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Capital Structure & Cost of Capital. Introduction. Capital budgeting affects the firm’s well-being Discount rate is based on the risk of the cash flows Errors in capital budgeting can be serious Need to compensate investors for financing Project Expect Return Project Cash Flows . WACC.

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introduction
Introduction
  • Capital budgeting affects the firm’s well-being
    • Discount rate is based on the risk of the cash flows
    • Errors in capital budgeting can be serious
  • Need to compensate investors for financing
    • Project Expect Return
    • Project Cash Flows
slide3
WACC
  • Weighted Average Cost of Capital
    • Also called the hurdle rate
  • D = Market Value of Debt
  • E = Market Value of Equity
  • P = Market Value of Preferred Stock
  • V = D + E + P
costs of financing
Costs of Financing
  • Cost of Preferred Stock
    • Based on preset dividend rate (r = D/P)
  • Cost of Debt
    • YTM is good estimate
  • Cost of Common Stock
    • Derived from current market data – Beta
    • Cost has 2 factors
      • Business or Asset Risk
      • Financing or Leverage Risk (Leverage increases common stock risk)
cost of equity example
Cost of Equity Example
  • Market risk premium = 9%
  • Current risk-free rate = 6%
  • Company beta = 1.5
  • Last dividend = $2, dividend growth = 6%/year
  • Stock price = $15.65
  • What is our cost of equity?
example wacc
Equity Information

50 million shares

$80 per share

Beta = 1.15

Market risk prem. = 9%

Risk-free rate = 5%

Debt Information

$1 billion

Coupon rate = 10%

YTM = 8%

20 years to maturity

Tax rate = 40%

Example – WACC
  • Cost of equity?
    • RE =
  • Cost of debt?
    • RD=
example wacc1
Example – WACC
  • Capital structure weights?
    • E = 50 million shares ($80/share) = $4 billion
    • D = $1 billion face
    • V = 4 + 1 = $5 billion
    • wE = E/V =
    • wD = D/V =
  • What is the WACC?
    • WACC =
capital restructuring
Capital Restructuring
  • Capital restructuring
    • Adjusting leverage without changing the firm’s assets
    • Increase leverage
      • Issue debt and repurchase outstanding shares
    • Decrease leverage
      • Issue new shares and retire outstanding debt
  • Choose capital structure to max stockholder wealth
    • Maximizing firm value
    • Minimizing the WACC
ebit 650 000
EBIT $650,000
  • D = $0
    • Interest = 0, Net Income = $650,000
    • EPS = $650,000/500,000 = $1.30
  • D = $2.5 mil (D/E = 1)
    • Interest =
    • Net Income =
    • EPS = /250,000 =
ebit 300 000
EBIT $300,000
  • D = $0
    • Interest = 0, Net Income = $300,000
    • EPS = $300,000/500,000 = $0.60
  • D = $2.5 mil (D/E = 1)
    • Interest = $2,500,000 * 10% = $250,000
    • Net Income =
    • EPS = /250,000 =
break even ebit
Break-Even EBIT
  • EBIT where EPS is the same under both the current and proposed capital structures
  • If EBIT > break-even point

then leverage is beneficial to our stockholders

  • If EBIT < break-even point

then leverage is detrimental to our stockholders

cost of equity varies
Cost of Equity Varies
  • If the level of debt increases, the riskiness of the firm increases.
  • Increases the cost of debt.
  • However, the riskiness of the firm’s equity also increases, resulting in a higher re.
impact of leverage
Impact of Leverage
  • $200,000 in assets, all equity, 10,000 shares
impact of leverage1
Impact of Leverage
  • $200,000 in assets, half equity, 5,000 shares
m m perfect market
M&M – Perfect Market
  • Miller and Modigliani (1958)
    • Fathers of capital structure theory
  • Proposition I
    • Firm value is NOT affected by the capital structure
    • Since cash flows don’t change, value doesn’t change
  • Proposition II
    • Firm WACC is NOT affected by capital structure
m m perfect market1
M&M – Perfect Market
  • Assumes no taxes or bankruptcy costs
  • WACC = (E/V)RE + (D/V)RD
    • No taxes
  • RE = RA + (RA – RD)(D/E)
    • RA: “cost” of the firm’s business risk
    • (RA – RD)(D/E): “cost” of the firm’s financial risk
risks
Risks
  • Business risk:
    • Uncertainty in future EBIT
    • Depends on business factors such as competition, industry trends, etc.
    • Level of systematic risk in cash flows
  • Financial risk:
    • Extra risk to stockholders resulting from leverage
    • Depends on the amount of leverage
    • NOT the same as default risk
ex perfect market
Ex: Perfect Market
  • RA = 16%, RD = 10%; % debt = 45%
  • Cost of equity?
    • RE = 16 + (16 - 10)(.45/.55) = 20.91%
  • If the cost of equity is 25%, what is D/E?
    • 25 = 16 + (16 - 10)(D/E)
    • D/E =
  • Then, what is the % equity in the firm?
    • E/V =
capital structure example
Capital Structure Example
  • Balance Sheet

Assets (A) 100 Debt Value (D) 40

Equity Value (E) 60

Assets 100 Firm Value (V) 100

  • rdebt=8% & requity=15%

WACC = rassets =(D/V)* rdebt + (E/V)* requity

WACC =

capital structure example1
Capital Structure Example
  • New capital structure

Assets (A) 100 Debt Value (D) 30

Equity Value (E) 70

Assets 100 Firm Value (V) 100

  • Has the risk of the project changed?
  • Is the go-ahead decision different?
after refinancing
After Refinancing
  • Before
    • WACC = .4 (8%) + .6 (15%) = 12.2%
  • After
    • Imagine cost of debt dropped to 7.3%
    • WACC = .3 (7.3%) + .7 (requity) = 12.2%
    • requity =
example
Example
  • Debt/equity mix doesn’t affect the project’s inherent risk
    • Required return on the package of debt and equity is unaffected
  • However reducing debt level changes the required returns
    • Reduced debtholder risk (rdebt fell)
    • Reduced equityholder risk (requity fell)
  • How is it, then, that reducing firm risk did not reduce the required rate of return?
    • Project risk is the same.
    • Weights changed.
corporate taxes
Corporate Taxes
  • Interest is tax deductible
    • Effectively, govt subsidizes part of interest payment
  • Adding debt can reduce firm taxes
  • Reduced taxes increases the firm cash flows
ex taxes
Ex: Taxes

Bondholders 0 500

Equityholders 3300 2970

Total Cash Flows 3300 3470

interest tax shield
Interest Tax Shield
  • Annual interest tax shield
    • Tax rate times interest payment
    • $6250 * .08 = $500 in interest expense
    • Annual tax shield = .34(500) = 170
  • PV of annual interest tax shield
    • Assume perpetual debt
    • PV =
    • PV = D(RD)(TC) / RD = DTC =
taxes firm value
Taxes – Firm Value
  • Firm value increases by value of tax shield
    • VL = VU + PV (interest tax shield)
    • If perpetuity, VU = EBIT(1-.t) / rA
    • Value of equity = Value of the firm – Value of debt
  • Ex: Unlevered cost of capital (rA)= 12%; t = 35%; EBIT = 25 mil; D = $75 mil; rD = 9%;
    • VU =
    • VL =
    • E =
taxes wacc
Taxes - WACC
  • WACC decreases as D/E increases
    • WACC = (E/V)RE + (D/V)(RD)(1-TC)
    • RE = RA + (RA – RD)(D/E)(1-TC)
  • rA= 12%; t = 35%; D = $75 mil; rD = 9%; VU = $135.42 mil; VL = $161.67 mil; E = $86.67 mil
    • RE =
    • WACC=
example proposition ii taxes
Example: Proposition II - Taxes
  • Firm restructures its capital so D/E = 1
  • rA= 12%; t = 35%; rD = 9%
  • New cost of equity?
    • RE =
  • New WACC?
    • WACC =
taxes bankruptcy
Taxes + Bankruptcy
  • Probability of bankruptcy increases with debt
    • Increases the expected bankruptcy costs
  • Eventually, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost
  • At this point, the value of the firm will start to decrease and the WACC will start to increase
cost of debt varies
Cost of Debt Varies

Amount D/V D/E Bond

borrowed ratio ratio rating rd

$ 0 0 0 -- --

250 0.125 0.1429 AA 8.0%

500 0.250 0.3333 A 9.0%

750 0.375 0.6000 BBB 11.5%

1,000 0.500 1.0000 BB 14.0%

times interest earned
Times Interest Earned

TIE = EBIT / Interest

EBIT = $400,000 t=40%

80,000 shares outstanding, with price of $25

bankruptcy costs
Bankruptcy Costs
  • Direct costs
    • Legal and administrative costs
    • Additional losses for bondholder
  • Indirect bankruptcy or financial distress costs
    • Preoccupies management
    • Reduces sales
    • Lose valuable employees
options of distress
Options of Distress
  • The right to go bankrupt
    • Valuable
    • Protects creditors from further loss of assets
  • Creditors will renegotiate – why?
    • Avoid bankruptcy costs
    • Voluntary debt restructuring
tradeoff theory
Tradeoff Theory
  • Tradeoff between the tax benefits and the costs of distress.
    • Tradeoff determines optimal capital structure
  • VL = VU + tC*D - PV (cost of distress)
    • With higher profits, what should happen to debt?
in practice
In Practice
  • Tax benefit matters only if there’s a large tax liability
  • Risk and costs of financial distress vary
  • Capital structure does differ by industries
    • Increased risk of financial distress
    • Increased cost of financial distress
  • Lowest levels of debt
    • Pharma, Computers
  • Highest levels of debt
    • Steel, Department stores, Utilities
wacc review
WACC Review
  • Capital budgeting affects the firm’s well-being
    • Discount rate is based on the risk of the cash flows
    • Errors in capital budgeting can be serious
  • Need to compensate investors for financing
    • Project Expect Return > Cost of Capital
    • Project Cash Flows > Return to Investors
general electric
General Electric
  • 6 Divisions
    • Commercial Finance – loans, leases, insurance
    • Healthcare – medical technology, drug discovery
    • Industrial – appliances, lighting, equipment services
    • Infrastructure – aviation, water, oil & gas technology
    • Money – consumer finance (credit cards, auto loans)
    • NBC Universal – entertainment and news
project wacc
Project WACC
  • Using a general industry or company cost of capital will lead to bad decisions.
using firm wacc
Using Firm WACC
  • Only for projects that mirror the overall firm risk
  • Only be used if the new financing has the same proportion of debt, preferred, and equity
  • Otherwise, use the project cost of capital
pure play
Pure Play
  • Find several publicly traded companies exclusively in project’s business
  • Use pure play betas to proxy for project’s beta
    • May be difficult to find such companies
    • Note if the pure play is levered
    • Betas are non-stationary over time
    • Cross-sectional variation of betas, even within the same industry
leverage beta
Leverage & Beta
  • Equity risk =

business risk (operating leverage)

+

financial risk (financial leverage)

  • L = U(1+(1-t)D/E)
    • L = E= Equity beta = Levered beta
    • U = A = Asset beta = Unlevered beta
    • t = Company’s marginal tax rate
capital structure beta
Capital Structure & Beta
  • Beta varies with capital choice
    • assets (U) =portfolio = (D/V) debt + (E/V) equity
  • Original Capital Structure
    • bdebt = .2 bequity = 1.2
    • (40/100)*.2 + (60/100)*1.2 = assets = .8
  • Debt drops to 30%
    • Suppose the debt beta falls to .1
    • Then, assets(U) = .8 = (.3 * .1) + (.7 * equity) so equity = 1.1
  • Unlever betas, we move from an observed equity to asset
leverage beta1
Leverage & Beta
  • Firm with no debt decides to issue $100 million in bonds and retire some outstanding stock.
  • Historically, βL = .75
  • Value of the equity after $100 million is retired is $235 million. The tax rate is 35%.
  • What is β after the transaction?
    • L = U(1+(1-t)D/E), where L = lev, U= unlev
    • L =
post acquisition beta
Post-Acquisition Beta
  • 1995: Disney announced it was acquiring Capital Cities for $120/share
  • At acquisition, Disney
    • bequity (L) = 1.15 E = $31.1 bil D = $3.186 bil
  • Based on $120 offer price, Capital Cities
    • bequity(L)= 0.95 E = $18.5 bil D = $615 mil
    • Corporate tax rate was 36%
disney capital cities
Disney/Capital Cities
  • Step 1
    • Find unlevered betas for each company
  • Step 2
    • Use market values of DIS & CC to find unlevered beta of combined firm
  • Step 3
    • Find levered beta using leverage of combined firm