Valuation and Capital Budgeting For The Levered Firm: Contact: 778.863.8693 Email: Info@financetraining - Ca

Valuation and Capital
Budgeting for the Levered Firm
Contact : 778.863.8693 Email : info@financetraining.ca
Prospectus
Recall that there are three questions in corporate
finance.
The first regards what long-term investments the
firm should make (the capital budgeting
question).
The second regards the use of debt (the capital
structure question).
This chapter is the nexus of these questions.
Adjusted Present Value Approach

APV = NPV + NPVF
The value of a project to the firm can be thought of as
the value of the project to an unlevered firm (NPV)
plus the present value of the financing side effects
(NPVF):
There are four side effects of financing:
The Tax Subsidy to Debt

The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing
APV Example
Consider a project of the Pearson Company, the timing and
size of the incremental after-tax cash flows for an all-equity
firm are:
-$1,000
0
$125
$250
$375
$500
The unlevered cost of equity is r0 = 10%:
NPV10%
NPV10%
$125
$250
$375
$500
$1,000
2
3
(1.10) (1.10) (1.10) (1.10) 4
$56.50
The project would be rejected by an all-equity firm: NPV < 0.

APV Example (continued)

Now, imagine that the firm finances the project with
$600 of debt at rB = 8%.
Pearsons tax rate is 40%, so they have an interest
tax shield worth TCBrB = .40$600.08 = $19.20
each year.
The net present value of the project under leverage is:
APV NPV NPVF

4
$19.20
APV $56.50
t
(
1
.
08
)
t 1
APV $56.50 63.59 $7.09

So, Pearson should accept the project with debt.
APV Example (continued)

Note that there are two ways to calculate the NPV
of the loan. Previously, we calculated the PV of the
interest tax shields. Now, lets calculate the actual
NPV of the loan: 4
$600 .08 (1 .4) $600
NPVloan $600
t
4
(
1
.
08
)
(
1
.
08
)
t 1
NPVloan $63.59
APV NPV NPVF
APV $56.50 63.59 $7.09

Which is the same answer as before.
Flows to Equity (FTE) Approach

Discount the cash flow from the project to
the equity holders of the levered firm at the
cost of levered equity capital, rS.
There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows
Step Two: Calculate levered cost of equity rS.
Step Three: Valuation of the levered cash flows at
rS.
Step One: Levered Cash Flows for Pearson
LO18.3
Since the firm is using $600 of debt, the equity holders only have to
come up with $400 of the initial $1,000.
Thus, CF0 = -$400
Each period, the equity holders must pay interest expense. The after-tax
cost of the interest is BrB(1-TC) = $600.08(1-.40) = $28.80
CF3 = $375 -28.80

CF2 = $250 -28.80
CF1 = $125-28.80
-$400
0
CF4 = $500 -28.80 -600
$96.20
$221.20
$346.20
-$128.80
Step Two: Calculate rS for Pearson
LO18.3
B
rS r0 (1 TC )(r0 rB )
S
To calculate the debt-to-equity ratio, B/S, start with the debt
to value ratio. Note that the value of the project is
4
$125
$250
$375
$500
19.20
PV
2
3
4
t
(1.10) (1.10) (1.10) (1.10)
(
1
.
08
)
t 1
PV $943.50 63.59 $1,007.09

B = $600 when V = $1,007.09 so S = $407.09.
$600
rS .10
(1 .40)(.10 .08) 11 .77%
$407.09
Step Three: Valuation for Pearson
LO18.3
Discount the cash flows to equity holders at rS = 11.77%

-$400
0
$96.20
1
$221.20
2
$346.20
3
-$128.80
4
$96.20
$221.20
$346.20
$128.80
PV $400
2
3
(1.1177 ) (1.1177 ) (1.1177 ) (1.1177 ) 4
PV $28.56
WACC Method for Pearson

rWACC
S
B
rS
rB (1 TC )
S B
S B
To find the value of the project, discount the unlevered cash

flows at the weighted average cost of capital.
Suppose Pearson Inc. target debt to equity ratio is 1.50.
B
1.5S B
1.50
S
B
1 .5 S
1 .5
S
0.60
1 0.60 0.40
S B S 1 .5 S 2 .5
S B
rWACC (0.40) (11 .77%) (0.60) (8%) (1 .40)
rWACC 7.58%
Valuation for Pearson using WACC

To find the value of the project, discount the
unlevered cash flows at the weighted average
cost of capital
$125
$250
$375
$500
NPV $1,000
2
3
(1.0758) (1.0758) (1.0758) (1.0758) 4
NPV6.88% $6.68
A Comparison of the APV, FTE, and WACC

Approaches
All three approaches attempt the same task:

valuation in the presence of debt financing.
Guidelines:
Use WACC or FTE if the firms target debt-tovalue ratio applies to the project over the life of
the project.
Use the APV if the projects level of debt is
known over the life of the project.
In the real world, the WACC is the most

widely used approach by far.
Summary: APV, FTE, and WACC

APV WACC FTE
Initial Investment
Cash Flows
Discount Rates
All
UCF
r0
PV of financing effects Yes
All
UCF
rWACC
Equity Portion
LCF
rS
No
No
Which approach is best?

Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is constant
WACC is by far the most common
FTE is a reasonable choice for a highly levered firm
APV Example:
LO18.5
Worldwide Trousers, Inc. is considering a $5

million expansion of their existing business.
The initial expense will be depreciated
straight-line over five years to zero salvage
value
The pretax salvage value in year 5 will be
$500,000.
The project will generate pretax earnings of
$1,500,000 per year, and not change the risk
level of the firm.
APV Example:
LO18.5
The firm can obtain a five-year $3,000,000

loan at 12.5% to partially finance the project.
If the project were financed with all equity,
the cost of capital would be 18%. The
corporate tax rate is 34%, and the risk-free
rate is 4%.
The project will require a $100,000 initial
investment in net working capital. Will be
recaptured at the end
Calculate the APV.
APV Example: Cost
LO18.5
Lets work our way through the four terms in this equation:
APV Cost PVunlevered PVdepreciation PV interest

project
tax shield
tax shield
The cost of the project is not $5,000,000.

We must include the round trip in and out of net working
capital and the after-tax salvage value.
NWC is riskless, so
we discount it at rf.
Salvage value should Cost $5.1m 100,000 500,000(1 .34)
5
5
(
1
r
)
(
1
r
)
have the same risk as
f
0
the rest of the firms $4,873.561.25
assets, so we use r0.
APV Example: PV unlevered project

LO18.5
Turning our attention to the second term,
APV $4,873.561.25 PVunlevered PVdepreciation PV interest

project
tax shield
tax shield
The PV unlevered project is the present value of the unlevered cash

flows discounted at the unlevered cost of capital, 18%.
PVunlevered
project
5
UCFt
$1.5m (1 .34)
t
t
(
1
r
)
(
1
.
18
)
t 1
t 1
o
PVunlevered $3,095,899
project
APV Example: PV depreciation tax shield

Turning our attention to the third term,
APV = $4,873,561.25 + $3,095,899 + PV depreciation + PV interest

tax shield
tax shield
The PV depreciation tax shield is the present value of the tax savings
due to depreciation discounted at the risk free rate, at rf = 4%
PVdepreciation
tax shield
D TC
t
(
1
r
)
t 1
f
$1m .34
$1,513,619
t
t 1 (1.04)
APV Example: PV interest tax shield
LO18.5
Turning our attention to the last term,
APV = $4,873,561.25 + $3,095,899 + $1,513,619 + PV interest

tax shield
The PV interest tax shield is the present value of the tax savings due
to interest expense discounted at the firms debt rate, at rD =
12.5%
5
5
TC rD $3m
0.34 0.125 $3m
PV interest
t
t
(
1
r
)
(
1
.
125
)
t 1
t 1
D
tax shield
PV interest
tax shield
127,500
453,972.46
t
t 1 (1.125)
APV Example: Adding it all up
LO18.5
Lets add the four terms in this equation:
APV = Cost + PV unlevered + PV depreciation + PV interest

project
tax shield
tax shield
APV = $4,873,561.25 + $3,095,899 + $1,513,619 + $453,972.46

APV = $189,930
Since the project has a positive APV, it looks like a go.
Capital Budgeting When the Discount Rate

Must Be Estimated
LO18.6
A scale-enhancing project is one where the project
is similar to those of the existing firm.
In the real world, executives would make the
assumption that the business risk of the non-scaleenhancing project would be about equal to the
business risk of firms already in the business.
No exact formula exists for this. Some executives
might select a discount rate slightly higher on the
assumption that the new project is somewhat riskier
since it is a new entrant.
Capital Budgeting When the Discount Rate Must

Be Estimated: An Example
LO18.6
World-Wide Enterprises (WWE) is planning to enter
into a new line of business (widget industry)
American Widgets (AW) is a firm in the widget
industry.
WWE has a D/E of 1/3, AW has a D/E of 2/3.
Borrowing rate for WWE is10 %
Borrowing rate for AW is 8 %
Given: Market risk premium = 8.5 %, Rf = 8%, Tc=
40%
What is the appropriate discount rate for WWE to
use for its widget venture?
Capital Budgeting When the Discount Rate Must

Be Estimated: An Example
LO18.6
A four step procedure to calculate discount

rates:
1. Determining AWs cost of Equity Capital (rs)
2. Determining AWs Hypothetical All-Equity
Cost of Capital. (r0)
3. Determining rs for WWEs Widget Venture
4. Determining rWACC for WWEs Widget Venture.
STEP 1:Determining AWs cost of Equity

Capital (rs)
r R ( R R )
s
r 8% 1.5 8.5 %
s
r 20.75 %
s
LO18.6
STEP 2 :Determining AWs Hypothetical

All-Equity Cost of Capital. (r0) LO18.6
B
rS r0 (1 TC )(r0 rB )
S
2
0.2075 r (0.6)(r 0.12)
3
0
r 0.1825
0
STEP 3 :Determining rs for WWEs Widget

Venture
Assuming that the business risk of WWE and AW
are the same,
B
rS r0 (1 TC )(r0 rB )
S
1
r 0.1825 (0.6)(0.1825 0.10)
3
s
r 0.199
s
NOTE : rs (WWE) < rs (AW)
because D/E (WWE) < D/E (AW)
STEP 4: Determining rWACC for WWEs

Widget Venture.
S
B
rWACC
rS
rB (1 TC )
S B
S B
WACC
WACC
3
1
0.199 0.10(0.6)
4
4
0.16425 16.425%
LO18.6
Beta and Leverage

Recall that an asset beta would be of the
form:
Asset
Cov(UCF , Market )
2Market
Beta and Leverage: No Corp.Taxes
LO18.7
In a world without corporate taxes, and with riskless

corporate debt, it can be shown that the relationship
between the beta of the unlevered firm and the beta of
levered equity is:
Asset
Equity
Equity
Asset
In a world without corporate taxes, and with risky
corporate debt, it can be shown that the relationship

between the beta of the unlevered firm and the beta of
levered equity is:
Asset
Debt
Equity
Debt
Equity
Asset
Asset
Beta and Leverage: with Corp. Taxes

In a world with corporate taxes, and riskless debt, it can
be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:
Equity
Debt
1
(1 TC ) Unlevered firm
Equity
Debt
Since 1 Equity (1 TC ) must be more than 1 for a
levered firm, it follows that Equity Unlevered firm

Beta and Leverage: with Corp. Taxes

If the beta of the debt is non-zero, then:
Equity
B
Unlevered firm (1 TC )( Unlevered firm Debt )
SL
Appendix: The APV approach to Valuing

Leveraged Buyouts (LBOs)
An LBO is the acquisition by a small group of investors
of a public or private company financed primarily with
debt.
In an LBO, the equity investors are expected to pay off
outstanding principal according to a specific timetable.
The owners know that the firms debt-to-equity ratio
will fall and can forecast the dollar amount of debt
needed to finance future operations.
Under these circumstances, the APV approach is more
practical than the WACC approach because the capital
structure is changing.
Example 1: The APV Approach to

Valuing LBOs: The RJR Nabisco Buyout
In 1988, the CEO of the firm announced a bid of
$75 per share to take the firm private in a
management buyout.
Another bid of $90 per share by Kohlberg Kravis
and Roberts (KKR) was followed.
At the end, KKR emerged from the bidding process
with an offer of $109 a share, totalling $25 billion.
We use the APV technique to analyze KKRs
winning strategy.
The RJR Nabisco Buyout (cont.)

KKR planned a significant increase in leverage with
accompanying tax benefits.
The firm issued almost $24 billion of new debt to complete
the buyout with annual interest costs of $3 billion.
4 Steps for RJR LBO valuation
Step1: Calculating the PV of UCF for 1989-93:
PV
1988
PV
1988
$5.404 $4.311 $2.173 $2.336 $2.536
(1.14) (1.14) (1.14) (1.14) (1.14)

2
$12.224 billion

Step2: Calculating the PV of UCF beyond 1993:
Assume :UCF grow at 3 % after 1993
PV
1993
PV
1988
$2.536(1.03)
$23.746 billion
0.14 0.03
$23.746 billion
$12.333 billion
(1.14)
5
TOTAL UNLEVERED VALUE = 12.224 +12.333 = $24.557 b

Step3: Calculating the PV of interest tax shields 1989-93:
Given: average cost of debt (pretax) = 13.5 %
$1.151 $1.021 $1.058 $1.120 $1.184

PV
$3.877 b
(1.135) (1.135) (1.135) (1.135) (1.135)
1988
Step4: Calculating the PV of interest tax shields beyond 1993:

Assume: debt/assets ratio will be maintained at 25 %.
The WACC method will be appropriate to find terminal value.

1
r 0.14 (1 0.34)(0.14 0.135) 0.141
3
s
WACC
3
1
(0.141) 0.135(1 0.34) 0.128 12.8%
4
4
PV
1993
$2.536(1.03)
$26.654 billion
0.128 0.03

We know that: VL= VU + PVTS
PVTS = VL (1993)-VU(1993)
VL (1993)(from Step4) and Vu (1993)(from Step1)
PVTS = $26.654 23.746 = $2.908 billion
$2.908 billion
PV
$1.544 billion
(1.135)
1988
Total value of interest tax shields = 1.544 + 3.877 (from Step3)

= $5.421

Total value of RJR = Total unlevered value +
Total value of interest tax shields
= $24.557 (Step1) + 5.421 (Step 4)
= $29.978 billion
Example 2: Hamilos Worldwide
Hamilos Worldwide is considering a $5 million expansion

of their existing business.
The initial expense will be depreciated straight-line over 5
years to zero salvage value; the pretax salvage value in year
5 will be $500,000.
The project will generate pretax gross earnings of
$1,500,000 per year, and not change the risk level of the
firm.
Hamilos can obtain a 5-year 12.5% loan to partially finance
the project. Flotation costs are 1% of the proceeds.
If undertaken, this project should maintain a target D/E
ratio of 1.50.
If the project were financed with all equity, the cost of
capital would be 18%. The corporate tax rate is 30%, and
the risk-free rate is 6%.
The project will require a $100,000 investment in net
working capital.
Hamilos Worldwide Using WACC

a) Using the WACC methodology, comment on
the desirability of this project.
rWACC
S
D
rs rD (1 TC )
V
V
rs r0
D
(r0 rD )(1 TC )
E
3
rs 18% (18% 12.5%)(1 0.30)
2
rWACC
2
3
23.775% 12.5% (1 .30)
5
5
rWACC 14.76%
Hamilos Worldwide Using WACC

a) Using the WACC methodology, comment on
NPVWACC $5,100,000
5
$500,000 (1 0.30) 1,000,000
t
(
1
.
1476
)
t 1
$100,000 $500,000 (1 .30)
(1.1476) 5
$322,677.06
Hamilos Worldwide Using APV

b) Using the APV methodology, comment on
First some preliminaries: The firm wants to finance the project
such that the debt-equity ratio = 1.5.
This implies a debt-to-value ratio of 3/5:
D 3
E 2
3
D E
2
3
E
2
DE 3
EE
2
3
E
3
3 2
2

5
5
E 2 5
2

So, lets find PV unlevered and borrow 3/5 of that value.
project
STEP ONE:
PV unlevered = PV unlevered + PV depreciation + PV interest PV flotation

project
project
tax shield
tax shield
costs

PV
levered
project
= PV unlevered + PV depreciation + PV interest PV flotation

project
PV unlevered =
project
tax shield
t=1
tax shield
UCFt
(1 + r0)t
5
PV depreciation =
tax shield
t=1
DTC
(1 + rf)t
costs

PV
levered
project
project
tax shield
3
D = PV unlevered
5
project
PV interest
tax shield
PV interest
tax shield
TCrDD
=
t
t = 1 (1 + rD)
t=1
3
TCrD PV unlevered
5
project
(1 + rD)t
tax shield
costs
Recall that the

dollar amount of
debt depends on
the PV levered.
project

PV
levered
project
project
3
D = PV unlevered
5
project
tax shield
tax shield
costs
We need to borrow D* such that:

3
*
D (1 .01) = PV unlevered
5
project
1
3
*
PV unlevered
D =
0.99 5
project
Our pre-tax flotation costs are one percent of D*
0.01 3
0.01D =
PV unlevered
0.99 5
project
*
A digression on floatation costs

Oh by the way, flotation costs are deductible.
So the present value of the after-tax flotation costs are
PV flotation
costs
0.01 3
PV unlevered
= (1 TC)
0.99 5
project

PV
levered
project
project
t=1
tax shield
UCFt
(1 + r0)t
t=1
t=1
tax shield
costs
DTC
(1 + rf)t
3
TCrD PV unlevered
5
project
(1 + rD)t
0.01 3
(1 TC)
PV unlevered
0.99 5
project

PV
levered
project
project
`
5
5
UCFt
D TC
t
t
(
1
r
)
(
1
r
)
t 1
t 1
t 1
o
f
5
PVlevered
project
tax shield
tax shield
3
TC rD PVlevered
5
project
(1 rD ) t
costs
0.01 3
(1 TC )
PVlevered
.99 5
project
PVlevered
project
1,500,000 (.70) 5 $1,000,000 .30
t
t
(
1
.
18
)
(
1
.
06
)
t 1
t 1
t 1
3
0.30 0.125 PVlevered
5
project
(1.125) t
0.01 3
(.70)
PVlevered
.99 5
project

PV
levered
project

project
tax shield
tax shield
costs
PVlevered = $3,283,529.57 + $1,263,709.14 +

project
0.08011 PVlevered 0.00424 PVlevered
project
project
PVlevered 0.08011 PVlevered + 0.00424 PVlevered = $4,547,238.71

project
PVlevered =
project
project
$4,547,238.71
=
1 0.08011 + 0.00424
project
$4,547,238.71
0.92413
= $4,920,563.66

APV
$100,000 500,000 (1 .30)
$5,100,000
$4,920,563.66
5
5
(1.06)
(1.18)
APV 48,277.71
Hamilos Worldwide Using FTE

c) Using the FTE methodology, comment on
Since the bondholders are financing $2,952,338.20, the

shareholders only have to pony up
$2,047,661.80 = $5,100,000 $2,952,338
Thus the year-zero levered cash flow is $2,047,661.80 + after-tax

flotation costs
.01 3
LCF0 $2,147,662 (1 .30) $4,920,563.66

.99 5
= $2,147,662 $20,875.11
LCF0 = $2,168,536.92
Hamilos Worldwide Using FTE

LCF0 = $2,168,536.92
The LCF for years one through 4 is
$1,091,670.41 =
= [$1.5m $1m .125$2,952,338.20 ] (1 .30) + $1,000,000
The LCF for year 5 is

$1,410,667.79 = $1,091,670.41 $2,952,338.20 + $100,000 +
$500,000(1 .30)
The NPV at rs = 23.775% is $18,759.67

Summary Hamilos Worldwide
Using WACC
NPV = $322,677.06
Using APV
NPV = $48,277.71
Using FTE
NPV = $18,759.67
Should we accept or reject the project?

If the dollar amount of debt is known over the
projects life, (in this example the amount of debt
would be $2,952,338.20) then the APV method is
appropriate and the firm would accept the project.
Otherwise, the firm should reject the project.
Dividends and Other

Payouts
Different Types of Dividends

Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
Often companies will declare stock dividends.

No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.

Wrigleys Gum sends around a box of chewing gum.
Dundee Crematorium offers shareholders discounted
cremations.
Standard Method of Cash Dividend PaymentLO19.2

Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.
Procedure for Cash Dividend Payment

25 Oct.
1 Nov.
2 Nov.
6 Nov.
LO19.2
7 Dec.
Declaration
Date
ExCumdividend dividend
Date
Date
Record
Date
Payment
Date
Declaration Date: The board of directors declares a payment

of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.
Price Behaviour around the Ex-Dividend Date

In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
-t
-2
-1
+1
+2
$P
$P - div
The price drops
Exby the amount of
dividend
Date
the cash
dividend Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
The Benchmark Case: An Illustration of the

Irrelevance of Dividend Policy
LO19.3
A compelling case can be made that dividend

policy is irrelevant.
Since investors do not need dividends to convert
shares to cash they will not pay higher prices for
firms with higher dividend payouts.
In other words, dividend policy will have no
impact on the value of the firm because
investors can create whatever income stream
they prefer by using homemade dividends.
The Benchmark Case: An Illustration of the

Irrelevance of Dividend Policy
LO19.3
Example: York Corporation , an all-equity firm

At date 0, the managers are able to forecast
cash flows perfectly.
The firm will receive a cashflow of $10,000
at date 0 and $10,000 at date 1
The firm will dissolve at date 1.
The firm has no additional positive NPV
projects
An Illustration of the Irrelevance of Dividend

Policy (continued)
LO19.3
I ) Current Policy: Dividends set equal to

cashflow
Dividends (Div.) at each date = $10000
The firm value will be :
DIV 1
V 0 DIV 0
1 rs
$10000
V 0 $10000
$19090.91
1.1

Policy (continued)
LO19.3
Assume 1,000 shares are outstanding, then:

$10
P 0 $10
$19.09
1.1
After the imminent dividend is paid, the
stock price will fall to $9.09 (19.09-10)

Policy (continued)
LO19.3
I I)
Alternative Policy: Initial dividend > cash

flow
Pay $11 per share immediately i.e., $11 X 1000 shares =

$11,000 as total dividend.
The extra $1,000 must be raised by issuing new stock.
Date 0
Date1
Total dividends to old shareholders $11,000
$8,900
Dividends per share
$11
$8.9
Note: at date1, the new shareholders will get $1,100 of
the total cash flow leaving only $8,900 to old
shareholders.

Policy (continued)
LO19.3
The PV of dividends per share with the

alternative policy:
$8.9
P 0 $11
$19.09
1.1
The indifference proposition:
-The PV of the stock in both scenarios is the same.
-The change in dividend policy did not affect the value of a
share.
Modigliani and Miller (MM) proposition

MM proposition: Investors are indifferent to
dividend policy
Assumptions:
1) No taxes, brokerage fees, etc.
2) Homogeneous expectations
3) The investment policy of the firm is set
ahead of time
LO19.3
Homemade Dividends
LO19.3
ABC Inc. is a $42 stock about to pay a $2 cash dividend.

Bob Investor owns 80 shares and prefers $3 cash dividend.
Bobs homemade dividend strategy:
Sell two shares ex-dividend
homemade dividends
Cash from dividend
$160
Cash from selling stock
$80
Total Cash
$240
Value of Stock Holdings $40 78 =
$3,120
$3 Dividend
$240
$0
$240
$39 80 =
$3,120
Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to
cash, dividend policy will have no impact on the value of the
firm.
In the above example, Bob Investor began with total wealth
of $3,360:
$42
$3,360 80 shares
share
After a $3 dividend, his total wealth is still $3,360:
$39
$3,360 80 shares
$240
share
After a $2 dividend, and sale of two ex-dividend shares,his
total wealth is still $3,360:
$40
$3,360 78 shares
$160 $80
share
Irrelevance of Stock Dividends: Example
LO19.3
XYZ Inc. has two million shares currently outstanding at $15

per share. The company declares a 50% stock dividend. How
many shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by
50%:
2 million1.5 = 3 million shares
After the stock dividend what is the new price per share and
what is the new value of the firm?
The value of the firm was $2m $15 per share = $30 m. After
the dividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share
Dividends and Investment Policy

Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time).
Recall that one of the assumptions underlying the
dividend-irrelevance arguments was The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.
A final note:
-Dividends are relevant
-Dividend policy is irrelevant
Repurchase of Stock
Instead of declaring cash dividends, firms can
rid itself of excess cash through buying
shares of their own stock.
Recently share repurchase has become an
important way of distributing earnings to
shareholders.
When tax avoidance is important, share
repurchase is a potentially useful adjunct to
dividend policy.
Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to
its shareholders.
Assets
A.Original balance sheet
Liabilities & Equity
Cash
$150,000 Debt
0
Otherassets
850,000 Equity
1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

If they distribute the $100,000 as cash dividend, the
balance sheet will look like this:
Assets
Liabilities & Equity
B. After $1 per share cash dividend

Cash
$50,000
Debt
Other assets
850,000
Equity
Value of Firm 900,000
0
900,000
Value of Firm 900,000
Shares outstanding = 100,000

Price per share = $900,000/100,000 = $9

If they distribute the $100,000 through a stock repurchase,
the balance sheet will look like this:
Assets
C. After stock repurchase
Liabilities& Equity
Cash
$50,000 Debt
0
Other assets 850,000 Equity
900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10
Share Repurchase (Real-World Considerations)

Lower tax
Tender offers
If offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchase
Greenmail
Gadflies
Repurchase as investment
Recent studies have shown that the long-term stock price
performance of securities after a buyback is significantly
better than the stock price performance of comparable
companies that do not repurchase.
Personal Taxes, Issuance Costs, and Dividends

To get the result that dividend policy is irrelevant,
we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In Canada, individual investors face a lower

dividend tax rate due to the dividend tax credit.
Capital gains for individuals are taxed at 50% of the
marginal tax rate, and the effective tax rate on
dividend income is higher than the tax rate on
capital gains.
Firms Without Sufficient Cash to Pay a Dividend

Investment Bankers
Cash: stock issue

Firm
The direct costs of

stock issuance will
add to this effect.
Stock
Holders
Cash: dividends
Taxes
Gov.
In a world of personal taxes,

firms should not issue stock
to pay a dividend.
Firms With Sufficient Cash to Pay a Dividend

The above argument does not necessarily apply to
firms with excess cash.
Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
The firm has several options:
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
Personal Taxes, Issuance Costs, and Dividends

In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative
uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all
dividends.
Expected Return, Dividends, and Personal Taxes
What is the relationship between the expected

return on the stock and its dividend yield?
The expected pretax return on a security with a
high dividend yield is greater than the expected
pretax return on an otherwise-identical security
with a low dividend yield.
After tax is a different story; otherwise-identical
securities should have the same return.
Evidence on Dividends and Taxes in Canada

Prior to 1972, capital gains were untaxed in Canada
In 1985, a life-time exemption on capital gains was
introduced.
Anticipation of the tax break on capital gains caused
investors to bid up prices of low-dividend yield
stocks.
Firms responded by lowering their dividend
payouts.
The dividend tax credit works to reduce taxes on
dividends received from Canadian firms.
Real World Factors Favouring a High Dividend

Policy
LO19.7
Desire for Current Income
Behavioral Finance
Agency Costs
Dividends Signalling

The homemade dividend argument relies on
no transactions costs.
To put this in perspective, mutual funds can
repackage securities for individuals at very
low cost: they could buy low-dividend stocks
and with a controlled policy of realizing
gains, pay their investors at a specified rate.
Behavioral Finance
LO19.7
Investors deal with self-control in investing and

consumption.
Selling stocks to realize cash for consumption:
may sell off too much.
Holding high dividend paying stocks: sticking to
a firm personal rule of never dipping into
principal.
Agency Costs
Agency Cost of Debt
Firms in financial distress are reluctant to cut
dividends. To protect themselves, bondholders
frequently create loan agreements stating
dividends can only be paid if the firm has
earnings, cash flow, and working capital above
pre-specified levels.
Agency Costs of Equity

Managers will find it easier to squander funds if
they have a low dividend payout.
Dividends Signalling
LO19.7
Stock price rises when a firm stats or resumes

dividends, and falls following announcements of
dividend omissions.
Firms will raise the dividend only when future
earnings and cash flows are expected to rise enough
so that the dividend is not likely to be reduced later.
The rise in the stock price following the dividend
signal is called the information content effect of
dividend.
The Clientele Effect: A Resolution of Real-World

Factors?
LO19.8
Reasons for Low Dividend
Personal Taxes
High Issuing Costs
Reasons for High Dividend

Information Asymmetry
Dividends as a signal about firms future performance
Lower Agency Costs

capital market as a monitoring device
reduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?

Uncertainty resolution
Clientele Effect
The Clientele Effect: A Resolution of Real-World

Factors?
LO19.8
Clienteles for various dividend payout policies are
likely to form in the following way:
Group
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Stock
Zero to Low payout stocks
Low-to-Medium payout
Medium Payout Stocks
High Payout Stocks
Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.
What We Know and Do Not Know About Dividend

Policy
LO19.9
Corporations Smooth Dividends.

Dividends Provide Information to the Market.
Firms should follow a sensible dividend
policy:
Dont forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few
better uses for the cash.

Valuation and Capital Budgeting For The Levered Firm: Contact: 778.863.8693 Email: Info@financetraining - Ca

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Valuation and Capital Budgeting For The Levered Firm: Contact: 778.863.8693 Email: Info@financetraining - Ca

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Valuation and Capital

Budgeting for the Levered Firm

Contact : 778.863.8693 Email : info@financetraining.ca

Contact : 778.863.8693 Email : info@financetraining.ca

Adjusted Present Value Approach

The Tax Subsidy to Debt

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The unlevered cost of equity is r0 = 10%:

The project would be rejected by an all-equity firm: NPV < 0.

APV Example (continued)

The net present value of the project under leverage is:

APV NPV NPVF

APV $56.50 63.59 $7.09

APV Example (continued)

APV $56.50 63.59 $7.09

Flows to Equity (FTE) Approach

Step One: Levered Cash Flows for Pearson

CF3 = $375 -28.80

CF4 = $500 -28.80 -600

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Step Two: Calculate rS for Pearson

PV $943.50 63.59 $1,007.09

Step Three: Valuation for Pearson

Discount the cash flows to equity holders at rS = 11.77%

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WACC Method for Pearson

To find the value of the project, discount the unlevered cash

Valuation for Pearson using WACC

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A Comparison of the APV, FTE, and WACC

All three approaches attempt the same task:

In the real world, the WACC is the most

Summary: APV, FTE, and WACC

PV of financing effects Yes

Which approach is best?

Worldwide Trousers, Inc. is considering a $5

The firm can obtain a five-year $3,000,000

APV Example: Cost

APV Cost PVunlevered PVdepreciation PV interest

The cost of the project is not $5,000,000.

APV Example: PV unlevered project

Turning our attention to the second term,

APV $4,873.561.25 PVunlevered PVdepreciation PV interest

The PV unlevered project is the present value of the unlevered cash

APV Example: PV depreciation tax shield

APV = $4,873,561.25 + $3,095,899 + PV depreciation + PV interest

APV Example: PV interest tax shield

Turning our attention to the last term,

APV = $4,873,561.25 + $3,095,899 + $1,513,619 + PV interest

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APV Example: Adding it all up

Lets add the four terms in this equation:

APV = Cost + PV unlevered + PV depreciation + PV interest

APV = $4,873,561.25 + $3,095,899 + $1,513,619 + $453,972.46

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Capital Budgeting When the Discount Rate

Capital Budgeting When the Discount Rate Must

Capital Budgeting When the Discount Rate Must

A four step procedure to calculate discount

STEP 1:Determining AWs cost of Equity

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STEP 2 :Determining AWs Hypothetical