IsWrong

Anna Kramer, a recent Wharton graduate, is evaluating a project for Unitron that is virtually risk-

less and returns 12 percent per year.Given that the risk-free borrowing rate is currently at 10

percent, she recommends to her supervisor that the company undertake the project because

¹⁴Alternatively,

we could have a) used a formula that substitutes the risk-premiums of levered and

unlevered assets for betas in equation (13.7) to unlever the equity expected returns associated with the

comparison firms’equity betas, or b) used the Modigliani-Miller adjusted cost of capital formula to

unlever the comparable firms’WACCs, as computed from equation (13.8) with the risk-free rate as the

input for the cost of debt. These two approaches give the same answer as the procedure described in the

text, although it is important to recognize that both equation (13.1) and the adjusted cost-of-capital

formula assume risk-free debt. Hence, if any portion of the estimation does not use the risk-free rate for

the cost of debt, it will appear as if the methods are providing different answers, when they are simply

being applied incorrectly.

¹⁵If

we were using the APVmethod, we would use the unlevered cost of capital, estimated from the

comparison firms, to obtain the value of the unlevered assets of Marriott’s restaurant division by

discounting its unlevered future cash flows. We would then add the present value of the restaurant

division’s debt tax shield to obtain the value of the restaurant division’s assets.

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Markets and Corporate		the Impact of Financing on	Companies, 2002
Strategy, Second Edition		Real Asset Valuation

Chapter 13

Corporate Taxes and the Impact of Financing on Real Asset Valuation

489

its return exceeds the cost of capital for a riskless project.Her supervisor, Harold McGovern, a

1952 Wharton graduate, thinks that the company should reject the project.He notes that Uni-

tron, which is highly levered, has a BBB debt rating and cannot borrow at the 10 percent rate

assumed in Kramer’s analysis.How can Unitron make money, he asks, if it borrows at 13 per-

cent to fund an investment that yields only 12 percent? Kramer finds it difficult to answer this

question.On the one hand, she has been taught that risk-free projects should be discounted at

the risk-free rate.However, when taking the project’s financing mix into account, the project gen-

erates negative cash flows to the firm’s equity holders.Who is right?

Answer:McGovern is correct if you believe the firm’s goal is to maximize its share price.

However, to maximize the value of the firm, as would be the case if the firm was also

beholden to bankers and other debt holders, Kramer’s point is correct.

In the last example, the cash flows from the Unitron project that accrue to the

equity holders are negative with certainty. This implies that the value to the equity hold-

ers must necessarily be negative. However, since these certain returns of the project

exceed the risk-free return, the project must create value for someone. In this example,

the project creates value for existing debt holders. The addition of a riskless project

reduced the overall risk of the firm, which in turn increases the amount that the debt

holders expect to recover in the event of default.¹⁶

Example 13.16 illustrates that it is not enough to ask whether a project generates

a value that exceeds its cost. Instead, the analyst has to ask whether the value created

accrues to the firm’s equity holders or its debt holders. In Example 13.14, where United

Technologies had no debt, the marginal WACC generated a project selection rule that

maximized share price. It is important to emphasize that the shareholders of United

Technologies would have profited even if their project had been financed with new

debt. However, when a firm is already partly financed with debt, as in Example 13.16,

discounting expected unlevered cash flows with the marginal WACC measures a value

that accrues to existing debt holders as well as equity holders.

Computing Cash Flows to Equity Holders

For the firm as a whole, cash flow to equity holdersis the pretax unlevered cash flow

less payments to debt holders less taxes. Computing a project’s incremental cash

flows to equity holders is similar to the computation of incremental real asset

cash flows described in Chapter 10. First, compute the cash flows equity holders receive

(from all of the firm’s existing projects) if the new project is not adopted; then, sub-

tract this from the cash flows to the sameshareholders, assuming that the project is

adopted. This difference is the project’s incremental cash flow to equity holders.

While it is easy to state how to compute incremental cash flows, it is not simple

to implement this computation in practice. Analysts typically avoid the complexities by

computing the cash flow to equity holders as the difference between the incremental

unlevered cash flows of the project and the after-tax interest payments associated with

the project’s debt financing. This approach is correct with non-recourse debt, also

called project financing, which is debt with claims only to the project’s cash flows.

However, it should be noted that, with non-recourse debt, the cash flows that accrue to

the equity holders from a project can never be negative and thus have option-like

¹⁶Chapter

16 will discuss this in detail. As Chapter 16 points out, the opposite is also true: For equity

holders, high-risk projects are more attractive than comparable NPVlow-risk projects when the firm’s

debt is risky.

Grinblatt993Titman: Financial	III. Valuing Real Assets	13. Corporate Taxes and	© The McGraw993Hill
Markets and Corporate		the Impact of Financing on	Companies, 2002
Strategy, Second Edition		Real Asset Valuation

490Part IIIValuing Real Assets

properties. When a firm finances a project with corporate debt (with claims on all cor-

porate assets) one must take into account that the cash flows to equity holders can be

negative. In addition, as we will discuss in more detail in Chapter 16, the incremental

cash flows to equity holders, in this case, will also be determined by the correlation

between the new project returns and the returns on existing projects. When the corre-

lation is very low, the new project decreases the overall risk of the firm (through the

diversification effect), and thus a large portion of the value created by the project

accrues to the firm’s debt holders. When the project is very risky, and highly correlated

with existing projects, the cash flows to equity holders will often be higher, and the

implementation of the project might hurt the debt holders.