© the mcgraw-hill companies, inc., 2000 irwin/mcgraw hill 19- 1 topics covered after tax wacc ...
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©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
19- 1
Topics Covered
After Tax WACC Tricks of the Trade Capital Structure and WACC Adjusted Present Value
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
19- 2
Alternative Specifications
Tax-adjusted required rate
where t = marginal corporate tax rate
D/V = virtual debt ratio
r = rF + (rM – rF)
)1(*
V
Dtrr
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
19- 3
After Tax WACC
The tax benefit from interest expense deductibility must be included in the cost of funds.
This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.
ED r
V
Er
V
DWACC
ED r
V
Er
V
DWACC
Old Formula
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19- 4
After Tax WACC
ED r
V
Er
V
DTcWACC )1(
Tax Adjusted Formula
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19- 5
After Tax WACC
Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?
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19- 6
After Tax WACCExample - Sangria Corporation - continued
Balance Sheet (Book Value, millions)Assets 100 50 Debt
50 EquityTotal assets 100 100 Total liabilities
Balance Sheet (Book Value, millions)Assets 100 50 Debt
50 EquityTotal assets 100 100 Total liabilities
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19- 7
After Tax WACCExample - Sangria Corporation - continued
Balance Sheet (Market Value, millions)Assets 125 50 Debt
75 EquityTotal assets 125 125 Total liabilities
Balance Sheet (Market Value, millions)Assets 125 50 Debt
75 EquityTotal assets 125 125 Total liabilities
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19- 8
After Tax WACCExample - Sangria Corporation - continued
Debt ratio = (D/V) = 50/125 = .4 or 40%
Equity ratio = (E/V) = 75/125 = .6 or 60%
ED r
V
Er
V
DTcWACC )1(
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19- 9
After Tax WACCExample - Sangria Corporation - continued
ED r
V
Er
V
DTcWACC )1(
%84.10
1084.
146.125
7508.
125
50)35.1(
WACC
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19- 10
After Tax WACCExample - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax.
Given an initial investment of $12.5 million, what is the value of the machine?
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19- 11
After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?
Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million
Cash FlowsPretax cash flow 2.085Tax @ 35% 0.73After-tax cash flow $1.355 million
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
19- 12
After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?
01084.
355.15.12
10
gr
CCNPV
01084.
355.15.12
10
gr
CCNPV
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19- 13
After Tax WACC
Preferred stock and other forms of financing must be included in the formula.
EPD r
V
Er
V
Pr
V
DTcWACC )1(
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19- 14
After Tax WACC
Balance Sheet (Market Value, millions)Assets 125 50 Debt
25 Preferred Equity50 Common Equity
Total assets 125 125 Total liabilities
%04.11
1104.
146.125
5010.
125
2508.
125
50)35.1(
WACC
Example - Sangria Corporation - continuedCalculate WACC given preferred stock is $25 mil of total equity and yields 10%.
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19- 15
Adjusted Present Value
APV = Base Case NPV
+ PV Impact
Base Case = All equity finance firm NPV. PV Impact = all costs/benefits directly
resulting from project.
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19- 16
example:
Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.
Adjusted Present Value
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19- 17
example:
Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000.
Project NPV = 150,000
Stock issue cost = -200,000
Adjusted NPV- 50,000
don’t do the project
Adjusted Present Value
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19- 18
example:
Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.
Adjusted Present Value
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
19- 19
example:
Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. Assume that Project B is your only option.
Project NPV = - 20,000
Stock issue cost = 60,000
Adjusted NPV 40,000
do the project
Adjusted Present Value
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19- 20
Topics Covered
Leveraged Buyouts Spin-offs and Restructuring Conglomerates Private Equity Partnership Control and Governance
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Definitions
Corporate control -- the power to make investment and financing decisions.
Corporate governance -- the role of the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions.
Financial architecture -- the financial organization of the business.
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19- 22
Leveraged Buyouts
The difference between leveraged buyouts and ordinary acquisitions:
1. A large fraction of the purchase price is debt financed.
2. The LBO goes private, and its share is no longer trade on the open market.
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19- 23
Leveraged Buyouts
The three main characteristics of LBOs:
1. High debt
2. Incentives
3. Private ownership
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19- 24
Leveraged Buyouts
Acquirer Target Year Price ($bil)
KKR RJR Nabisco 1989 24.72$ KKR Beatrice 1986 6.25$ KKR Safeway 1986 4.24$ Thompson Co. Southland 1987 4.00$ AV Holdings Borg-Warner 1987 3.76$ Wing Holdings NWA, Inc. 1989 3.69$ KKR Owens-Illinois 1987 3.69$ TF Investments Hospital Corp of America 1989 3.69$ FH Acquisitions For Howard Corp. 1988 3.59$ Macy Acquisition Corp. RH Macy & Co 1986 3.50$ Bain Capital Sealy Corp. 1997 811.20$ Citicorp Venture Capital Neenah Corp. 1997 250.00$ Cyprus Group (w/mgmt) WESCO Distribution Inc. 1998 1,100.00$ Clayton, Dublier & Rice North Maerican Van Lines 1998 200.00$ Clayton, Dublier & Rice (w/mgmt) Dynatech Corp. 1998 762.90$ Kohlberg & Co. (w.mgmt) Helley Performance Products 1998 100.00$
10 Largest LBOs in 1980s and 1997/98 examples
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Private Equity Partnership
Investment PhaseInvestment Phase Payout PhasePayout Phase
General Partner put up 1% of capital
General Partner get carried interest in 20% of profits
Limited partners put in 99% of capital
Limited partners get investment
back, then 80% of profits
Investment in diversified portfolio of companies
Sale or IPO of companies
Partnership Partnership
Company 1Company 1
Company 2Company 2
Company NCompany N
Mgmt fees