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Chapter 5
Discussion Topics
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Countervailing Forces
We do not observe companies maximizing debt to maximize the
value from interest tax shields
Countervailing forces offset the benefits of ITSs
Potential forces are real and can be large (more in Chapter 11)
Financial distress or bankruptcy costs
Agency costs between owner/managers and debtholders (such as enforcing bond
covenants)
Difference in personal income tax rates between investor returns on equity and
debt
Will the company be sufficiently profitable to use the interest deduction?
Conclusion – debt creates some value, depending on the magnitude of the
countervailing forces
Could also have other value from financing from a government subsidized
interest rate, but this is less common
For our purposes, we’ll assume the value created from financing is equal to the
value of the interest tax shields, VFIN = VITS for now
© Robert W. Holthausen Corporate Valuation - Chapter 5 18
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No ITS
Same free Different discount rates separate in
cash flows rWACC ≤ rUA WACC
method
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If you know
all that, what
do you know?
© Robert W. Holthausen Corporate Valuation - Chapter 5 52
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Implementation Details
Interest Deduction Limitations
Adjusting for inflation
Expected free cash flows – what are they?
Risk-adjusted discount rates and the certainty
equivalent approach
Do not use fudge factors
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Real valuation
VF = FCF0 x (1+greal)/(rreal – greal)
greal = (1+gnominal)/(1+inflation)-1
= 1.122/1.1 – 1 = .02
rreal = (1+rnominal)/(1+inflation)-1
= 1.155/1.1 – 1 = .05
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What is rWACC?
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© Cambridge Business Publishers 2019 101 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 103 Corporate Valuation by Holthausen & Zmijewski
© Cambridge Business Publishers 2019 104 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 105 Corporate Valuation by Holthausen & Zmijewski
© Cambridge Business Publishers 2019 106 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 107 Corporate Valuation by Holthausen & Zmijewski
© Cambridge Business Publishers 2019 108 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 111 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 113 Corporate Valuation by Holthausen & Zmijewski
© Cambridge Business Publishers 2019 114 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 115 Corporate Valuation by Holthausen & Zmijewski
© Cambridge Business Publishers 2019 116 Corporate Valuation by Holthausen & Zmijewski
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© Cambridge Business Publishers 2019 117 Corporate Valuation by Holthausen & Zmijewski
Note – the unlevered and equity free cash flows have to grow at the
same rate for all the methods to yield the same answer
© Cambridge Business Publishers 2019 118 Corporate Valuation by Holthausen & Zmijewski
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Laid-Back Takeaways
WACC DCF method is directly implementable when
capital structure ratios are known – APV method is not
APV DCF method is directly implementable when dollar
magnitudes of debt, interest and interest tax shields are
known – WACC DCF method is not
WACC and APV methods yield the same value if given
the same information but we always have to solve for the
value of the firm each period to use the other method
Equity DCF method is never directly implementable as
must always solve for the value of the firm in each period
to determine the equity cost of capital or EFCF
© Cambridge Business Publishers 2019 119 Corporate Valuation by Holthausen & Zmijewski
What We Covered
© Cambridge Business Publishers 2019 120 Corporate Valuation by Holthausen & Zmijewski
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Interest tax shields are often measured as the tax rate x interest
ITS = TINT x INT
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No ITS
Same free Different discount rates separate in
cash flows rWACC ≤ rUA WACC
method
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