Capital Budgeting for the

Levered Firm
B.B.Chakrabarti
Indian Institute of
Management Calcutta

Chapter Outline
1. Adjusted Present Value Approach
2. Flows to Equity Approach
3. Weighted Average Cost of Capital Method
4. A Comparison of the APV, FTE, and WACC
Approaches

Project Data for Calculations

Cash revenue: $500,000 per year till
infinity
Cash costs: 72% of sales
Initial investment: $475,000
Corporate tax rate, tc = 34%
Cost of capital for all-equity firm, R 0 = 20%
Source of funding: Debt $126,229.50
@10% cost (RB) and equity $348,770.50

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

Calculation of APV
Unlevered cash flow, UCF = $500,000*(10.72)*(1-0.34) = $92,400
NPV of the perpetual project
= - Initial investment +PV of UCF (UCF/R 0)
= - $475,000 + $92,400/0.20
= - $13,000
APV = NPV + Interest tax shield (t c*B)
= - $13,000+0.34*$126,229.50
= $29,918
The project is acceptable based on APV.

D/E ratio
PV of the project with initial
investment = $475,000 + $29,918 =
$504,918
Amount of debt = $126,229.50
Debt to value ratio =
126,229.50/504,918 = 0.25
Debt to equity ratio = 1/3

Cost of Equity and WACC

Cost of equity, Rs = R0+B/S*(1tc)*(R0-RB)
=
0.20+1/3*0.66*(0.20-0.10) = 0.222
WACC = *0.222+1/4*0.10*0.66 =
0.183

Flow to Equity 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
(LCFs)
Step Two: Calculate RS.
Step Three: Value the levered cash flows at RS.

Calculation of NPV under FTE

Approach
Levered cash flow, LCF = {$500,000*(1-0.72)10%*$126,229.50}*(1-0.34) = $84,068.85
NPV = - Equity investment + PV of LCF
(LCF/RS)
= - $348,770.50 + $84,068.85/0.222
= $29,918
The project is acceptable using FTE approach.

WACC Method
To find the value of the project, discount
the unlevered cash flows at the weighted
average cost of capital.
NPV = -Initial investment+PV of
UCF(UCF/WACC)
= - $475,000 + $92,400/0.183
= $29,918
The project is acceptable.
All methods yield the same result.

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, by far, the

most widely used.

Summary: APV, FTE, and

WACC
APV WACC FTE
Initial Investment
Portion

All

All

Cash Flows

UCF

UCF

LCF

Discount Rates

R0

RWACC

RS

PV of financing
effects

Yes

No

No

Equity

Summary: APV, FTE, and

WACC
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

Summary
1. The APV formula can be written as:
Additional
Initial
UCFt
APV
effects of
t
investment
t 1 (1 R0 )
debt

2. The FTE formula can be written as:

Amount
Initial
LCFt

FTE

t
t 1 (1 RS )
investment borrowed

3. The WACC formula can be written

Initial
UCFt
as
NPV

WACC

(1 R
t 1

t
)
WACC

investment

Summary
4. Use the WACC or FTE if the firm's target
debt to value ratio applies to the project
over its life.

WACC is the most commonly used by far.

FTE has appeal for a firm deeply in debt.

5. The APV method is used if the level of debt

is known over the projects life.

The APV method is frequently used for special

situations like interest subsidies, LBOs, and
leases.

6. The beta of the equity of the firm is

positively related to the leverage of the
firm.