Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 CHAPTER NINETEEN 522 FINANCING AND V A L U A T I O N Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 WE FIRST ADDRESSED problems of capital budgeting in Chapter 2. At that point we said hardly a word about financing decisions; we proceeded under the simplest possible assumption about fi- nancing, namely, all-equity financing. We were really assuming an idealized Modigliani–Miller (MM) world in which all financing decisions are irrelevant. In a strict MM world, firms can analyze real in- vestments as if they are to be all-equity-financed; the actual financing plan is a mere detail to be worked out later. Under MM assumptions, decisions to spend money can be separated from decisions to raise money. In this chapter we reconsider the capital budgeting decision when investment and financing decisions interact and cannot be wholly separated. In the early chapters you learned how to value a capital investment opportunity by a four-step procedure: 1. Forecast the project’s incremental after-tax cash flow, assuming the project is entirely equity- financed. 2. Assess the project’s risk. 3. Estimate the opportunity cost of capital, that is, the expected rate of return offered to investors by the equivalent-risk investments traded in capital markets. 4. Calculate NPV, using the discounted-cash-flow formula. In effect, we were thinking of each project as a mini-firm, and asking, How much would that mini-firm be worth if we spun it off as a separate, all-equity-financed enterprise? How much would investors be willing to pay for shares in the project? Of course, this procedure rests on the concept of value additivity. In well-functioning capital mar- kets the market value of the firm is the sum of the present value of all the assets held by the firm 1 — the whole equals the sum of the parts. In this chapter we stick with the value-additivity principle but extend it to include value contributed by financing decisions. There are two ways of doing this: 1. Adjust the discount rate. The adjustment is typically downward, to account for the value of inter- est tax shields. This is the most common approach. It is usually implemented via the after-tax weighted-average cost of capital or “WACC.” 2. Adjust the present value. That is, start by estimating the project’s “base-case” value as an all- equity-financed mini-firm, and then adjust this base-case NPV to account for the project’s impact on the firm’s capital structure. Thus Once you identify and value the side effects of financing a project, calculating its APV (adjusted net present value) is no more than addition or subtraction. This is a how-to-do-it chapter. In the next section, we explain and derive the after-tax weighted- average cost of capital, reviewing required assumptions and the too-common mistakes people make using this formula. Section 19.2 then covers the tricks of the trade: helpful tips on how to estimate continued ϩNPV of financing decisions caused by project acceptance Adjusted NPV 1APV for short2ϭ base-case NPV 523 1 All assets means intangible as well as tangible assets. For example, a going concern is usually worth more than a haphazard pile of tangible assets. Thus, the aggregate value of a firm’s tangible assets often falls short of its market value. The difference is ac- counted for by going-concern value or by other intangible assets such as accumulated technical expertise, an experienced sales force, or valuable growth opportunities. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 Think back to Chapter 17 and Modigliani and Miller’s (MM’s) proposition I. MM showed that, without taxes or financial market imperfections, the cost of capital does not depend on financing. In other words, the weighted average of the ex- pected returns to debt and equity investors equals the opportunity cost of capital, regardless of the debt ratio: Here r is the opportunity cost of capital, the expected rate of return investors would demand if the firm had no debt at all; and are the expected rates of return on debt and equity, the “cost of debt” and “cost of equity.” The weights D/V and E/V are the fractions of debt and equity, based on market values; V, the total market value of the firm, is the sum of D and E. But you can’t look up r, the opportunity cost of capital, in The Wall Street Journal or find it on the Internet. So financial managers turn the problem around: They start with the estimates of and and then infer r. Under MM’s assumptions, This formula calculates r, the opportunity cost of capital, as the expected rate of re- turn on a portfolio of all the firm’s outstanding securities. r ϭ r D D V ϩ r E E V r E r D r E r D ϭ r, a constant, independent of D/V Weighted-average return to debt and equity ϭ r D D V ϩ r E E V 524 PART V Dividend Policy and Capital Structure inputs and how the formula is used in practice. Section 19.3 shows how to recalculate the weighted- average cost of capital when capital structure or asset mix changes. Section 19.4 turns to the Adjusted Present Value or APV method. This is simple enough in con- cept: Just value the project by discounting at the opportunity cost of capital—not the WACC— and then add the present values gained or lost due to financing side effects. But identifying and valuing the side effects is sometimes tricky, so we’ll have to work through some numerical examples. Section 19.5 reexamines a basic and apparently simple issue: What should the discount rate be for a risk-free project? Once we recognize the tax deductibility of debt interest, we will find that all risk-free, or debt-equivalent, cash flows can be evaluated by discounting at the after-tax inter- est rate. We show that this rule is consistent with both the weighted-average cost of capital and with APV. We conclude the chapter with a question and answer section designed to clarify points that man- agers and students often find confusing. An Appendix providing more details and more formulas can be obtained from the Brealey–Myers website. 2 2 www.mhhe.com/bm7e. 19.1 THE AFTER-TAX WEIGHTED-AVERAGE COST OF CAPITAL Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 We have discussed this weighted-average cost of capital formula in Chapters 9 and 17. However, the formula misses a crucial difference between debt and equity: Interest payments are tax-deductible. Therefore we move on to the after-tax weighted-average cost of capital, nicknamed WACC: Here is the marginal corporate tax rate. Notice that the after-tax WACC is less than the opportunity cost of capital (r), be- cause the “cost of debt” is calculated after tax as . Thus the tax advantages of debt financing are reflected in a lower discount rate. Notice too that all the variables in the weighted-average formula refer to the firm as a whole. As a result, the formula gives the right discount rate only for projects that are just like the firm undertaking them. The formula works for the “average” project. It is incorrect for projects that are safer or riskier than the average of the firm’s existing assets. It is incorrect for projects whose acceptance would lead to an increase or decrease in the firm’s debt ratio. Example: Sangria Corporation Let’s calculate WACC for the Sangria Corporation. Its book and market value bal- ance sheets are r D 11 Ϫ T c 2 T c WACC ϭ r D 11 Ϫ T c 2 D V ϩ r E E V CHAPTER 19 Financing and Valuation 525 Sangria Corporation (Book Values, millions) Asset value $100 $ 50 Debt 50 Equity $100 $100 Sangria Corporation (Market Values, millions) Asset value $125 $ 50 Debt (D) 75 Equity (E) $125 $125 Firm Value (V) We calculated the market value of equity on Sangria’s balance sheet by multiply- ing its current stock price ($7.50) by 10 million, the number of its outstanding shares. The company has done well and future prospects are good, so the stock is trading above book value ($5.00 per share). However, the book and market values of Sangria’s debt are in this case equal. Sangria’s cost of debt (the interest rate on its existing debt and on any new bor- rowing) is 8 percent. Its cost of equity (the expected rate of return demanded by in- vestors in Sangria’s stock) is 14.6 percent. The market value balance sheet shows assets worth $125 million. Of course we can’t observe this value directly, because the assets themselves are not traded. But we know what they are worth to debt and equity investors ( mil- lion). This value is entered on the left of the market value balance sheet. Why did we show the book balance sheet? Only so you could draw a big X through it. Do so now. When estimating the weighted-average cost of capital, you are not interested in past investments but in current values and expectations for the future. San- gria’s true debt ratio is not 50 percent, the book ratio, but 40 percent, because its 50 ϩ 75 ϭ $125 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 The company’s WACC is That’s how you calculate the weighted-average cost of capital. 3 Now let’s see how Sangria would use this formula. Sangria’s enologists have proposed investing $12.5 million in construction of a perpetual crushing ma- chine, which, conveniently for us, never depreciates and generates a perpetual stream of earnings and cash flow of $2.085 million per year pretax. The after-tax cash flow is WACC ϭ .0811 Ϫ .352 1.42ϩ .1461.62ϭ .1084, or 10.84% 526 PART V Dividend Policy and Capital Structure 3 In practice it’s pointless to calculate discount rates to four decimal places. We do so here to avoid confusion from rounding errors. Earnings and cash flows are carried to three decimal places for the same reason. Pretax cash flow $2.085 Tax at 35% .730 After-tax cash flow $1.355 million Notice: This after-tax cash flow takes no account of interest tax shields on debt sup- ported by the perpetual crusher project. As we explained in Chapter 6, standard capital budgeting practice calculates after-tax cash flows as if the project were all- equity-financed. However, the interest tax shields will not be ignored: We are about to discount the project cash flows by Sangria’s WACC, in which the cost of debt is entered after tax. The value of interest tax shields is picked up not as higher after- tax cash flows, but in a lower discount rate. The crusher generates a perpetual cash flow of million, so NPV is means a barely acceptable investment. The annual cash flow of $1.355 mil- lion per year amounts to a 10.84% rate of return on investment ( ), exactly equal to Sangria’s WACC. If project , the return to equity investors must exactly equal the cost of equity, 14.6%. Let’s confirm that Sangria shareholders could actually forecast a 14.6% return on their investment in the perpetual crusher project. NPV ϭ 0 1.355/12.5 ϭ .1084 NPV ϭ 0 NPV ϭϪ12.5 ϩ 1.355 .1084 ϭ 0 C ϭ $1.355 Cost of debt ( ) .08 Cost of equity ( ) .146 Marginal tax rate ( ) .35 Debt ratio (D/V) Equity ratio (E/V)75/125 ϭ .6 50/125 ϭ .4 T c r E r D assets are worth $125 million. The cost of equity, , is the expected rate of return from purchase of stock at $7.50 per share, the current market price. It is not the return on book value per share. You can’t buy shares in Sangria for $5 anymore. Sangria is consistently profitable and pays tax at the marginal rate of 35 percent. That is the final input for Sangria’s WACC. The inputs are summarized here: r E ϭ .146 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 Calculate the expected dollar return to shareholders: The project’s earnings are level and perpetual, so the expected rate of return on eq- uity is equal to the expected equity income divided by the equity value: The expected return on equity equals the cost of equity, so it makes sense that the project’s NPV is zero. Review of Assumptions By discounting the perpetual crusher’s cash flows at Sangria’s WACC, we as- sume that • The project’s business risks are the same as Sangria’s other assets. • The project supports the same fraction of debt to value as in Sangria’s overall capital structure. You can see the importance of these two assumptions: If the perpetual crusher had greater business risk than Sangria’s other assets, or if acceptance of the project would lead to a permanent, material 4 change in Sangria’s debt ratio, then Sangria’s shareholders would not be content with a 14.6 percent expected return on their eq- uity investment in the project. We have illustrated the WACC formula only for a project offering perpetual cash flows. But Miles and Ezzell have shown that the formula works for any cash-flow pattern if the firm adjusts its borrowing to maintain a constant debt ra- tio over time. When the firm departs from this borrowing policy, WACC is only approximately correct. 5 ϭ 1.095 7.5 ϭ .146, or 14.6% Expected equity return ϭ r E ϭ expected equity income equity value Expected equity income ϭ C Ϫ 11 Ϫ T c 2r D D ϭ 1.355 Ϫ .26 ϭ 1.095 After-tax interest ϭ r D 11 Ϫ T c 2D ϭ .0811 Ϫ .352 152ϭ .26 CHAPTER 19 Financing and Valuation 527 Perpetual Crusher (Market Values, millions) Project value $12.5 $ 5.0 Debt (D) 7.5 Equity (E) $12.5 $12.5 Project Value (V) 4 Users of WACC need not worry about small or temporary fluctuations in debt-to-value ratios. Suppose that Sangria management decided for convenience to borrow $12.5 million to allow im- mediate construction of the crusher. This does not necessarily change Sangria’s long-term financ- ing policy. If the crusher supports only $5.0 million of debt, Sangria would have to pay down debt to restore its overall debt ratio to 40 percent. For example, it could fund later projects with less debt and more equity. 5 J. Miles and R. Ezzell, “The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification,” Journal of Financial and Quantitative Analysis 15 (September 1980), pp. 719–730. Suppose Sangria sets up this project as a mini-firm. Its market-value balance sheet looks like this: Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 Sangria had just one asset and two sources of financing. A real company’s market value balance sheet has many more entries, for example: 6 528 PART V Dividend Policy and Capital Structure 6 This balance sheet is for exposition and should not be confused with a real company’s books. It in- cludes the value of growth opportunities, which accountants do not recognize, though investors do. It excludes certain accounting entries, for example, deferred taxes. Deferred taxes arise when a company uses faster depreciation for tax purposes than it uses in re- ports to investors. That means the company reports more taxes than it pays. The difference is accumu- lated as a liability for deferred taxes. In a sense there is a liability, because the Internal Revenue Service “catches up,” collecting extra taxes, as assets age. But this is irrelevant in capital investment analysis, which focuses on actual after-tax cash flows and uses accelerated tax depreciation. Deferred taxes should not be regarded as a source of financing or an element of the weighted-average cost of capital formula. The liability for deferred taxes is not a security held by investors. It is a balance sheet entry created to serve the needs of accounting. Deferred taxes can be important in regulated industries, however. Regulators take deferred taxes into account in calculating allowed rates of return and the time patterns of revenues and consumer prices. 7 Financial practitioners have rules of thumb for deciding whether short-term debt is worth including in the weighted-average cost of capital. Suppose, for example, that short-term debt is 10 percent of to- tal liabilities and that net working capital is negative. Then short-term debt is almost surely being used to finance long-term assets and should be explicitly included in WACC. 19.2 USING WACC—SOME TRICKS OF THE TRADE Current assets, Current liabilities, including cash, inventory, including accounts payable and accounts receivable and short-term debt Plant and equipment Long-term debt (D) Preferred stock (P) Growth opportunities Equity (E) Firm value (V) Several questions immediately arise: 1. How does the formula change when there are more than two sources of financing? Easy: There is one cost for each element. The weight for each element is proportional to its market value. For example, if the capital structure includes both preferred and common shares, where is investors’ expected rate of return on preferred stocks. 2. What about short-term debt? Many companies consider only long-term financing when calculating WACC. They leave out the cost of short-term debt. In principle this is incorrect. The lenders who hold short-term debt are investors who can claim their share of operating earnings. A company that ignores this claim will misstate the required return on capital investments. But “zeroing out” short-term debt is not a serious error if the debt is only temporary, seasonal, or incidental financing or if it is offset by holdings of cash and marketable securities. 7 Suppose, for example, that your company’s Italian subsidiary takes out a six-month loan from an Italian bank to finance its inventory and accounts receivable. The dollar equivalent r P WACC ϭ r D 11 Ϫ T c 2 D V ϩ r P P V ϩ r E E V Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 of this loan will show up as a short-term debt on the parent’s balance sheet. At the same time headquarters may be lending money by investing surplus dollars in short-term securities. If lending and borrowing offset, there is no point in including the cost of short-term debt in the weighted-average cost of capital, because the company is not a net short-term borrower. 3. What about other current liabilities? Current liabilities are usually “netted out” by subtracting them from current assets. The difference is entered as net working capital on the left-hand side of the balance sheet. The sum of long- term financing on the right is called total capitalization. CHAPTER 19 Financing and Valuation 529 Net working capital Long-term debt (D) Plant and equipment Preferred stock (P) Growth opportunities Equity (E) Total capitalization (V) Ϫ current liabilities ϭ current assets When net working capital is treated as an asset, forecasts of cash flows for capital investment projects must treat increases in net working capital as a cash outflow and decreases as an inflow. This is standard practice, which we followed in Section 6.2. Since current liabilities include short-term debt, netting them out against current assets excludes the cost of short-term debt from the weighted-average cost of capital. We have just explained why this can be an acceptable approximation. But when short-term debt is an important, permanent source of financing—as is common for small firms and firms outside the United States—it should be shown explicitly on the right side of the balance sheet, not netted out against current assets. The interest cost of short-term debt is then one element of the weighted-average cost of capital. 4. How are the costs of the financing elements calculated? You can often use stock market data to get an estimate of , the expected rate of return demanded by investors in the company’s stock. With that estimate, WACC is not too hard to calculate, because the borrowing rate and the debt and equity ratios D/V and E/V can be directly observed or estimated without too much trouble. 8 Estimating the value and required return for preferred shares is likewise usually not too complicated. Estimating the required return on other security types can be troublesome. Convertible debt, where the investors’ return comes partly from an option to exchange the debt for the company’s stock, is one example. We will leave convertibles to Chapter 23. Junk debt, where the risk of default is high, is likewise difficult. The higher the odds of default, the lower the market price of the debt and the higher the promised rate of interest. But the weighted-average cost of capital r D r E 8 Most corporate debt is not actively traded, so its market value cannot be observed directly. But you can usually value a nontraded debt security by looking to securities that are traded and that have approxi- mately the same default risk and maturity. See Chapter 24. For healthy firms the market value of debt is usually not too far from book value, so many managers and analysts use book value for D in the weighted-average cost of capital formula. However, be sure to use market, not book, values for E. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 is an expected, that is, average, rate of return, not a promised one. For example, in October 2001, Crown Cork bonds maturing in 2005 sold at only 76 percent of face value and offered an 18.6 percent promised yield, more than 14 percentage points above yields on the highest-quality debt issues maturing at the same time. The price and yield on the Crown Cork bond demonstrated investors’ concern about the company’s chronic financial ill- health. But the 18.6 percent yield was not an expected return, because it did not average in the losses to be incurred if Crown Cork defaults. Including 18.6 percent as a “cost of debt” in a calculation of WACC would therefore overstate Crown Cork’s true cost of capital. This is bad news: There is no easy or tractable way of estimating the expected rate of return on most junk debt issues. 9 The good news is that for most debt the odds of default are small. That means the promised and expected rates of return are close, and the promised rate can be used as an approximation in the weighted-average cost of capital. Industry Costs of Capital You can also calculate WACC for industries. Suppose that a pharmaceutical com- pany has a subsidiary that produces specialty chemicals. What discount rate is bet- ter for the subsidiary’s projects—the company WACC or a weighted-average cost of capital for a portfolio of “pure-play” specialty chemical companies? The latter rate is better in principle and also in practice if good data are available for firms with operations and markets similar to the subsidiary’s. An Application to the Railroad Industry Every year the United States Surface Transportation Board (STB) estimates a cost of capital for the railroad industry, de- fined as Class I (big) railroads. We will use the STB’s data and estimates to calcu- late a railroad industry WACC for 1999. The STB took care to estimate the market value of the railroads’ common shares and all outstanding debt issues, including debt-equivalents such as equipment trust certificates and financial leases. 10 The aggregate industry capital structure was 11 530 PART V Dividend Policy and Capital Structure 9 When betas can be estimated for the junk issue or for a sample of similar issues, the expected return can be calculated from the capital asset pricing model. Otherwise, the yield should be adjusted for the probability of default. Evidence on historical default rates on junk bonds is described in Chapter 25. 10 Equipment trust certificates are described in Section 25.3; financial leases are discussed in Chapter 26. 11 There were three tiny preferred issues. For simplicity we have added them to debt. Market Value (billions) Financing Weights Debt $31,627.8 37.3% Equity 53,210.0 62.7 The average cost of debt was 7.2 percent. To estimate the cost of equity, the STB used the constant-growth DCF model, which you will recall with pleasure from Section 4.3. If investors expect dividends to grow at a constant, perpetual rate, g, then the ex- pected return is the sum of the dividend yield and the expected growth rate: r E ϭ DIV 1 P 0 ϩ g Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and Valuation © The McGraw−Hill Companies, 2003 An investor who bought a portfolio of the shares of Class I railroads in 1999 got a dividend yield of about 2.0 percent. A review of security analysts’ forecasts gave an average expected growth rate for earnings and dividends of 10.9 percent. The cost of equity was thus estimated at r E ϭ 2.0 ϩ 10.9 ϭ 12.9 percent. Using the statutory marginal tax rate of 35 percent, 12 the railroad industry WACC is Valuing Companies: WACC vs. the Flow-to-Equity Method WACC is normally used as a hurdle rate or discount rate to value proposed capi- tal investments. But sometimes it is used as a discount rate for valuing whole com- panies. For example, the financial manager may need to value a target company to decide whether to go ahead with a merger. Valuing companies raises no new conceptual problems. You just treat the com- pany as if it were one big project. Forecast the company’s cash flows (the hardest part of the exercise) and discount back to present value. The company’s WACC is the right discount rate if the company’s debt ratio is expected to remain reasonably close to constant. But remember: • If you discount at WACC, cash flows have to be projected just as you would for a capital investment project. Do not deduct interest. Calculate taxes as if the company were all-equity-financed. The value of interest tax shields is picked up in the WACC formula. • The company’s cash flows will probably not be forecasted to infinity. Financial managers usually forecast to a medium-term horizon—10 years, say—and add a terminal value to the cash flows in the horizon year. The terminal value is the present value at the horizon of post-horizon flows. Estimating the terminal value requires careful attention because it often accounts for the majority of the value of the company. See Section 4.5. • Discounting at WACC values the assets and operations of the company. If the object is to value the company’s equity, that is, its common stock, don’t forget to subtract the value of the company’s outstanding debt. If the task is to value equity, there’s an obvious alternative to discounting com- pany cash flows at its WACC. Discount the cash flows to equity, after interest and af- ter taxes, at the cost of equity. This is called the flow-to-equity method. If the com- pany’s debt ratio is constant over time, the flow-to-equity method should give the same answer as discounting company cash flows at the WACC and subtracting debt. The flow-to-equity method seems simple, and it is simple if the proportions of debt and equity financing stay reasonably close to constant for the life of the com- pany. But the cost of equity depends on financial leverage; it depends on financial risk as well as business risk. If financial leverage will change significantly, dis- counting flows to equity at today’s cost of equity will not give the right answer. A one-shot change in financing can usually be accommodated. Think again of a proposed takeover. Suppose the financial manager decides that the target’s 20 per- cent debt-to-value ratio is stodgy and too conservative. She decides the company WACC ϭ 0.07211Ϫ.3521.3732ϩ .1291.6272ϭ .098, or about 10% CHAPTER 19 Financing and Valuation 531 12 The STB actually uses a pretax cost of debt. If the STB’s reported WACC is used as a discount rate, in- terest tax shields have to be valued separately, as in the adjusted-present-value method described in Section 19.4. [...]... cost of capital S N Kaplan and R S Ruback, “The Valuation of Cash Flow Forecasts: An Empirical Analysis,” Journal of Finance 50 (September 199 5), pp 1059–1093 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation CHAPTER 19 Financing and Valuation The Value of Interest Tax Shields In Table 19. 1,... (May–June 199 7) Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation CHAPTER 19 Financing and Valuation 553 There have been dozens of articles on the weighted-average cost of capital and other issues discussed in this chapter Here are two: J Miles and R Ezzell: “The Weighted Average Cost of Capital,... APV ϭ base-case NPV ϩ of financing Ͼ 0 side effects The base-case NPV is the project’s NPV computed assuming all-equity financing and perfect capital markets Think of it as the project’s value if it were set up as a separate mini-firm You would compute the mini-firm’s value by forecasting its SUMMARY Visit us at www.mhhe.com/bm7e Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Brealey−Meyers:. .. capital and is independent of leverage Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 534 PART V V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation Dividend Policy and Capital Structure FIGURE 19. 2 This plot shows WACC for the Sangria Corporation at debt-to-equity ratios of 25 and 67 percent The corresponding debt-to-value ratios are 20... percent debt Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation CHAPTER 19 Financing and Valuation FIGURE 19. 1 Rates of return WACC plotted against the debt– equity ratio WACC equals the opportunity cost of capital when there is no debt WACC declines with financial leverage because of interest... out, and the present value of its cost or benefit to the firm is calculated Finally, all the present values are added together to estimate the project’s total contribution to the value of the firm Thus, in general, Project APV ϭ base-case NPV ϩ sum of the present values of the side effects of accepting the project 539 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 540 V Dividend Policy... General Definition of the Adjusted Cost of Capital We recapitulate the two concepts of cost of capital: • Concept 1: The opportunity cost of capital (r) This is the expected rate of return offered in capital markets by equivalent-risk assets This depends on the risk of the project’s cash flows The opportunity cost of capital is the correct discount rate for the project if it is all-equity-financed • Concept... along with the aftertax cost of debt and the debt-to-value and equity-to-value ratios, in the WACC formula We covered this in Chapter 9 The only change here is use of the after-tax cost of debt, rD 11 Ϫ Tc 2 Of course the CAPM is not the only way to estimate the cost of equity For example, you might be able to use arbitrage pricing theory (APT—see Section 8.4) or the dividend-discount model (see Section... percent of assets as a rule of thumb for optimal capital structure It could borrow more if it wanted to run increased risks of costs of financial distress 537 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 538 PART V V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation Dividend Policy and Capital Structure Year Debt Outstanding at Start of. .. percent debt? Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 19 Financing and Valuation CHAPTER 19 Financing and Valuation Step 1 Calculate the unlevered opportunity cost of capital r ϭ 0721.3732 ϩ 1291.6272 ϭ 108 Step 2 Assume that the cost of debt increases to 8 percent at 45 percent debt The cost of equity is . website. 2 2 www.mhhe.com/bm7e. 19. 1 THE AFTER-TAX WEIGHTED-AVERAGE COST OF CAPITAL Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 19. Financing and. at debt-to-equity ratios of 25 and 67 percent. The corre- sponding debt-to-value ratios are 20 and 40 percent. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy. Ruback, “The Valua- tion of Cash Flow Forecasts: An Empirical Analysis,” Journal of Finance 50 (September 199 5), pp. 1059–1093. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V.