1 / 6

Chapter 14: The Link Between Capital Structure and Capital Budgeting

Chapter 14: The Link Between Capital Structure and Capital Budgeting. Corporate Finance , 3e Graham, Smart, and Megginson. M&M, Capital Budgeting, and the WACC. When calculating project NPVs using the WACC… We use unlevered project cash flows (ignoring financing effects).

taffy
Download Presentation

Chapter 14: The Link Between Capital Structure and Capital Budgeting

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 14:The Link Between Capital Structure and Capital Budgeting Corporate Finance, 3e Graham, Smart, and Megginson

  2. M&M, Capital Budgeting, and the WACC • When calculating project NPVs using the WACC… • We use unlevered project cash flows (ignoring financing effects). • We capture the effect of financing choices by discounting cash flows at the WACC. • This is fine as long as two conditions hold: • The business risk of the project under consideration is similar to that of the firm’s existing assets. • The project does not materially alter the firm’s long-run target debt-to-equity ratio.

  3. M&M, Capital Budgeting, and the WACC • Two other approaches analysts can use to calculate project values when firms use both debt and equity: • The adjusted present value (APV) method calculates an investment’s value as if it were financed only with equity, then adds back the present value of any financing side effects. • The flow-to-equity (FTE) method uses the firm’s cost of equity to discount levered project cash flows.

  4. Adjusted Present Value Method APV = NPV(Unlevered) + NPV(Financing effects) Calculates the project’s unlevered cash flows, just as the WACC does. APV discounts these cash flows using the discount rate that applies if the firm is financed only with equity. Analysts using the APV technique must add (or subtract) the PVs of any financing side effects that arise because the firm uses leverage.

  5. The Flow-to-Equity Method FTE method differs from WACC and APV approaches by focusing exclusively on cash flows to shareholders. WACC and APV project cash flow calculations ignore interest expense, while an FTE analysis deducts interest costs and taxes from project cash flows. This type of cash flow calculation is referred to as levered cash flow.

  6. Interactions Between Investment and Financing Decisions Under certain conditions, all three methods (WACC, FTE, and APV) generate estimates of an investment’s value that agree. In such cases, choose the method that is easiest to apply given the available data. When the firm plans to maintain a constant target debt-to-equity ratio in the long run, use the WACC or FTE methods. When the firm’s debt-to-equity ratio varies over a project’s life, but the amount of debt outstanding at any given time is known, use the APV method. When financing side effects beyond the interest tax shield are an important part of the investment project under consideration, use the APV method.

More Related