Toyota Motor Corp. engages in the manufacture and sale of motor vehicles and parts. It operates through the following segments: Automotive Operations, Financial Services, and All Other. The Automobile segment is engaged in the design, manufacture and sale of car products including passenger cars, minivans and trucks, as well as the related parts and accessories. It has various expansion projects in the past five years including full production of new Toyota Corolla, Toyota invests R1 billion in Prospection manufacturing facility and New model to be built in left and right hand drive variants for local and export markets (Toyota Motor Corporation, 2014). However the financial information of individual projects in Automotive segment are not available. Therefore in this assignment, whole Automotive segment will be evaluated by using the Weighted Average Cost of Capital (WACC), Adjusted Present Value (APV), and Flow-to-Equity (FTE) methods. The information are collected from the annual reports, segmental reports and other relevant sources. Meantime some assumptions are used because some relevant information are not available in these sources.

Toyota Automotive Segment (Project Valuation)

2.0 Facts and Assumptions:

Statutory tax rate in 2011 and 2012 was 40.2% but it was decreased to 37.6% in 2013. The corporate tax rate taken for these calculations is 40.2%.

It is assumed that no net working capital is required for this project and no financial distress.

It is assumed that R&D expenses (Operating expenses) for the project is ¥150,000 million.

The estimated cost of equity = 5.54% and cost of debt = 2.4%.

It is assumed that this company is maintaining a Constant Debt-Equity Ratio.

Cost of debt (2.4%) and cost of equity (5.54%) are estimated figures by an analyst in 2010.

To scale down the figures, the cash, exiting assets, debt, and equity are multiplied by ratio of assets in Automotive segment to whole company’s total assets (Eg: Cash = 12,359,404÷30,349,287×1,865,746 = 759,804) in the year 2010.

Note: Cost of debt and cost of equity are estimated figures. Cost of debt is an average cost of debt percentage in 2010 (Damodaran, 2010).

3.0 Part-A. Determine the WACC for the company. Compute the NPV of the new project based on the free cash flows you calculated using the WACC method.

3.1 Using the WACC to value the project

rwacc = [4,451,299 /( 4,451,299 + 7,148,301)]5.54% + [7,148,301 /(4,451,299 + 7,148,301)] 2.4%(1 – 0.402)

rwacc = [4,451,299 / 11,599,600]5.54% + [7,148,301 / 11,599,600]2.4%(1 – 0.402)

rwacc = 2.13 + 0.88 = 3.01%

Toyota has ¥ 759,804 of cash and ¥ 7,908,105 of debt; since the cash could be used to pay off an equivalent amount of debt, we can reduce debt by the amount of cash to get the net amount of debt. Hence Toyota’s debt-value ratio is 7,148,301 / 11,599,600.

Note that net debt = D= 7,908,105 - 759,804 = ¥7,148,301 million

The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows.

V0L = 178,6201.0301+-39,8061.03012+373,1181.03013 +904,1451.03014=1,280,252.6

NPVWACC = VL – Initial Investment

The NPV of the project is ¥574,336.6 million

¥1,280,252.60 million – ¥705,916 million = ¥574,336.6 million

4.0 Implementing a Constant Debt-Equity Ratio

The WACC method assumed that Toyota would keep its debt-equity ratio constant.
This requires Toyota to change the amount of its debt as its market value changes, as it will if it accepts the Toyota project.
To begin with, note that Toyota has a debt-value ratio of 0.6163 (7,148,301 / 11,599,600)
After Toyota takes on the new project, its value will go up by the amount of the value of the new assets added due to the project, ¥1,280,252.6
Hence Toyota will have to issue 1,280,252.6×0.6163 = 789,019.7 in net new debt.
Assume that Toyota will do that by spending its ¥759,804 million cash and issuing ¥29,215.7 in new debt.
Since the firm only needs ¥705,916 million for the project, the additional ¥83,103.7 (789,019.7 - 705,916) million will be paid out as a dividend.
By Implementing a Constant Debt-Equity Ratio (0.6163), its balance sheet will now appears as follows:

5.0 Part B

5.1 APV Method

The unlevered cost of equity works out to (0.383745905) × (5.54) + (0.616254095) × (2.4) = 3.604962142%

Pretax WACC = 3.6049%

VU = 178,6201.036049+-39,8061.0360492+373,1181.0360493 +904,1451.0360494=1,255,554.6

PV(interest tax shield)= 7,612.51.036049+6,779.51.0360492+7,220.31.0360493 +5,2191.0360494=24,685.7

The tax shields, discounted at rU = 3.605% are worth ¥24,685.7 million.

The unlevered project value is ¥1,255,554.6 million for a total of ¥1,280,240.3 million.

The present value is ¥1,280,240.3 million – ¥705,916 million = ¥574,324.3 million approximately as before. Previous calculation under WACC method, the NPV of the project was ¥574,336.6 million. Hence it shows almost the same answer.

5.2 Flow-to-Equity Method

Below table shows the calculation of free cash flow to equity by considering interest expenses and net borrowing. Net borrowing figures show the decrease or increase of debt capacity in each year. Net borrowing is calculated by deducting following year’s debt capacity by present year’s debt capacity.

NPV (FCFE) = 83,104 + 80,9621.0554+-4,2071.05542+154,9511.05543 +355,4391.05544=574,329.2

Cost of equity is 5.54%. Discounting FCFE at 5.54%, it shows an approximate NPV of ¥574,329.2 as before. Previous calculation under WACC method, the NPV of the project was ¥574,336.6 million. Hence it shows almost the same answer.

6.0 Part C

Comparison of the APV, FTE, and WACC Approaches.

All three approaches attempt the same task: valuation in the presence of debt financing. These three methods for calculating the value of a proposed project should be viewed as complementary.

The following are guidelines for choosing between these models:

1. Use the WACC and FTE methods if the target debt ratio will be constant throughout the life of the project. FTE is a reasonable choice for a highly levered firm.

2. Use the APV method if the debt level will be constant throughout the life of the project.

3. Use the WACC or FTE if the firm's target debt to value ratio applies to the project over its life. WACC is the most commonly used by far. FTE has appeal for a firm deeply in debt.

4. The APV method is used if the level of debt is known over the project’s life. The APV method is frequently used for special situations like interest subsidies, LBOs, and leases (Berk, J & DeMarzo, 2011).

Summary of the Flow-to-Equity Method

This method calculates the free cash flow available to equity holders taking into account all payments to and from debt holders. The cash flows to equity holders are then discounted using the equity cost of capital.

Step 1. Determine the free cash flow to equity of the investment.

Step 2. Determine the equity cost of capital.

Step 3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital.

The FTE method is simpler to use when calculating the value of equity for the entire firm, if the firm’s capital structure is complex and the market values of other securities in the firm’s capital structure are not known. It may be viewed as a more transparent method for discussing a project’s benefit to shareholders by emphasizing a project’s implication for equity. However one must compute the project’s debt capacity to determine the interest and net borrowing before capital budgeting decisions can be made (Berk, & DeMarzo, 2011).

Summary of the APV Method

This method determines the levered value of an investment by first calculating its unlevered value and then adding the value of the interest tax shield.

Step 1. Determine the investment’s value without leverage.

Step 2. Determine the present value of the interest tax shield.

Determine the expected interest tax shield.
Discount the interest tax shield.

Step 3. Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage.

The APV method is easier to apply than the WACC method when the firm does not maintain a constant debt-equity ratio. The APV approach also explicitly values market imperfections and therefore allows managers to measure their contribution to value (Berk, & DeMarzo, 2011).

Summary of the WACC Method

WACC incorporates the tax savings from debt, and it computes the levered value of an investment, by discounting its future free cash flow using the WACC.

Step1. Determine the free cash flow of the investment.

Step 2. Compute the weighted average cost of capital.

Step 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio (Berk, & DeMarzo, 2011).

7.0 References

Berk, J & DeMarzo, P. (2011). Corporate Finance (2nd Edition). Australia: Pearson Prentice Hall.

Damodaran, A. (2010). The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd Edition). USA: Pearson Education Inc.

Toyota Motor Corporation. (2010). Annual Report 2010. Tokyo: Japan. Retrieved June 15, 2015, from http://www.toyota-global.com/investors/ir_library/annual/

Toyota Motor Corporation. (2011). Annual Report 2011. Tokyo: Japan. Retrieved June 15, 2015, from http://www.toyota-global.com/investors/ir_library/annual/

Toyota Motor Corporation. (2012). Annual Report 2012. Tokyo: Japan. Retrieved June 15, 2015, from http://www.toyota-global.com/investors/ir_library/annual/

Toyota Motor Corporation. (2013). Annual Report 2013. Tokyo: Japan. Retrieved June 15, 2015, from http://www.toyota-global.com/investors/ir_library/annual/

Toyota Motor Corporation. (2014). Annual Report 2014. Tokyo: Japan. Retrieved June 15, 2015, from http://www.toyota-global.com/investors/ir_library/annual/