Capital Structure

Capital Structure
& Cost of Capital
& Cost of Capital
Introduction
Introduction

Capital budgeting affects the firms

well-being

Discount rate is based on the risk of the

Discount rate is based on the risk of the
cash flows
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

WACC
WACC

Weighted Average Cost of Capital Weighted Average Cost of Capital

Also called the hurdle rate Also called the hurdle rate

D = Market Value of Debt D = Market Value of Debt

E = Market Value of Equity E = Market Value of Equity

P = Market Value of Preferred Stock P = Market Value of Preferred Stock

V = D + E + P V = D + E + P

,
`

.
|
+

,
`

.
|
+

,
`

.
|

E P D
r
V
E
r
V
P
r
V
D
T WACC ) 1 (
Costs of Financing
Costs of Financing

Cost of Preferred Stock

Cost of Preferred Stock

Cost of Debt
Cost of Debt

Cost of Common Stock

Cost of Common Stock
Common Mistakes
Common Mistakes

Cost of Debt Existing Coupon Rate

Wrong cost of equity

Rounding estimate upwards to be

safe
Cost of Equity Example
Cost of Equity Example

Market risk premium = 9%

Market risk premium = 9%

Current risk-free rate = 6%

Current risk-free rate = 6%

Company beta = 1.5

Company beta = 1.5

Last dividend = $2, dividend growth =

Last dividend = $2, dividend growth =
6%/year
6%/year

Stock price = $15.65. What is our cost of

Stock price = $15.65. What is our cost of
equity?
equity?

SML: R
SML: R
E E
=
=

DGM: R
DGM: R
E E
=
=
Example WACC
Example WACC

Equity Information
Equity Information

50 million shares 50 million shares

$80 per share $80 per share

Beta = 1.15 Beta = 1.15

Market risk prem. = Market risk prem. =

9% 9%

Risk-free rate = 5% Risk-free rate = 5%

Debt Information
Debt Information

$1 billion $1 billion

Coupon rate = 10% Coupon rate = 10%

YTM = 8% YTM = 8%

20 years to 20 years to
maturity maturity

Tax rate = 40%

Tax rate = 40%
Cost of equity?
R
E
=
Cost of debt?
R
D
=
Example WACC
Example WACC

Capital structure weights?

Capital structure weights?

E = 50 million shares ($80/share) = $4

E = 50 million shares ($80/share) = $4
billion
billion

D = $1 billion face
D = $1 billion face

V = 4 + 1 = $5 billion
V = 4 + 1 = $5 billion

w
w
E E
= E/V =
= E/V =

w
w
D D
= D/V =
= D/V =

What is the WACC?

What is the WACC?

WACC =
WACC =
Capital Restructuring
Capital Restructuring

Capital restructuring
Capital restructuring

Adjusting leverage without changing the

Adjusting leverage without changing the
firms assets
firms assets

Increase leverage
Increase leverage

Issue debt and repurchase outstanding shares Issue debt and repurchase outstanding shares

Decrease leverage
Decrease leverage

Issue new shares and retire outstanding debt Issue new shares and retire outstanding debt

Choose capital structure to max

Choose capital structure to max
stockholder wealth
stockholder wealth

Maximizing firm value

Maximizing firm value

Minimizing the WACC

Minimizing the WACC
Ex: Effect of Leverage
Ex: Effect of Leverage
EBIT $650,000
EBIT $650,000

D = $0
D = $0

Interest = 0, Net Income = $650,000

Interest = 0, Net Income = $650,000

ROE = $650,000/$5,000,000 = 13%

ROE = $650,000/$5,000,000 = 13%

EPS = $650,000/500,000 = $1.30

EPS = $650,000/500,000 = $1.30

D = $2.5 mil (D/E = 1)

D = $2.5 mil (D/E = 1)

Interest = $2,500,000 * 10% = $250,000

Interest = $2,500,000 * 10% = $250,000

Net Income = $650,000 250,000 =

Net Income = $650,000 250,000 =
400,000
400,000

ROE = $400,000 /$2,500,000 = 16%

ROE = $400,000 /$2,500,000 = 16%

EPS = $400,000/250,000 = $1.60

EPS = $400,000/250,000 = $1.60
EBIT $300,000
EBIT $300,000

D = $0
D = $0

Interest = 0, Net Income = $300,000

Interest = 0, Net Income = $300,000

ROE = $300,000/$5,000,000 = 6%
ROE = $300,000/$5,000,000 = 6%

EPS = $300,000/500,000 = $0.60

EPS = $300,000/500,000 = $0.60

D = $2.5 mil (D/E = 1)

D = $2.5 mil (D/E = 1)

Interest = $2,500,000 * 10% = $250,000

Interest = $2,500,000 * 10% = $250,000

Net Income = $300,000 250,000 =

Net Income = $300,000 250,000 =
50,000
50,000

ROE = $50,000 /$2,500,000 = 2%

ROE = $50,000 /$2,500,000 = 2%

EPS = $50,000/250,000 = $0.20

EPS = $50,000/250,000 = $0.20
Break-Even EBIT
Break-Even EBIT

EBIT where EPS is the same under both

EBIT where EPS is the same under both
the current and proposed capital
the current and proposed capital
structures
structures

If EBIT > break-even point

If EBIT > break-even point
leverage is beneficial to stockholders
leverage is beneficial to stockholders

If EBIT < break-even point

If EBIT < break-even point
leverage is detrimental to stockholders
leverage is detrimental to stockholders
Ex: Break-Even EBIT
Ex: Break-Even EBIT
( )
$1.00
500,000
500,000
EPS
$500,000 EBIT
500,000 EBIT * 2 EBIT
250,000 EBIT
250,000
500,000
EBIT
250,000
250,000 EBIT
500,000
EBIT

]
]
]

Debt With Equity All

EPS EPS
M&M Perfect Market
M&M Perfect Market

Miller and Modigliani (1958)

Fathers of capital structure theory

Proposition I
Proposition I

Firm value is NOT affected by the capital Firm value is NOT affected by the capital
structure structure

Since cash flows dont change, value doesnt Since cash flows dont change, value doesnt
change change

Proposition II
Proposition II

Firm WACC is NOT affected by capital structure Firm WACC is NOT affected by capital structure
M&M Perfect Market
M&M Perfect Market

Assumes no taxes or bankruptcy costs

Assumes no taxes or bankruptcy costs

WACC= Weighted Averaged Cost of Capital

WACC= Weighted Averaged Cost of Capital


= (E/V)R
= (E/V)R
E E
+ (D/V)R
+ (D/V)R
D D


R
R
U U
= (E/V)R
= (E/V)R
E E
+ (D/V)R
+ (D/V)R
D D

No taxes No taxes

R
R
E E
= R
= R
U U
+ (R
+ (R
U U
R
R
D D
)(D/E)
)(D/E)

R R
U U
: cost of the firms business risk : cost of the firms business risk

(R (R
U U
R R
D D
)(D/E): cost of the firms financial risk )(D/E): cost of the firms financial risk
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

M&M Perfect Market
M&M Perfect Market
Ex: Perfect Market
Ex: Perfect Market

R
R
U U
= 16%, R
= 16%, R
D D
= 10%; % debt = 45%
= 10%; % debt = 45%

Cost of equity?
Cost of equity?

R
R
E E
= 16 + (16 - 10)(.45/.55) = 20.91%
= 16 + (16 - 10)(.45/.55) = 20.91%

If the cost of equity is 25%, what is

If the cost of equity is 25%, what is
D/E?
D/E?

25 = 16 + (16 - 10)(D/E)
25 = 16 + (16 - 10)(D/E)

D/E =
D/E =

Then, what is the % equity in the firm?

Then, what is the % equity in the firm?

E/V =
E/V =
Capital Structure
Capital Structure
Example
Example

Balance Sheet
Balance Sheet
Assets (A)
Assets (A)
100
100
Debt Value (D)
Debt Value (D)
40
40


Equity Value (E)
Equity Value (E)
60
60
Assets
Assets
100
100
Firm Value
Firm Value
(V)
(V)
100
100

After taxes r
After taxes r
debt debt
=8% & r
=8% & r
equity equity
=15%
=15%
WACC = WACC =
WACC = WACC =
Capital Structure
Capital Structure
Example
Example

New capital structure

New capital structure
Assets (A)
Assets (A)
100
100
Debt Value (D)
Debt Value (D)
30
30


Equity Value (E)
Equity Value (E)
70
70
Assets
Assets
100
100
Firm Value (V)
Firm Value (V)
100
100

Has the risk of the project changed?

Has the risk of the project changed?

Is the go-ahead decision different?

Is the go-ahead decision different?
After Refinancing
After Refinancing

Before
Before

WACC =
WACC =

After
After

Imagine cost of debt dropped to 7.3%

Imagine cost of debt dropped to 7.3%

WACC =
WACC =

r
r
equity equity
=
=
Capital Structure
Capital Structure
Example
Example

Debt/equity mix doesnt affect the projects Debt/equity mix doesnt affect the projects
inherent risk inherent risk

Required return on the Required return on the package package of debt and equity is of debt and equity is
unaffected unaffected

However reducing debt level changes the However reducing debt level changes the
required returns required returns

How is it, then, that reducing firm risk did not How is it, then, that reducing firm risk did not
reduce the required rate of return? reduce the required rate of return?
Corporate Taxes
Corporate Taxes

Interest is tax deductible

Interest is tax deductible

Effectively, govt subsidizes part of

Effectively, govt subsidizes part of
interest payment
interest payment

Adding debt can reduce firm taxes

Adding debt can reduce firm taxes

Reduced taxes increases the firm

Reduced taxes increases the firm
cash flows
cash flows
Ex: Taxes
Ex: Taxes
Unlevere
d
Levered
EBIT 5000 5000
Interest ($6250 @
8%)
0 500
Taxable Income 5000 4500
Taxes (34%) 1700 1530
Net Income 3300 2970
Bondholders
Bondholders
Equityholders
Equityholders
Total Cash Flows
Total Cash Flows
Interest Tax Shield
Interest Tax Shield

Annual interest tax shield

Annual interest tax shield

Tax rate times interest payment

Tax rate times interest payment

$6250 * .08 = $500 in interest expense

$6250 * .08 = $500 in interest expense

Annual tax shield =

Annual tax shield =

PV of annual interest tax shield

PV of annual interest tax shield

Assume perpetual debt

Assume perpetual debt

PV =
PV =

PV = D(R
PV = D(R
D D
)(T
)(T
C C
) / R
) / R
D D
= DT
= DT
C C
=
=
Taxes Firm Value
Taxes Firm Value

Firm value increases by value of tax shield Firm value increases by value of tax shield
V V
L L
= V = V
U U
+ PV (interest tax shield) + PV (interest tax shield)
If perpetuity, V If perpetuity, V
U U
= EBIT(1-.t) / r = EBIT(1-.t) / r
U U

Value of equity = Value of the firm Value of debt Value of equity = Value of the firm Value of debt
Ex: Unlevered cost of capital (r Ex: Unlevered cost of capital (r
U U
)= 12%; t = 35%; EBIT )= 12%; t = 35%; EBIT
= 25 mil; D = $75 mil; r = 25 mil; D = $75 mil; r
D D
= 9%; = 9%;
V V
U U
= =
V V
L L
= =

E = E =
Taxes - WACC
Taxes - WACC

WACC decreases as D/E increases

WACC decreases as D/E increases

WACC = (E/V)R
WACC = (E/V)R
E E
+ (D/V)(R
+ (D/V)(R
D D
)(1-T
)(1-T
C C
)
)

R
R
E E
= R
= R
U U
+ (R
+ (R
U U
R
R
D D
)(D/E)(1-T
)(D/E)(1-T
C C
)
)

r
r
U U
= 12%; t = 35%; D = $75 mil; r
= 12%; t = 35%; D = $75 mil; r
D D
=
=
9%; V
9%; V
U U
= $135.42 mil; V
= $135.42 mil; V
L L
= $161.67
= $161.67
mil; E = $86.67 mil
mil; E = $86.67 mil

R
R
E E
=
=

WACC =
WACC =
Example: Taxes
Example: Taxes

Firm restructures its capital so D/E =

Firm restructures its capital so D/E =
1
1

r
r
U U
= 12%; t = 35%; r
= 12%; t = 35%; r
D D
= 9%
= 9%

New cost of equity?

New cost of equity?

R
R
E E
=
=

New WACC?
New WACC?

WACC =
WACC =
Taxes + Bankruptcy
Taxes + Bankruptcy

Probability of bankruptcy increases with

Probability of bankruptcy increases with
debt
debt

Increases the Increases the expected expected bankruptcy costs bankruptcy costs

Eventually, the additional value of the

Eventually, the additional value of the
interest tax shield will be offset by the
interest tax shield will be offset by the
increase in expected bankruptcy cost
increase in expected bankruptcy cost

At this point, the value of the firm will start

At this point, the value of the firm will start
to decrease and the WACC will start to
to decrease and the WACC will start to
increase
increase
Bankruptcy Costs
Bankruptcy Costs

Direct costs
Direct costs

Legal and administrative costs

Legal and administrative costs

Indirect bankruptcy or financial

Indirect bankruptcy or financial
distress costs
distress costs
Options of Distress
Options of Distress

The right to go bankrupt

The right to go bankrupt

Valuable
Valuable

Protects creditors from further loss of

Protects creditors from further loss of
assets
assets

Creditors will renegotiate why?

Creditors will renegotiate why?

Avoid bankruptcy costs

Avoid bankruptcy costs

Voluntary debt restructuring

Voluntary debt restructuring
Tradeoff Theory
Tradeoff Theory

Tradeoff between the tax benefits and the

costs of distress.

Tradeoff determines optimal capital structure

V
L
= V
U
+ t
C
*D - PV (cost of distress)

With higher profits, what should happen to debt?

Pecking Order Theory

Managers know true value of the firm

More likely to issue when shares are

overpriced

So, investors (rationally) interpret a security

issue as a signal that the firm is overvalued
and only purchase the security only at a
discount.

Faced with the prospect of dilution, firms may

pass up positive NPV projects.

No target debt ratio

Debt ratios are path dependent.

Pecking Order
Implications

Equity issuance announcements

cause the market value of the firms
existing shares to fall

New projects tend to be financed

from internal sources or the proceeds
of low-risk debt

The underinvestment problem should

be smallest after information releases
Agency Costs

Conflicts of interest exist between

stakeholders

Jensen and Meckling (1976)

Shareholders vs. Managers - separation of

ownership and control

Debtholders vs. Equityholders - Asset

substitution

These conflicts are mitigated, exacerbated,

respectively, when the firm is leveraged.
Corporate Control

Common stock carries voting rights,

debt does not.

Capital structure affects the outcome

of takeover contests as mgmt owns a
larger portion of the voting shares
In Practice
In Practice

Tax benefit matters only if theres a tax liability

Tax benefit matters only if theres a tax liability

Risk and costs of financial distress vary

Risk and costs of financial distress vary

Capital structure does differ by industries

Capital structure does differ by industries

Increased risk of financial distress Increased risk of financial distress

Increased cost of financial distress Increased cost of financial distress

Lowest levels of debt

Lowest levels of debt

Highest levels of debt

Highest levels of debt
Cost of Debt Varies
Cost of Debt Varies
Amount D/V D/E Bond
borrowed ratio ratio rating
r
d
$ 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
$3.00
80,000
(0.6) ($400,000)

g outstandin Shares
) T - 1 )( D k - EBIT (
EPS $0 D
d

TIE = EBIT / Interest
EBIT = $400,000 t=40%
80,000 shares outstanding, with price of
$25
EPS & TIE:
D = $250,000, r
d
= 8%
20x
$20,000
$400,000

Exp Int
EBIT
TIE
$3.26
10,000 - 80,000
000))(0.6) 0.08($250, - ($400,000

g outstandin Shares
) T - 1 )( D k - EBIT (
EPS
10,000
$25
$250,000
d repurchase Shares
d

EPS & TIE
D = $500,000, r
d
= 9%
8.9x
$45,000
$400,000

Exp Int
EBIT
TIE
$3.55
20,000 - 80,000
000))(0.6) 0.09($500, - ($400,000

g outstandin Shares
) T - 1 )( D k - EBIT (
EPS
20,000
$25
$500,000
d repurchase Shares
d

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 firms

equity also increases, resulting in a
higher r
e.
Impact of Leverage
Pre-tax Taxes Net
Demand Prob EBIT Interest Income 40% Income ROE EPS
Terrible 0.05 ($60,000) $0 ($60,000) ($24,000) ($36,000) -18.00% ($3.60)
Poor 0.2 ($20,000) $0 ($20,000) ($8,000) ($12,000) -6.00% ($1.20)
Normal 0.5 $40,000 $0 $40,000 $16,000 $24,000 12.00% $2.40
Good 0.2 $100,000 $0 $100,000 $40,000 $60,000 30.00% $6.00
Great 0.05 $140,000 $0 $140,000 $56,000 $84,000 42.00% $8.40
E(value): $40,000 $0 $40,000 $16,000 $24,000 12.00% $2.40
StdDev: 14.82% $2.96

$200,000 in assets, all equity,

10,000 shares
Impact of Leverage
Pre-tax Taxes Net
Demand Prob EBIT Interest Income 40% Income ROE EPS
Terrible 0.05 ($60,000) $12,000 ($72,000) ($28,800) ($43,200) -43.20% ($8.64)
Poor 0.2 ($20,000) $12,000 ($32,000) ($12,800) ($19,200) -19.20% ($3.84)
Normal 0.5 $40,000 $12,000 $28,000 $11,200 $16,800 16.80% $3.36
Good 0.2 $100,000 $12,000 $88,000 $35,200 $52,800 52.80% $10.56
Great 0.05 $140,000 $12,000 $128,000 $51,200 $76,800 76.80% $15.36
E(value): $40,000 $12,000 $28,000 $11,200 $16,800 16.80% $3.36
StdDev: 29.64% $5.93

$200,000 in assets, half equity,

5,000 shares
General Electric
General Electric

6 Divisions 6 Divisions

Commercial Finance loans, leases, insurance Commercial Finance loans, leases, insurance

Healthcare medical technology, drug discovery Healthcare medical technology, drug discovery

Industrial appliances, lighting, equipment services Industrial appliances, lighting, equipment services

Infrastructure aviation, water, oil & gas technology Infrastructure aviation, water, oil & gas technology

Money consumer finance (credit cards, auto loans) Money consumer finance (credit cards, auto loans)

NBC Universal entertainment and news 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

Only for projects that mirror the

Only for projects that mirror the
overall firm risk
overall firm risk

Only be used if the new financing has

Only be used if the new financing has
the same proportion of debt,
the same proportion of debt,
preferred, and equity
preferred, and equity

Otherwise, use the

Otherwise, use the
project cost of
project cost of
capital
capital
08/06/11
Pure Play

Find several publicly traded companies exclusively

in projects business

Use pure play betas to proxy for projects beta

May be difficult to find such companies

Note if the pure play is levered (has debt)

Practical Issues

Betas are non-stationary over

Betas are non-stationary over
time
time

Both for projects and firms

Both for projects and firms

Cross-sectional variation of betas,

Cross-sectional variation of betas,
even within the same industries
even within the same industries
Time Series of AT&T Betas
0
0.2
0.4
0.6
0.8
1
1.2
Each Based on 60-months of returns using S&P 500 as the market index
Nonstationarity
Cross Sectional Variation
Standard Standard Correlation Correlation Beta Beta
Deviation Deviation w/ S&P 500 w/ S&P 500 Estimate Estimate
S&P 500 S&P 500 0.1335 0.1335 1.0000 1.0000 1.00 1.00
Allied Signal Allied Signal 0.3617 0.3617 0.5153 0.5153 1.39 1.39
Alcoa Alcoa 0.2019 0.2019 0.4135 0.62 0.4135 0.62
AT&T AT&T 0.2934 0.2934 0.4554 0.4554 1.00 1.00
Caterpillar Caterpillar 0.2669 0.2669 -0.0396 -0.0396 -0.08 -0.08
Coca-Cola Coca-Cola 0.2648 0.2648 0.5039 0.5039 1.00 1.00
Disney Disney 0.2841 0.2841 0.4177 0.4177 0.89 0.89
Kodak Kodak 0.2207 0.2207 0.3997 0.3997 0.66 0.66
IBM IBM 0.2790 0.2790 0.1014 0.1014 0.21 0.21
Based on annual returns 1979-1995
Leverage & Beta
Leverage & Beta

Equity risk =
Equity risk =
business risk (operating leverage)
business risk (operating leverage)
+ +
financial risk (financial leverage)
financial risk (financial leverage)

E E
=
=

A A
(1+(1-t)D/E)
(1+(1-t)D/E)

E E
= Equity beta =
= Equity beta =
Levered
Levered
beta
beta

A A
= Asset beta =
= Asset beta =
Unlevered
Unlevered
beta
beta

t = Companys marginal tax rate

t = Companys marginal tax rate
Capital Structure & Beta

Beta varies with capital choice

Beta varies with capital choice

assets assets
= =

portfolio portfolio
= (D/V) = (D/V)

debt debt
+ (E/V) + (E/V)

equity equity

Original Capital Structure

Original Capital Structure

debt debt
= .2 = .2

equity equity
= 1.2 = 1.2

Debt drops to 30%

Debt drops to 30%

Suppose the debt beta falls to .1 Suppose the debt beta falls to .1

Then, Then,

assets assets
= =

Unlever betas, we move from an observed

Unlever betas, we move from an observed

equity equity
to
to

asset asset
Leverage & Beta
Leverage & Beta

Firm with no debt decides to issue $100 million

Firm with no debt decides to issue $100 million
in bonds and retire some outstanding stock.
in bonds and retire some outstanding stock.

Historically,
Historically,

equity equity
= .75
= .75

Value of the equity after $100 million is retired

Value of the equity after $100 million is retired
is $235 million. The tax rate is 35%.
is $235 million. The tax rate is 35%.

What is
What is

after the transaction?

after the transaction?

E E
= =
A A
(1+(1-t)D/E), (1+(1-t)D/E), where where
E E
= lev, = lev,
A A
= unlev = unlev

E E
= . = .
Post-Acquisition Beta

1995: Disney announced it was acquiring Capital

1995: Disney announced it was acquiring Capital
Cities for $120/share
Cities for $120/share

Partially financed with $10 billion debt Partially financed with $10 billion debt

At acquisition, Disney
At acquisition, Disney

equity equity
= 1.15 = 1.15 E = $31.1 bil E = $31.1 bil D = $3.186 bil D = $3.186 bil

Based on $120 offer price, Capital Cities

Based on $120 offer price, Capital Cities

equity equity
= 0.95 = 0.95 E = $18.5 bil E = $18.5 bil D = $615 mil D = $615 mil

Corporate tax rate was 36% Corporate tax rate was 36%
Disney/Capital Cities
Disney/Capital Cities

Step 1
Step 1

Find unlevered betas for each company Find unlevered betas for each company

Step 2
Step 2

Use market values of DIS & CC to find Use market values of DIS & CC to find
unlevered beta of combined firm unlevered beta of combined firm

Step 3
Step 3

Find levered beta using leverage of combined Find levered beta using leverage of combined
firm firm