capital structure & cost of capital. introduction capital budgeting affects the firm’s...

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 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

EPD r

V

Er

V

Pr

V

DTWACC )1(

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

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% Cost of equity?

RE =

Cost of debt? RD =

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 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

Ex: Effect of Leverage

  Current Proposed

Assets$5,000,00

0 $5,000,00

0

Debt $0 $2,500,00

0

Equity$5,000,00

0 $2,500,00

0

D/E 0 1

Share $ $10 $10

# Shares 500,000 250,000

Int. Rate N/A 10%

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

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

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

If EBIT > break-even pointthen leverage is beneficial to our stockholders

If EBIT < break-even pointthen leverage is detrimental to our stockholders

Ex: Break-Even EBIT

DebtWith Equity All EPS EPS

$500,000EBIT

500,000EBIT*2EBIT

250,000EBIT250,000

500,000EBIT

250,000

250,000EBIT

500,000

EBIT

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

        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

Std Dev: 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

Std Dev: 29.64% $5.93

$200,000 in assets, half equity, 5,000 shares

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 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 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

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

Balance SheetAssets (A) 100 Debt Value (D)

40 Equity Value (E)

60Assets 100 Firm Value (V)

100

rdebt=8% & requity=15%WACC = rassets =(D/V)* rdebt + (E/V)* requity

WACC =

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

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

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

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: TaxesUnlevere

dLevere

dEBIT 5000 5000

Interest ($6250 @ 8%)

0 500

Taxable Income 5000 4500

Taxes (34%) 1700 1530

Net Income 3300 2970Bondholders 0 500Equityholders 3300 2970Total Cash Flows 3300 3470

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

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 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

Firm restructures its capital so D/E = 1

rA= 12%; t = 35%; rD = 9%

New cost of equity? RE =

New WACC? WACC =

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

Amount D/V D/E Bondborrowed 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

$3.00

80,000

(0.6)($400,000)

goutstandin Shares

) T - 1 )( Dk - 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, rd = 8%

20x $20,000

$400,000

Exp Int

EBIT TIE

$3.26

10,000- 80,000

000))(0.6)0.08($250, - ($400,000

goutstandin Shares

) T - 1 )( Dk - EBIT ( EPS

10,000 $25

$250,000 drepurchase Shares

d

EPS & TIED = $500,000, rd = 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

goutstandin Shares

) T - 1 )( Dk - EBIT ( EPS

20,000 $25

$500,000 drepurchase Shares

d

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

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 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

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

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

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 WACCUsing a general industry or company cost of capital will lead to bad decisions.

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

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 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 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 & 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

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

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

1) Unlevered Betas

)(*)1(1 EDT

LU

2) Combined Beta

3) Levered Beta