Cost of Capital

Free Cash Flow

Cash flow identity
Operating and Investment cash flows on the LHS and
Financing cash Flows on the RHS.

PAT  Interest  Dep  Capex  ΔWorking Capital 

 Interest  Loan repay  Dividends - New Equity
PAT  I  Dep - Gross Investment  I  LR  Div - NE

Assuming dividends cannot be negative,

New Equity is a balancing item in the event that the net cash flow on the LHS is
negative.

Substituting for PAT  PBIT  I 1  tax PAT  I  PBIT 1  t   It

PBIT 1-t   It  Dep  GI  I  LR  Div  NE

PBIT 1-t   Dep  GI   It  LR  I   Div  NE
Free Cash Flow  Interest tax shield  Debt Flow Equity Flow
 PBIT 1-t   Dep  GI   I  t   LR  I   Div  NE
Free CashFlow  Interest tax shield  Debt Flow Equity Flow

In terms of Present Values

PV Free Cash Flows   PV Interest tax shield   PV Debt Flows  PV Equity Flows
Enterprise Value  Value of Debt  Value of Equity
Value of Equity  Enterprise Value - Value of Debt

What rate to use for discounting Free Cash Flows and Interest tax shield?
This implies the following stylized market value balance sheet for the
levered firm.

Value of unlevered firm cash flows A Equity (E)

Value of Interest Tax shield VITS  Debt (D)

Value of levered cash flows Total value of liabilities
 
Total value of assets V and equity V  
Equity and debt are assumed to be traded in efficient markets.

Their risk and required return can be estimated using market data.

This information can be used to infer the risk and required return of the
assets which are not traded.
 Unlevering/Levering beta
• Impact of change in leverage on a firm’s return
on equity and cost of capital.
• Using beta equity of a ‘comparable’ firm with
traded equity and different leverage to infer
the beta equity and cost of capital of an
untraded division.
 Unlevering/Levering equity beta
If CAPM holds, since the levered firm (from the liability side) is a portfolio of debt and
equity the beta of the levered firm can be written as

  E   L   D   L   L   D 
D E V D D
L  D  E
V V E E E
 E   L   L   D 
D
E
E D
Using the CAPM (or just portfolio return) we get r  rE  rD where r is the rate of
V V
return of the levered firm, also referred to as the ‘opportunity cost of capital’
(BMA page 504).

This gives the required/expected return on equity as rE  r  r  rD 

D
E
From the asset side the levered firm is a portfolio of the unlevered firm (or assets) and
interest tax shields. This implies
A V
 L   A  ITS  ITS
V V
In order to obtain the risk and return of assets we need to make some assumption about the
risk of interest tax shield.
 Constant debt ratio (BMA page 506)
The firm maintains a constant debt equity ratio by adjusting the debt to changes in value. Then debt
and the interest tax shield would be perfectly correlated with the value of the firm.

This implies that the Interest Tax Shield is as risky as the value of the firm’s free cash flows
 ITS   A
A V
Substituting this in  L   A  ITS  ITS and simplifying yields  L   A and r  rA .
V V
Therefore, Beta and rate of return of the levered and the unlevered (all equity) firm are equal.
Of course, value is not equal.
This gives the formula for unlevering and levering equity beta, using  L   A ,

  A   A   D 
D E D
 A  L  D  E and 
E
V V E

and r  r  r  rD 
D E D
Also from CAPM r  rD  rE
V V E E
r  rA , rE , rD : opportunity cost of capital for the firm, equity and debt respectively

These results assume continuous rebalancing. (See BMA page 508-509 including footnotes 13-15)
 Weighted Average Cost of Capital (WACC)
The WACC makes the assumption that debt is rebalanced in each period to
keep it at a constant fraction of future project value.
The cash flow available to the investors (equity and debt) of the levered firm
will be

CF  FCF  Interest tax shield

The value of the levered firm can be written as

FCF1  rD D0TC  V1 CF1  V1 D E

V0   where r  rD  rE
1  r  1  r  V V
Discounting happens at r since  L   A   ITS (continuous rebalancing)
CFt 1  Vt 1
Substituting repeatedly for Vt  since r is constant.
1  r 
CF1 CF2 CF3
V0     ..........
1  r  1  r 2 1  r 3
In order to implement this valuation the tax shield each period needs to be estimated.

However, this depends on the amount of debt which is assumed to be a constant

proportion of firm value, which is what is being estimated.

One way to resolve this circularity is to discount only the (unleverd) Free Cash Flow
(FCF), which is known in expectation, using a discount rate which accounts for the
tax shields.

Define Weighted Average Cost of Capital wacc as the rate which when used to
discount the Free Cash Flow (FCF) gives the value of the levered firm.

The value of the levered firm, using constant leverage ratio, is given as

FCF1  rD D0TC  V1 FCF1  rDV0dTC  V1 D

V0   where d  0 is constant
1  r  1  r  V0
 FCF1  V1
Solving for V0 we get V0 
1  r  rD dTC 
Dropping the 0 subscript and using
E D D
r  rE  rD and d  , the denominator can be written as
V V V
E D D
1  r  rD dTC  1  rE  rD  rD TC
V V V

 1  rE  rD 1  TC 
E D
V V
 1  wacc

wacc  rE  rD 1  TC 
E D
V V
This can also be written as

 rD 1  TC 
E D
wacc  rE
V V
E D D E D
 rE  rD  rD TC where r  rE  rD
V V V V V
D
 r  rD TC
V
Recall with constant debt ratio r  rA or the return (and beta) of the levered and
unlevered firm are equal.
This implies that as debt to value ratio increases wacc will decrease so long as TC is
positive. wacc decreases not because of the lower cost of debt financing, since this
is compensated for by an increase in rE , and a constant r , but because of higher tax
shield.
Discounting all future cash flows with a constant wacc assumes a constant r , rd ,
debt ratio and tax rate.
With increase in the debt ratio, given no change in the riskiness of assets
or r , both rE and rD will increase, but together they must always satisfy
D E
r  rD  rE using the new debt ratio.
V V

Ignoring costs of financial distress, wacc will decrease and firm value
increase as the debt ratio increases.

In the MM world with no taxes and no financial distress costs the wacc
will be constant at the expected return on assets, r .

With taxes and financial distress costs as the debt equity ratio increases
both the tax shields benefit and the costs of financial distress will increase.
Figure
19.1
Page 504
Figure 18.2
At moderate debt levels the probability of financial distress is trivial, and so
PV(cost of financial distress) is small and tax advantages dominate.

But at some point the probability of financial distress increases rapidly with
additional borrowing; the costs of distress begin to take a substantial bite out
of firm value.

Also, if the firm can’t be sure of profiting from the corporate tax shield, the
tax advantage of additional debt is likely to dwindle and eventually
disappear.

The theoretical optimum is reached when the present value of tax savings
due to further borrowing is just offset by increases in the present value of
costs of distress.

This is called the trade-off theory of capital structure.

 Adjusted (Net) Present Value

This is the valuation method when the capital structure changes in a

deterministic manner independent of the value of the firm.

The interest tax shields are predetermined and independent of the subsequent
value of the firm. Therefore, the risk of tax shields is the risk of the firm paying
interest, which is the risk of debt.
This implies  ITS   D

Hence tax shields should be discounted at the cost of debt rD .

The Adjusted Net Present Value is then obtained by discounting the FCF at r
and the tax shields at rD .