W5 Flashcards
(25 cards)
What is capital budgeting with leverage?
It is the process of evaluating investment projects considering both their operating cash flows and financing effects like debt tax shields.
What is free cash flow (FCF)?
Cash flow available to all investors after operating expenses, taxes, capital expenditures, and changes in net working capital.
What is debt capacity?
The amount of debt a firm can sustain at a given time while maintaining its target debt-to-value ratio.
What is a pro forma statement?
A financial statement projecting future income or cash flows under specific assumptions.
What are the three main methods for valuation with leverage?
- Weighted Average Cost of Capital (WACC) Method
- Adjusted Present Value (APV) Method
- Flow-To-Equity (FTE) Method.
What is the assumption behind all three valuation methods giving the same result?
If assumptions are equal (constant risk, constant D/E, taxes only imperfection), then all three methods produce the same valuation.
What is the WACC formula?
WACC = (E / (E + D)) * rE + (D / (E + D)) * rD * (1 − τc), where:
E = equity, D = debt, rE = cost of equity, rD = cost of debt, τc = corporate tax rate.
How does the WACC method value a project?
By discounting future free cash flows using the WACC, which includes the benefit of the debt tax shield.
What are the steps in the WACC method?
- Estimate free cash flows
- Compute WACC
- Discount FCFs using WACC to get levered value.
What is the APV formula?
APV = Unlevered Value + Present Value of Interest Tax Shield.
When is the APV method preferred?
When the firm’s capital structure is changing or when debt is project-specific.
What is the unlevered cost of capital?
rU = (E / (E + D)) * rE + (D / (E + D)) * rD, assuming no tax effects.
What is the FTE (flow-to-equity) method?
A valuation method where the value of equity is calculated by discounting expected cash flows to equity using the cost of equity.
What is the formula for equity value under FTE?
Equity Value = Present Value of Free Cash Flows to Equity, discounted at rE.
What is the formula for debt capacity at time t?
Dt = d × VLt, where d is the target debt-to-value ratio and VLt is the levered value at time t.
What is the continuation value formula?
VLt = (FCFt+1 + VLt+1) / (1 + rwacc), used to compute project value going backward in time.
How is sensitivity analysis used in valuation?
To test how changes in assumptions like growth rate, margins, or WACC affect valuation outcomes.
Why is it important to use comparables cautiously?
Because differences in growth, efficiency, and risk can distort the value derived from peer multiples.
What is the role of financial modeling in valuation?
To create detailed forecasts of operations and cash flows, which help assess investment feasibility and estimate firm value.
What are the steps to value a project using the Flow-To-Equity (FTE) method?
- Calculate free cash flows to equity: Net income + Depreciation - CapEx - ∆NWC - Debt repayments + Debt issuance.
- Use the cost of equity (rE) to discount the cash flows to equity.
- Sum the discounted equity cash flows to get the equity value of the project.
What is the detailed formula for Free Cash Flow (FCF)?
FCF = EBIT × (1 − τc) + Depreciation − Capital Expenditures − Change in Net Working Capital (∆NWC)
How can the APV method be adjusted for changing debt levels?
If the debt level varies over time, calculate the present value of the interest tax shield using the actual debt schedule and a discount rate appropriate to the tax shield’s risk.
What formula is used to value a growing perpetuity in capital budgeting?
Value = Cash Flow at t1 / (WACC − g), where g is the growth rate of the cash flow.
Why is maintaining a target debt-to-value ratio important in valuation?
It ensures that the firm’s risk profile remains consistent, allowing WACC or APV assumptions to hold and enabling consistent valuation over time.
