CAPITAL BUDGETING &

LEVERAGE
Introduction
Discuss three approaches to valuing a risky asset for
which both debt and equity financing are used.
Initial Assumptions
The project has average risk.
For simplicity the betas or costs of capital used will be for the
existing firm rather than being project specific. Iffy.
The firms debt-equity ratio is held constant.
This simplifies the application in that we dont need to worry
about changing costs of capital over time and identifies the
proper the adjustment of our risk measure for leverage. It is a
realistic and common policy.
Corporate taxes are the only imperfection relevant for
capital structure.
No agency, bankruptcy or issuance costs to quantify. Clearly
not!
The Weighted Average Cost
of Capital Method
Because the WACC incorporates the tax savings
from debt, we can compute the levered value (V for
enterprise value, L for leverage, 0 for current or time
0) of an investment, by discounting its future
expected free cash flow using the WACC.
(1 )

wacc E D c
E D
r r r
E D E D
t = +
+ +
3 1 2
0
2 3

1 (1 ) (1 )
L
wacc wacc wacc
FCF FCF FCF
V
r r r
= + + +
+ + +
Valuing a Project with WACC
Ralph Inc. is considering introducing a new
type of chew toy for dogs.
Ralph expects the toys to become obsolete after
five years when it will be discovered that chew
toys actually encourage dogs to eat shoes.
However, the marketing group expects annual
sales of $40 million for the first year, increasing by
$10 million per year for the following four years.
Manufacturing costs and operating expenses
(excluding depreciation) are expected to be 40%
of sales and $7 million, respectively, each year.
Valuing a Project with WACC
Developing the product will require upfront R&D
and marketing expenses of $8 million. The fixed
assets necessary to produce the product will
require an additional investment of $20 million.
The equipment will be obsolete once production
ceases and (for simplicity) will be depreciated via the
straight-line method over the five year period.
Ralph expects no incremental net working capital
requirements for the project.
Ralph has a target of 60% Equity financing.
Ralph pays a corporate tax rate of 35%.
Expected Future Free Cash
Flow
"Income Statement:" Year 0 1 2 3 4 5
Sales 40.00 50.00 60.00 70.00 80.00
COGS 16.00 20.00 24.00 28.00 32.00
Gross Profit 24.00 30.00 36.00 42.00 48.00
Operating Expenses 8.00 7.00 7.00 7.00 7.00 7.00
Depreciation Exp 4.00 4.00 4.00 4.00 4.00
EBIT -8.00 13.00 19.00 25.00 31.00 37.00
Tax (35%) -2.80 4.55 6.65 8.75 10.85 12.95
Unlevered NI -5.20 8.45 12.35 16.25 20.15 24.05
Free Cash Flow:
Unlevered NI -5.20 8.45 12.35 16.25 20.15 24.05
Plus Deprecition Exp 0.00 4.00 4.00 4.00 4.00 4.00
Less Net Cap Ex 20.00 0.00 0.00 0.00 0.00 0.00
Less Changes in NWC 0.00 0.00 0.00 0.00 0.00 0.00
Free Cash Flow -25.20 12.45 16.35 20.25 24.15 28.05
Market Value Balance Sheet
Without the project ($millions):




The firm is currently at its target leverage:
Equity to Net Debt plus Equity ratio is:
$510.00/($510.00 + $390.00 - $50.00) = 60.0%
Excess Cash 50.00 $ Debt 390.00 $ Debt 5%
Existing Assets 850.00 $ Equity 510.00 $ Equity 12%
Total Liabilities Risk Free 4%
Total Assets 900.00 $ and Equity 900.00 $
Assets Liabilities Cost of Capital
Valuing a Project with WACC
Ralph intends to maintain a similar (net) debt-
equity ratio for the foreseeable future,
including any financing related to the project.
Thus, Ralphs WACC is:
(1 )

510 340
(12%) (5%)(1 0.35)
850 850
8.5%
wacc E D c
E D
r r r
E D E D
t = +
+ +
= +
=
Valuing a Project with WACC
The value of the project, including the tax
shield from debt, is calculated as the present
value of its future free cash flows discounted at
the WACC.
The NPV (value added) of the project is $52.10 million
$77.30 million $25.20 million = $52.10 million
It is important to remember the difference between value
and value added.
0
2 3 4 5
12.45 16.35 20.25 24.15 28.05
+
1.085 1.085 1.085 1.085 1.085
$77.30 million
L
V = + + +
=
Summary of the WACC Method
1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital.
3. Compute the value of the investment, including
the tax benefit of leverage, by discounting the
free cash flow of the investment using the
WACC.
a. Note that only the tax benefit of debt is explicitly valued
via this method.
4. The WACC can be used throughout the firm as
the companywide cost of capital for new
investments that are of comparable risk to the
rest of the firm and that will not alter the firms
debt-equity ratio.

Implementing a Constant Debt-Equity
Ratio
By undertaking the project, Ralph adds new
assets to the firm with an initial market value
$77.30 million.
Therefore, to maintain the target debt-to-value
ratio, Ralph must initially add $30.92 million in
new debt.
40% $77.30 = $30.92
60% $77.30 = $46.38 (compare to $52.10)
Implementing a Constant Debt-Equity
Ratio
Ralph can add (net) debt in this amount either
by reducing cash and/or by borrowing and
increasing actual debt.
Suppose Ralph decides to spend $25.20 million
(cover the negative FCF in year 0) in cash to initiate
the project.
This increases net debt by $25.20 million
Excess Cash 24.80 $ Debt 390.00 $ Debt 39.4%
Existing Assets 850.00 $ Equity 562.10 $ Equity 60.6%
New Project 77.30 $
Total Liabilities
Total Assets 952.10 $ and Equity 952.10 $
Assets Liabilities % of Total Value
New Market Value Balance
Sheet
We need an increase in net debt of $30.92 and
equity of $46.38. So
Spend $25.20 million on the project and pay a
$5.72 million dividend so $30.92 million in
cash goes out (the dividend further increases
net debt and reduces equity by the required
amount).
Excess Cash 19.08 $ Debt 390.00 $ Debt 40.0%
Existing Assets 850.00 $ Equity 556.38 $ Equity 60.0%
New Project 77.30 $
Total Liabilities
Total Assets 946.38 $ and Equity 946.38 $
Assets Liabilities % of Total Value
Implementing a Constant Debt-Equity
Ratio
The market value of Ralphs equity increases by
$46.38 million.
$556.38 $510.00 = $46.38 (60% of $77.30)
Adding the dividend of $5.72 million into the mix,
the shareholders total gain is $52.10 million.
$46.38 + 5.72 = $52.10
Which is exactly the NPV calculated for the project
The first try: without the dividend the equity increased
by the projects NPV of $52.10 = $562.10 - $510.00.
This is too large an increase in equity, given an
increase in net debt of $25.20, if Ralph is to maintain
60% equity.
Implementing a Constant Debt-Equity
Ratio
Debt Capacity
The amount of debt at a particular date that is
required to maintain the firms target debt-to-value
ratio
The debt capacity at date t is calculated as:
Where d is the firms target debt-to-value ratio and V
L
t

is the projects levered continuation value on date t
(i.e. the present value of all future FCF as of time t).


L
t t
D d V =
Debt Capacity
In order to maintain the target financing, the
amount of new debt must fall over the life of
the project.
This is true because the value of the project
depends upon the future cash flow at each
point in time. Since the project ends, value
decreases. Since value decreases, debt must
also decrease.
year 0 1 2 3 4 5
Free Cash Flow (25.20) $ 12.45 $ 16.35 $ 20.25 $ 24.15 $ 28.05 $
Levered Value 77.30 $ 71.42 $ 61.14 $ 46.09 $ 25.85 $ - $
Debt Capacity d = 40% 30.92 $ 28.57 $ 24.46 $ 18.43 $ 10.34 $ - $
The Adjusted Present Value
Method
Adjusted Present Value (APV)
A valuation method to determine the levered
value
of an investment by first calculating its unlevered
value and then adding the value of the interest tax
shield and deducting any costs that arise from
other market imperfections
(Interest Tax Shield)
(Financial Distress, Agency, and Issuance Costs)
L U
V APV V PV
PV
= = +

The Unlevered Value of the

Project
The first step in the APV method is to calculate
the value of the free cash flows using the
projects cost of capital if it were financed
without leverage.
The Unlevered Value of the
Project
Unlevered Cost of Capital
The cost of capital of a firm, were it unlevered:
If the firm maintains a target leverage ratio, r
U

can be estimated (recall the picture) as the
weighted average cost of capital computed
without taking into account taxes (pre-tax WACC).
This is, strictly speaking, only true for firms that adjust
their debt to maintain a target leverage ratio, a
common but not universal policy.
Pretax WACC

U E D
E D
r r r
E D E D
= + =
+ +
The Unlevered Value of the
Project
For Ralph, the unlevered cost of capital is:

The projects value without leverage is:
( )
( )
340
850
0.60 12.0% 0.40 5.0%
9.2%
8.5% 0.35 5% 9.2%
U
D
E D
wacc c D
r
r r t
+
= +
=
= +
= + =
2 3 4 5
12.45 16.35 20.25 24.15 28.05
+
1.092 1.092 1.092 1.092 1.092
$75.71 million
U
V = + + +
=
Valuing the Interest Tax Shield
The $75.71 million is the value of the
unlevered project and does not include the
value of the tax shield provided by the interest
payments on any incremental debt associated
with the project.
The interest tax shield is equal to the interest
paid multiplied by the corporate tax rate.
1
Interest paid in year
D t
t r D

=
1
Interest tax shield for year
c D t
t r D t

=
Interest Tax Shield
From the debt capacity calculation we can find
the interest associated with the project if the
financing is kept on target.




year 0 1 2 3 4 5
Free Cash Flow (25.20) $ 12.45 $ 16.35 $ 20.25 $ 24.15 $ 28.05 $
Levered Value 77.30 $ 71.42 $ 61.14 $ 46.09 $ 25.85 $ - $
Debt Capacity d = 40% 30.92 $ 28.57 $ 24.46 $ 18.43 $ 10.34 $ - $
Interest - $ 1.55 $ 1.43 $ 1.22 $ 0.92 $ 0.52 $
Interest Tax Shield - $ 0.54 $ 0.50 $ 0.43 $ 0.32 $ 0.18 $
Valuing the Interest Tax Shield
The next step is to find the present value of the
annual interest tax shields created by the
borrowing associated with the project.
When the firm maintains a target leverage ratio,
its future interest tax shields have similar risk to
the projects cash flows, therefore they should be
discounted at the projects unlevered cost of
capital.
2 3 4 5
0.54 0.50 0.43 0.32 0.18
(interest tax shield) +
1.092 1.092 1.092 1.092 1.092
$1.59 million
PV = + + +
=
Valuing the Project with
Leverage
The total value of the project with leverage is
the sum of the value of the interest tax shield
and the value of the unlevered project.
The NPV of the project is $52.10 million
$77.30 million $25.20 million = $52.10 million
This is exactly the same value found using the WACC
approach.
(interest tax shield)
75.71 1.59 $77.30 million
L U
V V PV = +
= + =
Summary of the APV Method
1. Determine the investments value
without leverage.
2. Determine the present value of the interest
tax shield.
a. Determine the expected interest tax shield.
b. Discount the interest tax shield.
3. Add the unlevered value to the present value of
the interest tax shield to determine the value of
the investment with leverage.
4. Could subtract the costs associated with debt as
well if there is a reasonable way to quantify
them.
Summary of the APV Method
The APV method has some advantages.
It can be easier to apply than the WACC method
when the firm does not maintain a constant debt-
equity ratio.
The APV approach also explicitly values market
imperfections and therefore allows managers to
measure their contribution to value.
The Flow-to-Equity Method
Flow-to-Equity
A valuation method that calculates the free cash
flow available to equity holders taking into
account all payments to and from debt holders.
Free Cash Flow to Equity (FCFE), the free cash flow
that remains after adjusting for interest payments, debt
issuance and debt repayments
The cash flows to equity holders are then
discounted using the cost of equity capital.
Free Cash Flow to Equity
Free Cash Flow to Equity
Year 0 1 2 3 4 5
Unlevered NI (5.20) $ 8.45 $ 12.35 $ 16.25 $ 20.15 $ 24.05 $
Less After Tax Interest - $ 1.00 $ 0.93 $ 0.79 $ 0.60 $ 0.34 $
Plus Depr - $ 4.00 $ 4.00 $ 4.00 $ 4.00 $ 4.00 $
Less Net Cap Ex 20.00 $ - $ - $ - $ - $ - $
Less Change in NWC - $ - $ - $ - $ - $ - $
Plus Net Borrowing 30.92 $ (2.35) $ (4.11) $ (6.02) $ (8.09) $ (10.34) $
Free Cash Flow to Equity 5.72 $ 9.09 $ 11.31 $ 13.43 $ 15.46 $ 17.37 $
Valuing the Equity Cash Flows
Because the FCFE represents expected payments to
equity holders, they should be discounted at the
projects cost of equity capital.
Given that the risk and leverage of the project are the same
as for Ralph Inc. overall, we can use the firms cost of equity
capital of 12.0% to discount the projects FCFE.


The value of the projects FCFE represents the gain to
shareholders from the project and it is identical to the NPV
computed using the WACC and APV methods. (The debt is
sold at a fair price.)
2 3 4 5
9.09 11.31 13.43 15.46 17.37
( ) 5.72 +
1.12 1.12 1.12 1.12 1.12
$52.10 million
NPV FCFE = + + + +
=
Project-Based Costs of Capital
In the real world, a specific project may have
different market risk than the average project
for the firm.
In addition, different projects will may also vary
in the amount of leverage they will support.
Estimating the Unlevered Cost of
Capital
Suppose the project Ralph launches faces
different market risks than its main business.
The unlevered cost of capital for the new project
can be estimated by looking at publicly traded,
pure play firms that have similar business risk.
Estimating the Unlevered Cost of
Capital
Assume two firms are comparable to the chew
toy project in terms of basic business risk and
have the following observable characteristics:
Firm Equity Beta Debt Beta Debt-to-Value
Ratio

Firm A

1.7

0.05

40%

Firm B

1.9

0.10

50%
Estimating the Unlevered Cost
of Capital using Betas
We now find their unlevered or asset betas:




An average of these unlevered betas is 1.02.
Note, an unlevered beta of 1.02 gives an
unlevered cost of equity capital of:

0.6 0.4
1.7 0.05 1.04
0.6 0.4 0.6 0.4
0.5 0.5
1.9 0.1 1.0
0.5 0.5 0.5 0.5
A A
A A A
U E D
A A A A
B B
B B B
U E D
B B B B
E D
E D E D
E D
E D E D
| | |
| | |
= + = + =
+ + + +
= + = + =
+ + + +
( ) 4% 1.02(6%) 10.12% 9.2%
U f U
r r RP | = + = + = =
Project Leverage
and the Equity Cost of Capital
Now assume that Ralph plans to maintain a 20%
debt to value ratio for its chew toy project, and it
expects its borrowing cost for the project to be
4%.
We now relever the unlevered beta estimate of
1.02 and using the SML we find the cost of
levered equity:



A cost of debt capital of 4% is consistent with the
low leverage chosen and a debt beta of 0.
0.2
( ) 1.02 (1.02 0.0) 1.275
0.8
( ) 4% 1.275(6%) 11.65%
E U U D
E f E
D
E
r r RP
| | | |
|
= + = + =
= + = + =
Project Leverage and the
Weighted Average Cost of Capital
With a 20% debt to value ratio, a cost of equity
capital of 11.65%, and a cost of debt capital of
4% we can now estimate the WACC for the
project.

0.8 0.2
11.65% 4%(1 0.35) 9.84
0.8 0.2 0.8 0.2
WACC
r = + =
+ +
An Alternate Approach
From the observable (or measurable) data we
can get estimates of the cost of equity capital
and the cost of debt capital:
Firm A:


Firm B:
4% 1.7 6% 14.2%
4% 0.05 6% 4.3%
E
D
r
r
= + =
= + =
4% 1.9 6% 15.4%
4% 0.1 6% 4.6%
E
D
r
r
= + =
= + =
An Alternate Approach
Recall the relation between the levered cost of
equity capital and the unlevered cost of equity
capital:


Rearranging this we find:


In other words, the unlevered cost of equity capital
equals the pre-tax WACC
( )
E U U D
D
r r r r
E
= +
pre-tax WACC
U E D
E D
r r r
E D E D
= + =
+ +
Estimating the Unlevered Cost of
Capital
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.


Based on these comparable firms, we estimate
an unlevered cost of capital for the project that
is approximately 10.12%.
Firm A: 0.60 14.2% 0.40 4.3% 10.24%
Firm B: 0.50 15.4% 0.50 4.6% 10.0%
U
U
r
r
= + =
= + =
Project Leverage
and the Equity Cost of Capital
Ralph plans to maintain a 20% debt to value
ratio for its chew toy project, and it expects its
borrowing cost to be 4%.
Given the unlevered cost of capital estimate of
10.12%, the chew toy divisions equity cost of
capital can be estimated to be:
0.20
10.12% (10.12% 4%)
0.80
11.65%
E
r = +
=
Project Leverage and the
Weighted Average Cost of Capital
The divisions WACC can now be estimated to
be:
An alternate method for calculating the chew
toy divisions WACC is:
0.80 11.65% 0.20 4.0% (1 0.35)
9.84%
WACC
r = +
=

10.12% 0.20 0.35 4%
9.84%
WACC U c D
r r d r t =
=
=