Earlier chapters of this text showed how to calculate net present value for projects of all-equity firms. We pointed out in the last two chapters that the introduction of taxes and bankruptcy costs changes a firm's financing decisions. Rational corporations should employ some debt in a world of this type. Because of the benefits and costs associated with debt, the capital budgeting decision is different for levered firms than for unlevered firms. The present chapter has discussed three methods for capital budgeting by levered firms: the adjusted present value (APV), flows to equity (FTE), and weighted average cost of capital (WACC) approaches.
Use WACC or FTE if the firm's target debt-to-value ratio applies to the project over its life.
Use APV if the project's level of debt is known over the life of the project.
The APV method is used frequently for special situations like interest subsidies, LBOs, and leases. The WACC and FTE methods are commonly used for more typical capital budgeting situations. The APV approach is a rather unimportant method for typical capital budgeting situations.
The beta of the equity of the firm is positively related to the leverage of the firm.
