CORPORATE FINANCE EVENING PROGRAM
WEEK 7
SOME QUESTIONS TO THINK ABOUT
ANSWERS
At the end of the slides in week 7 there are the following two questions.
•A relatively recent innovation is ‘integrated finance’. This involves a single bank holding all the liabilities of a company (debt and equity). What’s the advantage of this?
Answer: Some of the costs of leverage are caused by conflicts between debt and equity holders. For instance, when a firm is put into financial distress by the debt holders, the cost is borne largely by the equity holders. If both the debt and equity are held by the same bank, then the capital structure can be managed to avoid these conflicts and maximise the benefits such as tax savings. It is difficult, however, to do this with very large firms, as it would involve banks holding huge stakes in these firms. So it is done only with small firms.
•Suppose that a company has an asset beta of 0.8, the riskless rate is 5%, the market risk premium 6%. There are no taxes. The operating free cash flow consists of $100 after one year and $100 after two years (that’s the lot). The company has to pay $70 to buy the assets that generate these flows. It will do this with $70 of debt and it will pay back $40 of the debt at the end of the first year. What is the value of the equity of the company at date zero? What is the value of the equity at date one? Calculate the discount rates that you would have to use to value the equity free cash flow and get the correct equity values. How does this relate to the amount of leverage at each date?
Answer:
The numbers work out as in the following table. Starting from the operating FCF, we can calculate the present value of the entire project at each stage using the required return on assets of (5%+0.8*6%), which is 9.8%.
After the initial investment of 70 has been made the project is worth 174.02. At the end of year one, once the first cash flow has been received, it is worth 91.07, the value at time one of the year two cash flow. At these dates, the outstanding debt is 70 and 30, respectively. The market value leverage is the ratio of the debt outstanding to the market value of the project.
Time / Operating / PV / PV / Debt / debt/value / Equity beta / RE / Equity / EquityFCF / Remaining / FCF / value
Op FCF
0 / -70 / -70 / 174.02 / 70 / 40.23% / 1.34 / 13.03% / 104.02
1 / 100 / 91.07 / 91.07 / 30 / 32.94% / 1.19 / 12.16% / 56.5 / 61.07
2 / 100 / 82.95 / 68.5
We then use this leverage ratio to calculate the equity beta that applies to each year. For the first year it is 1.34, for the second year 1.19 because the leverage has decreased. The next column shows the equity discount rates that these betas give. These are then used to discount the equity free cash flows. The equity free cash flow in the first year is 100 of operating free cash flow minus 40 of debt repayment minus 3.5 of interest, which is 56.5. The equity free cash flow in the second year is calculated in the same way. The final column uses these equity free cash flows with the equity discount rates to calculate the value of the equity. For the second year we discount 68.5 at 12.16% to give 61.07 as the equity value at the beginning of the second year. Notice that this is equal to the asset value of 91.07 minus the debt of 30. To get the year zero equity value we discount the year one equity free cash flow of 56.5 plus the year one equity value of 61.07 at the year zero equity rate of 13.03%. This gives a time zero equity value of 104.02, which is equal to the asset value of 174.02 minus the debt of 70.
Note how much easier it is to do everything with the operating cash flows.
The spreadsheet from which the above table is taken is also on this website.