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

2

CAPITAL STRUCTURE

NO TAXES TAXES BANKRUPTCY & OTHER COSTS TRADE-OFF THEORY PECKING ORDER HYPOTHESIS OTHER CONSIDERATIONS
3

COMPONENT COSTS

DEBT PREFERRED EQUITY

DISCOUNTED DIVIDENDS
CAPM

WACC Again

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
5

Investors Required v. Cost of Capital

Investors:

R = r + + RP

1st two same for most securities RP => Risk Premium

Securitys required return depends on risk of the securitys cash flows Cost of Capital => depends on risk of firms cash flows

FIRM RISK V. SECURITY RISK

FIRM RISK => CIRCLE CFS SECURITY RISK => RECTANGLE CFS

ALL EQUITY FIRM: SECURITY RISK = FIRM RISK Ra = Re = WACC DEBT => EQUITY RISKIER (WHY?)
7

Unlevered: Assets = Equity = 100

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%
8

Levered: A = 100: D = E = 50

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 COSTS EBIT INT EBT TAX NI ROE 82.50 80.00 2.50 5.00 (2.50) (1.00) (1.50) (3%)
9

Example:

Cash Flows to Assets same (EBIT)

Cash Flows to Equity Differ

10

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]

11

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
12

Business Risk

Sales/Input Price Variability High operating leverage Technology Regulation Management depth/breadth Competition
13

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

14

Optimal Capital Structure Benchmark Case

No Taxes No Transaction Costs Information is symmetric No other market imperfections

15

Optimal Capital Structure No Taxes

CFs 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

16

Optimal Capital Structure No Taxes

BUT, Debt is Cheaper than Equity, so why doesnt WACC fall? WACC relates to the CIRCLE Simply repackaging same CF stream
17

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
18

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
19

TAXES

Interest is deductible for tax purposes

Investors still require Rd After-tax cost to firm: = Rd * (1 - Tc) CFs higher by amount of tax savings
20

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
21

TAXES, cont.

Now, WACC < Re (all equity) = Ra

==> Logical Conclusion: ==> Use all debt

22

Why Not Use All Debt?

Other Tax Shields COSTS OF FINANCIAL DISTRESS DIRECT BANKRUPTCY COSTS

Accountants Attorneys Others Who Pays?
23

Costs of Financial Distress, cont.

INDIRECT COSTS: DISRUPTION IN MANAGEMENT Is B/R Management Specialty?

EMPLOYEE COSTS Morale Low Turnover increases
24

Indirect Costs, cont.

CUSTOMERS Quality concerns (airlines; insurance)

Service concerns (autos; computers)

25

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 doesnt matter
26

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
27

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

28

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

29

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

30

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 CFs to fund debt service ===> WILL ISSUE DEBT

31

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 CFs for debt service ===> WILL ISSUE EQUITY
32

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

33

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 firms profitability relative to invest. needs

34

OTHER FACTORS

CASH FLOW STABILITY ASSET STRUCTURE

TANGIBLE V. INTANGIBLE

PROFITABILITY AGENCY PROBLEMS

OVER & UNDER INVESTMENT

PROBLEM REMOVES CASH FROM MGMT

35

OTHER FACTORS, cont.

CURRENT MARKET CONDITIONS

FINANCIAL FLEXIBILITY
RESERVE OF BORROWING POWER TODAYS DECISION AFFECTS FUTURE

MANAGERIAL FLEXIBILTIY
DEBT COVENANTS CASH FLOW TAKEN FROM MGMT
36

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
37

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

38

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
39

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)

40

PREFERRED STOCK
Preferred is like a perpetuity Pp = D / Rp

==> Rp = D / Pp
Cost of preferred = Dividend Yield
41

COMMON STOCK

Three Methods

Capital Asset Pricing Model (CAPM) Dividend Discount Model Risk Premium Method

42

Capital Asset Pricing Model

2 TYPES OF RISK:
SYSTEMATIC (Market-wide; GDP) NONSYSTEMATIC (Firm specific)

Diversification => can virtually eliminate nonsystematic risk

43

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

44

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
45

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)]
46

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.
47

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)
48

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
49

Equity Cost: Risk Premium Method

Add risk premium to companys marginal cost of debt

Re = Rd + Risk Premium Problem: Where do you get risk premium
50

WACC SUMMARY

WACC = Re*[E/(D+E)] + Rd*(1-t)[D/(D+E)] Required return depends on firm risk.

Capital budgeting: Assumes project has same risk as firm.
51