Chapter 18
Capital Budgeting and Valuation with Leverage
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
18.2 The Weighted Average Cost of Capital Method (Slides 9–10)
• Interview with Zane Rowe
• Using the WACC to Value a Project (Slides 11–16)
• Table 18.1 Expected Free Cash Flow from Avco’s RFX Project (Slide 13)
31)
18.3 The Adjusted Present Value Method (Slides 37, 60)
• The Unlevered Value of the Project (Slides 38–42)
• Valuing the Interest Tax Shield (Slides 43–46)
18.4 The Flow-to-Equity Method (Slide 61)
• Calculating the Free Cash Flow to Equity (Slides 62–65)
• Table 18.6 Expected Free Cash Flows to Equity from Avco’s RFX Project (Slide 63)
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18.5 Project-Based Costs of Capital (Slide 77)
• Estimating the Unlevered Cost of Capital (Slides 78–81)
• Project Leverage and the Equity Cost of Capital (Slides 82–84)
18.6 APV with Other Leverage Policies (Slide 95)
• Constant Interest Coverage Ratio (Slides 96–98)
18.7 Other Effects of Financing (Slide 108)
• Table 18.9 Typical Issuance Costs for Different Securities, as a Percentage of Proceeds
(Slide 109)
18.8 Advanced Topics in Capital Budgeting (Slide 118)
• Periodically Adjusted Debt (Slide 118-123)
• Figure 18.1 Discounting the Tax Shield with Periodic Adjustments (Slide 120)
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136)
• Personal Taxes (Slides 137–139)
• Example 18.13 Using the APV Method with Personal Taxes (Slides 140–142)
Chapter 18 Appendix Foundations and Further Details
• Deriving the WACC Method (Slides 148-154)
• The Levered and Unlevered Cost of Capital (Slides 154-159)
– Target Leverage Ratio (Slide 156)
– Predetermined Debt Schedule (Slide 157–158)
– Risk of the Tax Shield with a Target Leverage Ratio (Slide 159)
• Solving for Leverage and Value Simultaneously (Slide 160)
II. Learning Objectives
18-1 Describe three methods of valuation discussed in the chapter, and list the steps in computing
each.
18-3 Estimate the cost of capital for a project, even if its risk is different from that of the firm as a
whole.
18-5 Discuss the importance of considering the overall incremental impact of the leverage of a
project on the firm.
or (2) the firm keeps debt at a constant level.
18-8 Describe situations in which the WACC method is best to use and situations in which the APV
method is advisable.
18-10 Calculate the value of the interest tax shield if a firm adjusts its debt annually to a target level.
18-12 Adjust the APV method for personal taxes.
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 79
III. Chapter Overview
This chapter discusses complexities in capital budgeting that were treated as assumptions in Chapter
7. The authors address how to estimate the appropriate cost of capital and how the financing decision
can affect the cost of capital and cash flows. The first part of the chapter introduces the three main
methods for capital budgeting with leverage and market imperfections: the weighted average cost of
18.1 Overview of Key Concepts
18.2 The Weighted Average Cost of Capital Method
The project that the next three sections will use is under consideration by Avco, Inc., a manufacturer
1. Determine the free cash flow of the investment.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the
18.3 The Adjusted Present Value Method
In the APV method, we “determine the levered value VL of an investment by first calculating its
1. Determine the investment’s value without leverage by discounting its free cash flows at the
unlevered cost of capital.
3. Add the unlevered value to the present value of the interest tax shield.
The method is a little more complicated than the WACC method, for several reasons. One reason