OPTIMAL

FINANCING MIX II: THE

COST OF CAPITAL APPROACH
It is be8er to have a lower hurdle rate than a higher
one.

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

The Cost of Capital Approach

Value of a Firm = Present Value of Cash Flows to the
Firm, discounted back at the cost of capital.
If the cash ows to the rm are held constant, and
the cost of capital is minimized, the value of the rm
will be maximized.

Applying Cost of Capital Approach: The

Textbook Example

Expected Cash flow to firm next year

200(1.03)
=
(Cost of capital - g)
(Cost of capital - g)

The U-shaped Cost of Capital Graph

Current Cost of Capital: Disney

The beta for Disneys stock in November 2013 was 1.0013. The T.
bond rate at that Zme was 2.75%. Using an esZmated equity risk
premium of 5.76%, we esZmated the cost of equity for Disney to
be 8.52%:
Cost of Equity = 2.75% + 1.0013(5.76%) = 8.52%
Disneys bond raZng in May 2009 was A, and based on this raZng,
the esZmated pretax cost of debt for Disney is 3.75%. Using a
marginal tax rate of 36.1, the aeer-tax cost of debt for Disney is
2.40%.
Aeer-Tax Cost of Debt = 3.75% (1 0.361) = 2.40%
The cost of capital was calculated using these costs and the
weights based on market values of equity (121,878) and debt
(15.961):
Cost of capital =
6

Mechanics of Cost of Capital EsZmaZon

1. EsZmate the Cost of Equity at dierent levels of debt:
Equity will become riskier -> Beta will increase -> Cost of Equity
will increase.
EsZmaZon will use levered beta calculaZon

2. EsZmate the Cost of Debt at dierent levels of debt:

Default risk will go up and bond raZngs will go down as debt
goes up -> Cost of Debt will increase.
To esZmaZng bond raZngs, we will use the interest coverage
raZo (EBIT/Interest expense)

3. EsZmate the Cost of Capital at dierent levels of debt

4. Calculate the eect on Firm Value and Stock Price.
7

Laying the groundwork:

1. EsZmate the unlevered beta for the rm

One approach is to use the regression beta (1.25) and then unlever, using the
average debt to equity raZo (19.44%) during the period of the.
Unlevered beta = = 1.25 / (1 + (1 - 0.361)(0.1944))= 1.1119

AlternaZvely, we can back to the source and esZmate it from the betas of the
businesses.

Business
Media Networks
Parks & Resorts
Studio
Entertainment
Consumer
Products
InteracZve
Disney
Opera,ons

Value of Propor5on Unlevered

Business of Disney
beta
Value Propor5on
$66,580 49.27%
1.03
$66,579.81 49.27%
$45,683 33.81%
0.70
$45,682.80 33.81%

Revenues
$20,356
$14,087

EV/Sales
3.27
3.24

$5,979

3.05

$18,234

13.49%

1.10

$18,234.27 13.49%

$3,555
$1,064

0.83
1.58

$2,952
$1,684

2.18%
1.25%

0.68
1.22

$2,951.50 2.18%
$1,683.72 1.25%
$135,132.1
1
100.00% 8

$45,041

$135,132 100.00%

0.9239

2. Get Disneys current nancials

I. Cost of Equity

Levered Beta = 0.9239 (1 + (1- .361) (D/E))

Cost of equity = 2.75% + Levered beta * 5.76%

10

EsZmaZng Cost of Debt

Start with the market value of the rm = = 121,878 + $15,961 = $137,839 million
D/(D+E)

0.00%
10.00%
Debt to capital
D/E

0.00%
11.11%
D/E = 10/90 = .1111
$ Debt

$0

$13,784

EBITDA

DepreciaZon $ 2,485

$12,517
$ 2,485

$12,517
Same as 0% debt
Same as 0% debt

EBIT
Interest

$10,032
$0

$10,032
$434

Same as 0% debt
Pre-tax cost of debt * $ Debt

Pre-tax Int. cov

23.10

EBIT/ Interest Expenses

Likely RaZng AAA

Pre-tax cost of debt

AAA
3.15%

From RaZngs table

3.15%
Riskless Rate + Spread

10% of $137,839

11

The RaZngs Table

Interest coverage ratio is

> 8.50

6.5 8.5

5.5 6.5

4.25 5.5

3 4.25

2.5 -3

2.25 2.5

2 2.25

1.75 -2

1.5 1.75

1.25 -1.5

0.8 -1.25

0.65 0.8

0.2 0.65

<0.2

Rating is

Aaa/AAA

Aa2/AA

A1/A+

A2/A

A3/A-

Baa2/BBB

Ba1/BB+

Ba2/BB

B1/B+

B2/B

B3/B-

Caa/CCC
Ca2/CC

C2/C
D2/D

Spread is
Interest rate

0.40%

3.15%
0.70%

3.45%
0.85%

3.60%
1.00%

3.75%
1.30%

4.05%
2.00%

4.75%
3.00%

5.75%
4.00%

6.75%
5.50%

8.25%
6.50%

9.25%
7.25%

10.00%
8.75%

11.50%
9.50%

12.25%
10.50%

13.25%
12.00%

14.75%

T.Bond rate =2.75%

12

A Test: Can you do the 30% level?

D/(D + E)
D/E
$ Debt
EBITDA
Depreciation
EBIT
Interest expense
Interest coverage ratio
Likely rating
Pretax cost of debt

20.00%
25.00%
$27,568
$12,517
$2,485
$10,032
$868
11.55
AAA
3.15%

Iteration 1
(Debt @AAA rate)
30.00%
30/70=42.86%
$41,352
$12,517
$2,485
$10,032
$1,302
7.70
AA
3.45%

Iteration 2
(Debt @AA rate)
30.00%

$1,427
7.03
AA
3.45%

13

Bond RaZngs, Cost of Debt and Debt RaZos

14

Stated versus EecZve Tax Rates

You need taxable income for interest to provide a tax savings. Note that
the EBIT at Disney is $10,032 million. As long as interest expenses are less
than $10,032 million, interest expenses remain fully tax-deducZble and
earn the 36.1% tax benet. At an 60% debt raZo, the interest expenses
are $9,511 million and the tax benet is therefore 36.1% of this amount.
At a 70% debt raZo, however, the interest expenses balloon to $11,096
million, which is greater than the EBIT of $10,032 million. We consider the
tax benet on the interest expenses up to this amount:

Maximum Tax Benet = EBIT * Marginal Tax Rate = $10,032 million * 0.361 = $
3,622 million
Adjusted Marginal Tax Rate = Maximum Tax Benet/Interest Expenses =
$3,622/$11,096 = 32.64%

15

Disneys cost of capital schedule

16

Disney: Cost of Capital Chart

17

Disney: Cost of Capital Chart: 1997

18

Task
Use the cost of
capital approach
to esZmate the
opZmal
nancing mix for
your company

19

Read
Chapter 8