Sampa Video Essay
• A small video chain is deciding whether to engage in a new line of delivery business and is conducting an economic analysis of the valuation impacts of this decision. • This is a case basically regarding how to measure the benefits of financial leverage via different valuation approaches.
Firm valuation (discount cash flow) and cost of capital
• When you use the after-tax cost of capital to be the discount rate, you basically take in the effect of the financing. • If you discount the project cash flows (without financing) by the after-tax cost of capital, you will get the exact net present value as you use it to discount the total cash flows (project cash flows plus the financing cash flows). • That is, when you …show more content…
Adjusted Present Value (APV) Approach
• 1. Calculate PV of project (or enterprise) assuming it is all equity financed (i.e. no interest expense) • 2. Calculate value of tax shield. Compare tax payments with vs. without debt. The difference equals the tax savings available from the interest deduction (tax shield). Discount tax savings at pre-tax rate of return on debt • 3. Total firm value = value of the all equity firm + side effects of financing.
All Equity Valuation of the Project
• Free Cash Flow to the Firm = EBIT (1 - tax rate) – (Capital Expenditures - Depreciation) – Change in Non-cash Working Capital
If depreciation is straight line, the initial capital expenditure appears to be depreciated over 7.5 years ($200,000; or $1,500,000/7.5). The annual capital expenditures of $300,000 seems to be depreciated over 12 years. ($25,000; or 300,000/12)
All Equity Valuation – Cost of Capital (unlevered equity)
• • • • Asset Beta Risk free rate Market risk premium Asset Return [A] from Exhibit 2 [B] from Exhibit 2 [C] from Exhibit 2 [D] = [B] + [A] *