Valuation with Changing Capital Structure Arzac, Chapter 6

Leverage Changes

• increase in debt ratio affects value

• value increases by extra value of interest tax shield • value decreases due to increase in cost of equity due to risk increasing

• relatively constant debt ratio implies use of WACC to discount FCFs • use different valuation method if debt ratio changes (especially large changes in ratio)

Adjusted Present Value

• Myers (1974) • value two components:

• unlevered FCFs discounted at the after-personal tax cost of capital of unlevered firm • tax shield discounted at the after-personal tax cost of debt

• AdvPak example

• plan to spin off to shareholders with $20million of debt which gradually increases to target debt ratio of 35% (Exhibit shows planned debt increases)

Exhibit 6.1. AdvPak Technologies. Adjusted Present Value Valuation as of 12/31/2006

($000) Year-end 2006 2007 2008 2009 Net Sales EBITDA Depreciation EBIT Taxes Unlevered net income Deferred taxes NOPAT Depreciation Capex & NWC incr.

Unlevered free cash flow Net debt at year-end Interest @ Tax shield Unlevered cost of equity PV FCF 2007-2011 @ Continuation value @ WACC PV '11 Cont. value @ PV Tax shield @ Enterprise value 38.25% 8.52% 38.25% 11.17% 10.03% 11.17% 8.52% 203,580 19,901 10,695 9,206 3,521 5,685 20,000 27,036 186,295 6,576 219,907 220,758 28,699 10,775 17,923 6,856 11,068 403 11,470 10,775 12,709 9,537 40,000 1,704 652 239,386 34,711 12,132 22,579 8,636 13,942 331 14,274 12,132 19,677 6,729 50,000 3,408 1,304 258,605 36,205 14,238 21,967 8,402 13,565 281 13,846 14,238 21,557 6,526 70,000 4,260 1,629 2010 2011 279,368 39,112 15,286 23,826 9,113 14,713 302 15,014 15,286 24,333 5,966 90,000 5,964 2,281 300,369 42,052 16,295 25,757 9,852 15,905 322 16,226 16,295 25,121 7,400 110,730 7,668 2,933 316,370

Exhibit 6.2. AdvPak Technologies

APV Valuation of Acquisition Financed with Leverage above Target as of 12/31/2006

($000) Year-end 2006 2007 2008 2009 2010 2011 Net Sales EBITDA Depreciation EBIT Net interest expense Income before taxes Taxes Net income Depreciation Deferred taxes 38.25% Capex and increase in net working cap.

Available for debt retirement 203,580 19,901 10,695 9,206 220,758 28,699 10,775 17,923 9,969 7,954 3,043 4,912 10,775 403 12,709 3,381 239,386 34,711 12,132 22,579 9,681 12,898 4,934 7,965 12,132 331 19,677 752 258,605 36,205 14,238 21,967 9,617 12,350 4,724 7,626 14,238 281 21,557 588 279,368 39,112 15,286 23,826 9,567 14,259 5,454 8,805 15,286 302 24,333 59 300,369 42,052 16,295 25,757 9,562 16,195 6,195 10,000 16,295 322 25,121 1,496 Net debt Interest @ Tax shield 8.52% Net income Interest after taxes Unlevered net income Deferred taxes NOPAT Depreciation Capex and increase in net working cap.

Unlevered free cash flow 117,005 113,624 9,969 3,813 112,873 9,681 3,703 112,285 9,617 3,678 112,226 9,567 3,659 110,730 9,562 3,657 4,912 6,156 11,068 403 11,470 10,775 12,709 9,537 7,965 5,978 13,942 331 14,274 12,132 19,677 6,729 7,626 5,938 13,565 281 13,846 14,238 21,557 6,526 8,805 5,907 14,713 302 15,014 15,286 24,333 5,966 10,000 5,904 15,905 322 16,226 16,295 25,121 7,400 Unlevered cost of equity PV FCF 2007-2011 @ Continuation value @ WACC PV '11 Cont. value @ PV Tax shield @ Enterprise value 11.17% 11.17% 10.03% 11.17% 8.52% 27,036 186,295 14,605 227,936 316,370

Exhibit 6.3. AdvPak Technologies

Recursive WACC Valuation of Acquisition Financed with Leverage above Target as of 12/31/2006

($000) Year-end 2006 2007 2008 2009 2010 Net Sales EBITDA Depreciation EBIT Net interest expense Income before taxes Taxes Net income Depreciation Deferred taxes 38.25% Capex and increase in net working cap.

Available for debt retirement 203,580 19,901 10,695 9,206 220,758 28,699 10,775 17,923 9,969 7,954 3,043 4,912 10,775 403 12,709 3,381 239,386 34,711 12,132 22,579 9,681 12,898 4,934 7,965 12,132 331 19,677 752 258,605 36,205 14,238 21,967 9,617 12,350 4,724 7,626 14,238 281 21,557 588 279,368 39,112 15,286 23,826 9,567 14,259 5,454 8,805 15,286 302 24,333 59 300,369 42,052 16,295 25,757 9,562 16,195 6,195 10,000 16,295 322 25,121 1,496 Net debt Interest @ Tax shield 8.52% 117,005 113,624 9,969 3,813 112,873 9,681 3,703 112,285 9,617 3,678 112,226 9,567 3,659 2011 110,730 9,562 3,657 Net income Interest after taxes Unlevered net income Deferred taxes NOPAT Depreciation Capex and increase in net working cap.

Unlevered free cash flow Riskless rate Equity premium Size premium Unlevered equity beta Debt ratio Relevered equity beta Relevered cost of equity WACC Continuation value @ WACC Enterprise value 4.62% 4.36% 3.90% 0.608

10.03% 226,983 4,912 6,156 11,068 403 11,470 10,775 12,709 9,537 7,965 5,978 13,942 331 14,274 12,132 19,677 6,729 7,626 5,938 13,565 281 13,846 14,238 21,557 6,526 8,805 5,907 14,713 302 15,014 15,286 24,333 5,966 10,000 5,904 15,905 322 16,226 16,295 25,121 7,400 52% 1.26

14.00% 9.49% 48% 1.16

13.58% 9.62% 238,994 255,264 44% 1.09

13.28% 9.73% 273,580 41% 1.03

13.02% 9.84% 294,521 38% 0.98

12.81% 9.93% 316,370 316,370

Riskless rate Equity premium Size premium Unlevered equity beta Debt ratio Relevered equity beta Relevered cost of equity WACC Continuation value @ WACC Enterprise value Unlevered cost of equity PV FCF 2007-2011 @ Continuation value @ WACC PV '11 Cont. value @ Enterprise value 4.62% 4.36% 3.90% 0.608

10.03% 226,983 52% 1.26

14.00% 9.49% 48% 1.16

13.58% 9.62% 238,994 255,264 44% 1.09

13.28% 9.73% 273,580 41% 1.03

13.02% 9.84% 294,521 38% 0.98

12.81% 9.93% 316,370 316,370 11.17% 11.17% 11.17% 11.17% 27,036 186,295 13,652 226,983

Exhibit 6.4. AdvPak Technologies

Compressed APV Valuation of Acquisition Financed with Leverage above Target as of 12/31/2006

($000) Year-end 2006 2007 2008 2009 2010 2011 Net Sales EBITDA Depreciation EBIT Net interest expense Income before taxes Taxes Net income Depreciation Deferred taxes 38.25% Capex and increase in net working cap.

Available for debt retirement 203,580 19,901 10,695 9,206 220,758 28,699 10,775 17,923 9,969 7,954 3,043 4,912 10,775 403 12,709 3,381 239,386 34,711 12,132 22,579 9,681 12,898 4,934 7,965 12,132 331 19,677 752 258,605 36,205 14,238 21,967 9,617 12,350 4,724 7,626 14,238 281 21,557 588 279,368 39,112 15,286 23,826 9,567 14,259 5,454 8,805 15,286 302 24,333 59 300,369 42,052 16,295 25,757 9,562 16,195 6,195 10,000 16,295 322 25,121 1,496 Net debt Interest @ Tax shield 8.52% Net income Interest after taxes Unlevered net income Deferred taxes NOPAT Depreciation Capex and increase in net working cap.

Unlevered free cash flow 117,005 113,624 9,969 3,813 112,873 9,681 3,703 112,285 9,617 3,678 112,226 9,567 3,659 110,730 9,562 3,657 4,912 6,156 11,068 403 11,470 10,775 12,709 9,537 7,965 5,978 13,942 331 14,274 12,132 19,677 6,729 7,626 5,938 13,565 281 13,846 14,238 21,557 6,526 8,805 5,907 14,713 302 15,014 15,286 24,333 5,966 10,000 5,904 15,905 322 16,226 16,295 25,121 7,400 Unlevered cost of equity PV FCF 2007-2011 @ Continuation value @ WACC PV '11 Cont. value @ PV Tax shield @ Enterprise value 11.17% 11.17% 10.03% 11.17% 11.17% 27,036 186,295 13,652 226,983 316,370

Problem 6.2

• Obtain the original APV of TPI Inc. using the data of Problem 2.7, and compare your result to that obtained using WACC in the solution to Problem 2.7. Project interest expenses on the basis of the EBIT coverage ratio. For continuous value, use the enterprise value calculated with WACC for a 26% debt ratio. Unlever beta using equation 3.17.

TPI, Inc. Adjusted Present Value Valuation as of 12/31/2007

($ millions) Year-end EBITDA Depreciation EBIT Taxes Unlevered net income Deferred taxes NOPAT Depreciation CAPEX & NWC incr.

Unlevered free cash flow EBIT interest coverage Interest expense @ Tax shield 38% 7.86% 2007 Unlevered beta Unlevered cost of equity PV FCF 2008-2012 @ Continuation value @ WACC PV '12 Cont. value @ PV Tax shield @ Enterprise value Net debt Value of equity Shares (mill) Value per share P/E 1.48

14.91% 14.91% 14.00% 14.91% 7.86% 2008 2009 2010 41.20

9.20

32.00

12.16

19.84

0.70

20.54

9.20

15.30

14.44

5.99

5.34

2.03

Continuation value @ growth g = 2011 44.20

10.20

34.00

12.92

21.08

0.70

21.78

10.20

16.10

15.88

5.99

5.68

2.16

7.00% 2005 Income Statement EBIT Interest 4.14

7.85

Riskless rate Equity premium Levered beta Micro-cap premium Levered cost of equity Debt ratio Cost of debt Tax rate WACC Taxes Net Income Shares EPS 0.85

Unlevered beta Unlevered k 2012 48.00

11.00

37.00

14.06

22.94

1.00

23.94

11.00

12.00

22.94

5.99

6.18

2.35

350.90

4.50% 4.40% 2.00

3.90% 17.20% 26.0% 7.86% 38.00% 14.00% 1.48

14.91%