This chapter starts with a review of the after-tax weighted average cost of capital (WACC) and its application to business valuation. Valuation of Rio Corporation is given an empirical example. Flow-to-equity method ids discussed briefly. Practical aspects of using the WACC are discussed in great detail.

Adjusting beta values for changes in leverage is explained in a detailed manner. The important concept of Adjusted Present Value (APV) is introduced in this chapter. This is based on MM’s Proposition I (with taxes). APV = Base-Case NPV + NPV of financing decisions. Base-case NPV is net project value calculated in a pure MM world in which financing is irrelevant. To the extent that financing is relevant, financing costs or benefits attributable to project acceptance should be subtracted from or added to base-case NPV. This is a conceptually simple and general way to recognize interaction among financing and investment decisions. The alternative is to estimate APV by discounting project cash flows at an adjusted discount rate, e.g., at the weighted-average cost of capital. Rules of thumb based on adjusted costs of capital appear to be simple and easy to use, but in this instance appearances are deceiving. Practical guidelines are provided and discussed.