3. The Cost of Capital

3.3. Summary

The preceding sections have discussed the relation between leverage and the cost of capital in a world with taxes. We have also seen how to incorporate the interest tax savings in the valuation of the company and its equity. 

 

A: What's the firm's financing policy?

The answer to this question helps us identify the riskiness of the future interest tax savings.

  • If the firm pursue a target debt ratio (debt in % of firm value), the risk of the DTS is similar to that of the overall assets. We can therefore use the overall cost of capital, kA, as the discount rate for the future expected tax savings.
  • If the firm pursues target debt levels (in currency), the risk of the DTS is similar to that of the firm's debt, which is why we use the cost of debt, kD, as the discount rate for the future expected tax savings.

  

B: What are the valuation implications?

Our next step was then to study the valuation implications of the financing policy. To do so, we have used a two-step valuation approach:

  • Step 1: Estimate the unlevered value of the company, VU.
    • In our simplified world, we found the unlevered value by dividing the net income of the fully equity financed firm by the overall cost of capital.
    • In a more realistic setup, we would forecast the firm's free cash flows and capitalize them with the overall cost of assets. For a detailed discussion of this approach, please refer to the module Cost of Capital and Valuation.
  • Step 2: Estimate the value of the future interest tax savings (DTS)
    • Forecast the future interest expenses and the associated tax savings
    • Compute the present value of these tax savings using the discount rate that matches the firm's financing policy (step A).

 

The basic logic of this valuation approach is, therefore, to estimate the base value of the company without debt financing (VU) and then adjust the valuation for financing effects. This is why this valuation method is generally referred to as the Adjusted Present Value (APV) Approach.

In the next section, we will briefly illustrate an alternative way to incorporate the side effects of financing, namely the Weighted Average Cost of Capital (WACC) Approach.