Corporate Finance

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Corporate Finance

NPV without salvage value = –Rs 72.80

NPV with salvage value = Rs 124

Much of the project’s value comes from salvage value. Without it, the project would become unviable.

The Impact of Debt Financing on NPV

To arrive at cash flows we did not deduct interest charges. The reason is that the discount rate (WACC)
already considers debt financing. WACC is calculated by taking weighted average after-tax costs of equity
and debt. The cost of debt in the WACC formula already accounts for project specific debt financing. Deducting
interest from EBIT would lead to double counting.

WACC = Kd (1 – T) (D/D + E) + Ke (E/D + E)

A project can be analyzed from the perspective of all investors or just equity investors. In the former case,
the cash flows do not consider interest charges and the discount rate is the WACC. While analyzing from the
equity investors perspective some changes need to be made. The initial investment would be equity investment
and not total investment; the discount rate would be cost of equity and the cash flow would be the residual
cash flow to equity investors.

Cash flow to equity =EBIT – Tax + Depreciation – Capital expenditure – Increase in working capital

• After tax interest payment – Principal repayment + New borrowing

Cash flow to equity is the residual cash flow after meeting investment requirements and contractual pay-
ments. It should be noted that cash flow to equity is more meaningful for a growing firm that borrows all the
time to invest. For a typical growing firm cash flow from operations would be negative.
In case of Leveraged Buyouts (discussed in a subsequent chapter) the leverage changes every year. So using
a constant discount rate (WACC) would be inappropriate. Valuing equity cash flows would be much easier.

An Illustration

Investment = Rs 3000

Discount rate (WACC)= 15 percent

(in Rs)

Year Cash flow Interest expense Cash flow after deducting interest

1 1,000 150 850

2 2,000 150 1,850

3 3,000 150 2,850

NPV without deducting interest = – 3000 + [1000 * PVIF (15,1) + 2000 * PVIF (12,2)

+ 3000 * PVIF (15,3)]

= Rs 1356

NPV after deducting interest = – 3000 + [850 * PVIF (15,1) + 1850 * PVIF (12,2)

+ 2850 * PVIF (15,3)]

= Rs 1016