to maintain
it at a constant level

Assume that the company now wants to replace the regular debt of 400 at 10%
with a subsidized debt of 400 at 5%

How would you value the company? WACC or APV?

34
Value of Company
Partially funded with subsidized debt
Table: Tax savings using debt

All equity With Leverage

1000 Debt at 10% 600 Debt at 10%
400 Debt at 5%
Assets 2000 2000 2000
Table: Firm details Equity 2000 1000 1000
Debt 0 1000 1000
Assets 2000
EBIT 400 400 400
RA 15%
RD 10% Interest
Tax rate 25%
EBIT 400 Regular 0 100 60
Subsidized 0 0 20
FCF 300 300 300
VU 2000 2000 2000
ITS 0 25 20
PV(ITS) 0 250 200
VL VU 2250 2200

35
Value of Company
Partially funded with subsidized debt

When we estimate VL = VU + PV (ITS), the taking subsidized leads to lower

tax shelter of 5

Further leading to drop in PV(ITS) by 50

Hence, VL drops by 50

But,

Are we missing something?

Is there no benefit of subsidized debt to shareholders?

36
Value of Company
Partially funded with subsidized debt

Lower interest payment is beneficial to the shareholders, hence, it increases firm

value

But the above approach does not reflect the value added by the subsidized debt

How to compute it?

37
Value of Company
Partially funded with subsidized debt

Subsidized debt of 400, lowers interest payment by 20 on a pre tax basis

(400 × 10% − 400 × 5%)

On an after basis, lower interest payment by 20 × (1 − 25%) = 15

How much additional debt can the firm take, such that the annual pre tax
interest payment is 20?

20
= 200
10%

The firm can borrow additional 200, if it can make total interest payment of
100 every year

Regular debt of 1000 at 10% requires same interest payment as regular debt of
800 at 10% plus subsidized debt of 400 at 5%

38
Value of Company
Partially funded with subsidized debt

If we assume that all the assets are fully funded, then 200 is the extra cash that
the company has

It can be directly paid as dividends to the shareholders

Hence the value of the shareholders increases by 200, therefore the value of
debt subsidy is 200

VL = VU + PV (ITS) + PV (Subsidy ) = 2000 + 200 + 200 = 2400

The above calculations assume that the firm would employ the after-tax savings to
borrow an additional loan of 200 million at 10% and return the cash to shareholders
and therefore earn its initial PV of ITS

39
Estimating the value of subsidy

How do you estimate the PV of subsidy in case the loan has a limited life rather than
perpetual life?

Assume that someone lent you 100 at 5% interest rate for one year. You can
earn rate of 10% on bank deposit. If there are no taxes, then how much is the
subsidized debt worth?

40
Estimating the value of subsidy

You need to pay 100 + 5 after 1 year

How much do you have to deposit at t = 0, so that you get 105 at t = 1

105
= 95.45
1 + 10%

At t = 0, you borrow 100 and deposit 95.45. This covers your obligation at
t=1

Hence, NPV of the subsidized loan is 100 − 95.45 = 4.55

What if the firm faces a tax of 40%?

41
Estimating the value of subsidy
Tax rate of 40%

After tax interest payment is 5 × (1 − 40%) = 3

Hence, you need to pay 103 at t = 1

But your interest income is also subject to taxes

How much should you deposit at t = 0?

100 + 5 × (1 − 40%) 103

= = 97.17
1 + 10% × (1 − 40%) 1 + 6%

Hence, NPV of the subsidized debt is 100 − 97.17 = 2.83

Note: PV of subsidized debt should always be computed on an after-tax basis

42
Estimating the value of subsidy
Alternative method

One can find the PV of incremental cash flows

After tax incremental cash flows are 100 × (10% − 5%) × (1 − 40%) = 3

After tax discount rate is 10% × (1 − 40%) = 6%

3
Value of subsidized debt is = 2.83
1 + 6%

43
Value of Company
Partially funded with subsidized debt

How can we compute the PV of subsidized debt (400 at 5%)?

Incremental after-tax cash flow per year is 400 × (10% − 5%) × (1 − 25%) = 15

After tax discount rate is 10% × (1 − 25%) = 7.5%

15
PV of subsidized perpetual debt is = 200
7.5%

44
References I

45