Chapter 18: Business Valuation & Financing Decisions

Business Valuation & Financing Decisions introduces the After-Tax Weighted-Average Cost of Capital (WACC) as a primary tool for adjusting the discount rate to account for the tax deductibility of interest payments, known as interest tax shields. The text explains how to properly estimate the inputs for WACC, including the cost of equity, the after-tax cost of debt, and market-value weights for capital structure components, while emphasizing that free cash flows must be forecasted assuming all-equity financing. A significant portion of the chapter is dedicated to valuing operating businesses, guiding students through the process of projecting free cash flows to a valuation horizon, calculating a terminal value, and subtracting the market value of debt to derive equity value. It critically analyzes the assumptions underlying WACC, specifically the requirement for a constant debt-to-value ratio, which implies continuous rebalancing of debt. For scenarios where business risk or leverage differs from the firm's average, the chapter outlines a three-step procedure to unlever and relever the cost of equity or beta. The discussion then expands to the Adjusted Present Value (APV) method, a "divide and conquer" approach that separates the base-case all-equity value from the present value of financing side effects, such as interest tax shields, issue costs, and subsidized loans. APV is presented as the superior method for valuing leveraged buyouts (LBOs) and project finance deals where debt levels are high and change according to a fixed schedule rather than a constant ratio. The chapter concludes by addressing the valuation of safe, nominal cash flows, such as lease obligations and depreciation tax shields, demonstrating that the correct discount rate for these specific flows is the after-tax borrowing rate.