Example – Avco
! New product with a 4 year life
Finish Capital Budgeting " Expected annual sales $60MM/year
" Manufacturing Costs $25 MM/year
for the Levered Firm
" Operating expenses $9MM/year
TIP ! Development
If you do not understand
" R&D and Marketing $6.67MM
ask me! " Capital Investment $24MM
! NO Working Capital implications
! Corporate tax rate of 40%
Solution Avco’s Leverage
! Step 1
" Calculate the FCF
! Step 2
" Determine the target D/E ratio
! Step 3
" Calculate the WACC
! Step 4
" Calculate the NPV
What if the project as different
Avco’s WACC leverage to the firm?
! In this case you need to infer the WACC of
the project from the WACC of the firm.
! Can we just use the same formula with the
new values for E and D?
! We proceed by first calculating the
unlevered cost of capital
Unlevered WACC (with a
Unlevered WACC target debt equity ratio)
! In a NORMAL market
Where is the market value of all future tax
! When the firm maintains a target debt equity ! The same expression as the frictionless case!
! Substituting and rearranging terms gives
Now we calculate the Cost of Cost of Equity Capital (with a
Equity Capital target debt equity ratio)
! Simply rearrange terms ! So
! Assuming you know the cost of capital of
debt, you can use this equation to get the
return on equity and calculate the new
WACC using the project leverage.
Example Avco’s Unlevered WACC
! Suppose AVCO decides to finance the ! Unlevered WACC:
project with all equity. What is the NPV?
! What if Avco uses 75% debt financing
(assume that with this level of debt
financing the cost of debt capital will be
What about a
Avco’s WACC with 75% Debt conglomerate?
! Equity Cost of Capital: ! In this case the WACC of the conglomerate
will not necessarily be the WACC of the
! So use a single product company that
maintains a target debt equity ratio, by
! WACC computing its unlevered WACC and using
that to compute the cost of equity capital
for the project. Assuming you can observe
the cost of debt capital, you can then use
them to calculate the project WACC.
What if the firm does not
Example maintain a target D/E ratio?
! Assume Avco launches a plastics division. The ! We have already seen that when the firm
following single product companies exist: maintains a constant level of debt then
! Assuming Avco maintains the same debt to ! That is, the value of the firm is the
equity ratio for the project as the firm as whole, unlevered value plus the value of the tax
and the plastics devision can borrow at the same
rate as the firm as a whole, calculate the WACC
for the plastics division. ! This is the basis of the APV approach
! Calculate the value of the firm ignoring ! Assume that rather than maintain a
leverage, that is, assuming NO leverage. constant debt equity ratio for the project,
! Then add the costs and benefits of leverage. AVCO decides to finance it by issuing a $18
In our case, we restrict attention to taxes, million four year coupon bond at 6%. What
which is a benefit. is the value of the project?
" IDEKO Case Study
" Final Project Due
# Chapter 20