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)
• Table 18.2 Avco’s Current Market Value Balance Sheet ($ million) and Cost of Capital
without the RFX Project (Slide 14)
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)
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)
• Issuance and Other Financing Costs (Slide 108)
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)
• Figure 18.2 Firms’ Leverage Policies (Slide 121)
78 Berk/DeMarzo • Corporate Finance, Fourth Edition
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)
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 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
of custom packaging products. The company is considering a new line of packaging. The expected
free cash flows are given in Table 18.1.
To summarize, the steps are:
1. Determine the free cash flow of the investment.
18.3 The Adjusted Present Value Method
In the APV method, we “determine the levered value VL of an investment by first calculating its
unlevered value VU, which is its value without any leverage, and then adding the value of the interest
tax shield and deducting any costs that arise from other market imperfections.” Equation 18.5 gives
the APV formula. This method was used in Chapter 16 to determine the optimal level of debt
according to the trade-off theory.
The steps to calculating the APV method are as follows:
18.4 The Flow-to-Equity Method
This method focuses on value to shareholders. Its calculation involves computing free cash flow to
equity holders, excluding all payments made to debt. The first step is to calculate the free cash flow to
equity. Table 18.6 shows this calculation for Avco’s RFX Project.
The steps in the Flow-to-Equity Method are as follows:
1. Determine the free cash flow to equity using equation 18.9.
18.5 Project-Based Costs of Capital
This section addresses how the calculations change when the project under consideration has different
characteristics than the company as a whole. For this section, the authors suggest that Avco launch a
new plastics manufacturing division that is very different from its main packaging business. The first
18.6 APV with Other Leverage Policies
When the debt-equity ratio is not constant, the WACC and FTE approaches are difficult to use. The
APV method is fairly easy. This section of the chapter shows how APV can be adjusted when there is
18.7 Other Effects of Financing
This section considers ways to adjust valuation to account for issuance costs, security mispricing, and
financial distress and agency costs.
18.8 Advanced Topics in Capital Budgeting
Four complications are addressed in this section. The first is the case in which debt is periodically
adjusted, the second is the relationship between a firm’s equity and unlevered cost of capital for
Three different levels of frequency with which debt is assumed to adjust to growth of the
investment are considered here: (1) continuously adjusted debt, (2) annually adjusted debt, and (3)
Chapter 18 Appendix: Foundations and Further Details
The appendix derives the WACC method starting by redefining WACC in terms of firm value. It
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 18 have spreadsheet versions of the problems available: 15, 16,
18, 21, 26, and 28.