[hplzz]

Hello.
I have a investment question.
The investment will cost me approximatly 2 million, and will be depriciated in 10 years time, My expected EBIT is expected to be 400 tousand each year in 10 year time. D/E ratio will be 1/3 with rE 8%, rD 15% and tax rate 30%.
I need to now the NPV and IRR before and after taxes.

I've come up to solutions but I'm not sure if I've caltulated right.
Help appreciated!

[ArcSine]

Happy to help, hplzz. Just show your answers, and the calculations you used to get there, and plenty o' guidance will be forthcoming. Back to you.

[hplzz]

Thanks.
Well, I think the net income, the free cash flow before tax will be 400' + ( 200'in depriation(2 million / 10)) for each year (year 1 - 10). In year 0, now that is, the cash flow is -2 million. So, using the WACC that we can calculate from the data we have (13,25%) I can know the NPV.
And after tax the wacc I get is 12,65%. So I will use that wacc then, and subtract the tax from EBIT with 30%.
Is that right?
And if the D/E changes during time, will that affect anything?

[ArcSine]

We've first got to make sure we're crunching exactly the same data. Your original post has debt standing at a 1:3 ratio with equity, which means Debt represents 1/4 of the total capital structure, and Equity is 3/4.

You also have the pre-tax cost of Equity as 8% and Debt's pre-tax cost as 15%.

So first confirm whether those are indeed the correct values we're working with. If they are, carefully recompute your pre- and post-tax WACC numbers, or show your calculations thereof, and we'll go from there.

[hplzz]

I think the debt represents 1/3 and equity 2/3, since its 1/3 D/E.
The cost of equity and debt are correct.
So putting these values on the wacc formula pre-tax I get 13,25%, and after tax 12,65%. In the calculations I used 1/3 as D, and 1 as E. Now Im even more confused, whether its 1 or 2/3 for E.

[hplzz]

I've look more into this now, and as you said the E is 3/4 and D 1/4.
But after this change I still get the same Wacc.

[ArcSine]

Your pre-tax WACC would be correct IF debt had a weight of 3/4 in the weighted-average computation, and equity had a weight of 1/4. But remember that if debt is 1/3 of equity, then its WACC weight is 1/4 and equity's weight is 3/4. So it appears you are reversing the weights in your pre-tax WACC calc'n.

Your post-tax WACC number seems to have a kink in it somewhere. If debt's pre-tax cost is 15%, and the tax rate is 30%, debt's after-tax cost is 0.15 x (1 - 0.30) = 10.5%.

So rerun your WACC calculations, and it'd be helpful if you'd show the details of your computations.

Also, carefully verify those capital cost rates against your textbook question. Not always, but typically, debt's cost is lower than equity's.

[hplzz]

You are absolutely right. The dept capital cost is lower, my mistake. So rE is 15% and rD 8%.
Maybe now, because of that, the wacc calculation is correct? I've calculated with the right data. I just mistaped the rD and rE here.
So again, using the wacc formula I get 13,25 pretax, and 12,65 after. (Using these data: Equity to value is 0,25 multiplied with the cost of equity, therefor Debt to value must be 0,75 multiplied with cost of debt, and 1 - tax rate for the post-tax wacc.

[hplzz]

Edit: equity to value 0,75 and debt 0,25, of course.

[ArcSine]

Yep, now you've got it going on. You had the correct pre- and post-tax WACC in your earlier posts, but those results were not derived from the information exactly as it was posted. And this is one of those cases where how you get there is as important---or more so---than simply having the correct answer.

Moving along, when valuing the firm using the WACC you generally want to use a hypothetical cash flow amount which represents the net after-tax cash flow the firm would generate IF it was all-equity; i.e. no deductible interest payments. That's because you've already allowed for the tax-savings effect of the interest in the WACC computation itself (here, e.g. the cost of debt in the WACC result is only 70% of its true pre-tax cost).

Thus if you also adjusted the cash flows to reflect the deductibility of the interest, you'd in effect be double-counting the tax-shield benefits when you discounted these cash flows by the WACC rate.

[hplzz]

Thanks again for replying.
Im not even sure if I'll calculate it with interest tax shield, since this is all the data I've got.
For the calculations without tax, this is how I've done:
Adding up 200' from the 10 year depreciation on the 400' EBIT from year 1-10 as I mentioned earlier. And -2mil on year 0. From that I got the cash flows and then discounted it with the calculated pre-tax wacc. Simple as that I got the NPV summarazing the present values. If that is the right way to do of course.
For the post-tax calculation I did subtract 120'(tax 30%) from the EBIT year 1-10, and then adding upp 200' in depreciation and also the -2mil in year 0. This way I got the cash flow and then discount them with my post-tax wacc. I haven't taken any consideration regarding interest tax shield, nor how this will affect the results if the D/E will change during time, so far. Not even sure how to do it.

[ArcSine]

Sounds good. You've discounted the pre-tax cash flows (EBIT + depreciation) at the pre-tax WACC rate, and the post-tax flows (EBIT + depreciation - tax on EBIT) at the after-tax WACC rate.

The tax-shield benefit of the interest deductibility is already in your post-tax calc. In the numerator of each present-value calculation you've reduced the cash flow amount by a hypothetical tax amount that would be paid if it was ALL equity-financed (30% on the entire EBIT). But then in the denominator the cost of the debt has been reduced to its after-tax amount (rD x 70%), so that the tax-deductible benefit of the interest expense is captured in the denominator.

As to the method for handling an expected change in the D/E ratio going forward, I'm afraid you'll have to consult your text for that. There are different schools of thought and correspondingly, different methods. But when it comes to getting credit on homework or a quiz, of course, the only method that counts is the one prescribed by the book or instructor.

It's nearly a given that if the ratio changes significantly, the costs of the components will change commensurately. If, e.g. a firm increases its leverage from 1/3 D/E (as in your case) to 3/2, it's a sure bet that the lenders will no longer be satisfied with just 8%, since their debt is now noticeably riskier.

So, unless you've given info on exactly how the component costs will change in response to D/E ratio changes, it's back to the instructor for specific guidance.

Best of luck with it!

[hplzz]

All right, thanks again!