1 / 51

FINANCE 7311

FINANCE 7311. Optimal Capital Structure & Cost of Capital. OUTLINE. Introduction Cost of Capital - General Required return v. cost of capital Risk WACC Capital Structure Costs of Capital. CAPITAL STRUCTURE. NO TAXES TAXES BANKRUPTCY & OTHER COSTS TRADE-OFF THEORY

keaton
Download Presentation

FINANCE 7311

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. FINANCE 7311 Optimal Capital Structure & Cost of Capital

  2. OUTLINE • Introduction • Cost of Capital - General • Required return v. cost of capital • Risk • WACC • Capital Structure • Costs of Capital

  3. CAPITAL STRUCTURE • NO TAXES • TAXES • BANKRUPTCY & OTHER COSTS • TRADE-OFF THEORY • PECKING ORDER HYPOTHESIS • OTHER CONSIDERATIONS

  4. COMPONENT COSTS • DEBT • PREFERRED • EQUITY • DISCOUNTED DIVIDENDS • CAPM • WACC Again

  5. Optimal Capital Structure • Goal: Maximize Value of Firm • See Lecture Note on Value of Firm • V = CF/R (In General) • We Can Max. Numerator or Min. Denominator • Optimal Capital Structure - that mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital

  6. Investors’ Required v. Cost of Capital • Investors: R = r + π + RP • 1st two same for most securities • RP => Risk Premium • Security’s required return depends on risk of the security’s cash flows • Cost of Capital => depends on risk of firm’s cash flows

  7. FIRM RISK V. SECURITY RISK • FIRM RISK => CIRCLE CF’S • SECURITY RISK => RECTANGLE CF’S • ALL EQUITY FIRM: SECURITY RISK = FIRM RISK • Ra = Re = WACC • DEBT => EQUITY RISKIER (WHY?)

  8. GOOD: SALES 100.00 COSTS 70.00 EBIT 30.00 INT 0.00 EBT 30.00 TAX 12.00 NI 18.00 ROE 18% BAD: SALES 82.50 COSTS 80.00 EBIT 2.50 INT 0.00 EBT 2.50 TAX 1.00 NI 1.50 ROE 1.5% Unlevered: Assets = Equity = 100

  9. GOOD: SALES 100.00 COSTS 70.00 EBIT 30.00 INT 5.00 EBT 25.00 TAX 10.00 NI 15.00 ROE 30% BAD: SALES 82.50 COSTS 80.00 EBIT 2.50 INT 5.00 EBT (2.50) TAX (1.00) NI (1.50) ROE (3%) Levered: A = 100: D = E = 50

  10. Example: • Cash Flows to Assets same (EBIT) • Cash Flows to Equity Differ

  11. COST OF CAPITAL, intro. • Cost of Capital is weighted average of cost of debt and the cost of equity (Why?) • CAPITAL IS FUNGIBLE • GRAIN EXAMPLE • BATHTUB EXAMPLE • WACC = Re*[E/(D+E)] + Rd(1-t)[D/D+E]

  12. Cost of Capital, cont. • Weights should be market; book may be ok • We can write Re as follows: • Re = Ra + (1 - Tc)(Ra - Rd) * D/E Business Financial • Risk Risk

  13. Business Risk • Sales/Input Price Variability • High operating leverage • Technology • Regulation • Management depth/breadth • Competition

  14. FINANCIAL RISK • The additional risk imposed on S/H from the use of debt financing. • Debt has a prior claim • S/H must stand in line behind B/H • Higher Risk ==> Higher Required Return

  15. Optimal Capital StructureBenchmark Case • No Taxes • No Transaction Costs • Information is symmetric • No other market imperfections

  16. Optimal Capital StructureNo Taxes • CF’s From Assets Unchanged • Value of Firm ==> Circle • Portfolio of Debt & Equity • ‘PIE’ Idea • Miller & Modigliani Proposition I (M&M I) • The Financing Decision is Irrelevant

  17. Optimal Capital StructureNo Taxes • BUT, Debt is Cheaper than Equity, so why doesn’t WACC fall? • WACC relates to the CIRCLE • Simply ‘repackaging’ same CF stream

  18. Cost of Capital, No Taxes • Re = Ra + (Ra - Rd)*D/E • Miller & Modigliani Prop. II (M&M II) • Re increases such that WACC is unchanged

  19. No Taxes - Summary • Value of Firm is INDEPENDENT of financing - M&M I • Re increases as D increases SUCH THAT WACC IS UNCHANGED - M&M II • EPS increase is offset by Re increase

  20. TAXES • Interest is deductible for tax purposes • Investors still require Rd • After-tax cost to firm: = Rd * (1 - Tc) • CF’s higher by amount of tax savings

  21. TAXES • Vl = Vu + PV (tax savings) • Value of levered Firm = • Value of unlevered + PV of tax advantage of debt • Vl = EBIT(1-t)/Ra + Tc x D

  22. TAXES, cont. • Now, • WACC < Re (all equity) = Ra • ==> Logical Conclusion: • ==> Use ‘all’ debt

  23. Why Not Use All Debt? • Other Tax Shields • COSTS OF FINANCIAL DISTRESS • DIRECT BANKRUPTCY COSTS • Accountants • Attorneys • Others • Who Pays?

  24. Costs of Financial Distress, cont. • INDIRECT COSTS: • DISRUPTION IN MANAGEMENT • Is B/R Management Specialty? • EMPLOYEE COSTS • Morale Low • Turnover increases

  25. Indirect Costs, cont. • CUSTOMERS • Quality concerns (airlines; insurance) • Serviceconcerns (autos; computers)

  26. TRADE-OFF THEORY • TRADE OFF TAX ADVANTAGE OF DEBT AGAINST COSTS OF FINANCIAL DISTRESS • PRACTICE: It is impossible to solve for precisely optimal capital structure • FLAT BOTTOM BOAT - None and too much important; between doesn’t matter

  27. Handout #1 - Notes • EBIT Unchanged - No effect on assets • Payments to B/H & S/H continually increase • Note that both Rd and Re increase • EPS continually increases • Share Price Maximized at 30% debt • WACC Minimized at 30% debt

  28. Handout #2 • Vl = Vu (No Taxes) • (M&M I) • Vl = Vu + Tc*D (Taxes) • Re = Ru + (Ru - Rd)*D/E*(1 - Tc) • (M&M II) • Pictures

  29. Simple Numerical Example • Vu = 500; Vl = $670 • E = 670 - 500 = 170 • Re = .20 + (.20 - .10)(1 - .34)(500/170) • = 39.41% • WACC = 14.92% • 100 / 14.92% = $670

  30. PECKING ORDER Hypothesis • Relaxes symmetric information assumption • Now assume that management knows more about the future prospects of the firm than do outsiders • The announcement to issue debt or equity is a SIGNAL

  31. PECKING ORDER Hypothesis • If management expects good prospects: • will not want to share with new S/H •  will not want to sell undervalued shares •  expects adequate CF’s to fund debt service • ===> WILL ISSUE DEBT

  32. Pecking Order Hypothesis, cont. • If management expects bad prospects: •  Will want to share with new S/H •  Will want to sell overvalued shares •  May not expect adequate CF’s for debt service • ===> WILL ISSUE EQUITY

  33. Market Reaction to Security Issue Announcements • Announcement of new Equity Issue • Negative reaction • 30% of new equity issue • 3% of existing equity • Announcement of new Debt Issue • Little or no reaction • Share repurchase ==> Positive reaction

  34. Pecking Order Summary • Firms use INTERNAL FUNDS first • Conservative dividend policy • If external funds, then DEBT FIRST (signaling problem) • When debt capacity is used, then EQUITY • Resulting capital structure is function of firm’s profitability relative to invest. needs

  35. OTHER FACTORS • CASH FLOW STABILITY • ASSET STRUCTURE • TANGIBLE V. INTANGIBLE • PROFITABILITY • AGENCY PROBLEMS • OVER & UNDER INVESTMENT PROBLEM • REMOVES CASH FROM MGMT

  36. OTHER FACTORS, cont. • CURRENT MARKET CONDITIONS • FINANCIAL FLEXIBILITY •  RESERVE OF BORROWING POWER •  TODAY’S DECISION AFFECTS FUTURE • MANAGERIAL FLEXIBILTIY •  DEBT COVENANTS •  CASH FLOW TAKEN FROM MGMT

  37. COST OF CAPITAL • DISCOUNT RATE DEPENDS ON RISK OF CASH FLOW STREAM • The Cost of Capital Depends on the USE of the money, not its SOURCE • When is WACC appropriate? •  Project has same risk as Firm

  38. COST OF CAPITAL • EXAMPLE: Project A has IRR of 13% and is financed with 8% debt; Project B has IRR of 15% & financed with 16% equity. WACC is 12%. Which should you do? • Both! ==> Why? • Both have IRR > Cost of Capital

  39. COMPONENT COSTS • DEBT => Return required by investor, Rd •  Capital market: YTM for O/S debt of firm •  YTM for debt of ‘similar’ firms • Similar: Business Risk & Financial Risk • Same Industry: controls for business risk •  YTM of different rating ‘classes’ • Standard &Poors, Moodys • Ratings: Business Risk & Financial Risk

  40. Debt, Bond Ratings • STANDARD & POORS • AAA => Highest rating • BBB => adequate capacity to repay P&I • BB => Speculative (below investment grade) • Junk • CCC, D (D = default)

  41. PREFERRED STOCK • Preferred is like a ‘perpetuity’ • Pp = D / Rp • ==> Rp = D / Pp • Cost of preferred = Dividend Yield

  42. COMMON STOCK • Three Methods •  Capital Asset Pricing Model (CAPM) •  Dividend Discount Model •  Risk Premium Method

  43. Capital Asset Pricing Model • 2 TYPES OF RISK: •  SYSTEMATIC (Market-wide; GDP) •  NONSYSTEMATIC (Firm specific) • Diversification => can virtually eliminate nonsystematic risk

  44. Common Stock, CAPM • Investors should only be rewarded for systematic risk, which is measured by Beta • Beta => a measure of the volatility of the stock relative to the market • Ri = Rf + B*(Rm - Rf) • Where: Rf = risk-free rate • Rm = market return • Rm - Rf = market ‘risk premium’

  45. BETA • Beta of Market = 1 • Portfolio Beta = weighted average of all betas in the portfolio • Where do we get Beta? •  Regression analysis •  Beta of firm if publicly traded •  Beta from portfolio of ‘similar’ firms •  Similar need not include financial risk

  46. Levered/Unlevered Beta • We can adjust Beta for Leverage as follows: • Bl = Bu * [1 + D/E*(1-t)] • and: • Bu = Bl / [1 + D/E*(1 - t)]

  47. Levered/Unlevered Beta • Take Levered Beta from sample portfolio • Unlever to find ‘unlevered’ or asset beta, using D/E of sample portfolio • ‘Relever’ unlevered beta using D/E of firm • Note: This is same process used to adjust Re to reflect additional financial risk.

  48. Cost of Equity: Discount Dividends • Recall: P0 = D1 / (R - g) • Expected returns = required in equilibrium • We can solve above for ‘expected’ return: • R = D1/P0 + g • The trick is to estimate g (Forecasts; history; SGR)

  49. Dividend Discount - New equity • If new equity is issued, there are transaction costs. • Not all proceeds go to firm. • Let c = % of proceeds as transaction costs • Then: R = D1/ [P0*(1-c)] + g

  50. Equity Cost: Risk Premium Method • Add risk premium to company’s marginal cost of debt • Re = Rd + Risk Premium • Problem: Where do you get risk premium

More Related