bambang s (1406512732) - capital structure and the coc (theory and evidence)

8/10/2019 Bambang S (1406512732) - Capital Structure and the COC (Theory and Evidence)

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Capital Structure and

the Cost of Capital :Theory and Evidence

Oleh :

Bambang Sutrisno (1406512732)


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The Capital Structure Question and The Pie Theory

The value of a firm is defined to be the sum of the value ofthe firmsdebt and the firmsequity.

V =B + S

where B is the market value of the debt and S is themarket value of the equity.

If the goal of the firms

management is to make thefirm as valuable as possible,then the firm should pick thedebt-equity ratio that makesthe pie as big as possible.


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The Capital Structure Question

There are really two important questions:

1. Why should the stockholders care about maximizing firmvalue? Perhaps they should be interested in strategies thatmaximize shareholdervalue.

2. What is the ratio of debt-to-equity that maximizes theshareholdersvalue?

As it turns out, changes in capital structure benefit thestockholders if and only ifthe value of the firm increases.


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Capital Structure Theory

MM I & II

Trade-off Theory

Signaling Theory

Pecking Order Theory

Market Timing


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The Cost of Equity Capital

Choices of a Firm with Extra Cash

The discount rate of a project should be the expected return

on a financial asset of comparable risk.


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Estimating the Cost of Equity Capital with the CAPM

Under the CAPM, the expected return on stock can be written as :

where RF is the risk free rate and RMRF is the difference betweenthe expected return on the market portfolio and the riskless rate. Thisdifference is often called the expected excess market return or marketrisk premium.

We now have the tools to estimate a firms cost of equity capital. To do

this, we need to know three things :1. The risk-free rate, RF

2. The market risk premium, RMRF

3. The stock beta,


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Example : Cost of Equity

Suppose the stock of the Quatram Company, a publisher of collegetextbooks, has a beta () of 1.3. The firm is 100 percent equity

financed; that is, it has no debt. Quatram is considering a number ofcapital budgeting projects that will double its size. Because these newprojects are similar to the firmsexisting ones, the average beta on newprojects is assumed to be equal to Quatrams existing beta. The riskfree rate is 5 percent. What is the appropriate discount rate for thesenew projects, assuming a market risk premium of 8.4 percent?

We estimate the cost of equity, RS, for Quatram as :

RS=5% + (8.4% x 1.3)

= 5% + 10.92%

= 15.92%


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Cost of Debt

The cost of debt is the required return on our companydebt.

The after-tax cost of debt can be written as :

After-tax cost of debt = (1Tax rate) x Borrowing rate


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Cost of Preferred Stock

Reminders

Preferred generally pays a constant dividendevery period

Dividends are expected to be paid every periodforever

Preferred stock is a perpetuity, so we take theformula, rearrange, and solve for r

r = C / PV


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Example : Cost of Preferred Stock

Your company has preferred stock that has anannual dividend of $3. If the current price is $25,what is the cost of preferred stock?

r = 3 / 25 = 12%


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Weighted Average Cost of Capital

If a firm uses both debt and equity, the cost ofcapital is a weighted average of each. This works

out to be :

where RSis the cost of equity and RBis the cost ofdebt.


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Weighted Average Cost of Capital

Interest is tax deductible at the corporate level. The after-tax cost of debt is :

Cost of debt (after corporate tax) = RB

x (1tc)

where t is the corporationstax rate.

Assembling these results, we get the average cost ofcapital (after tax) for the firm :

Because the average cost of capital weighs the cost ofequity and the cost of debt, it is usually referred to as theweighted average cost of capital (R

WACC).


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Example 1 : WACC

Consider a firm whose debt has a market value of $40million and whose stock has a market value of $60 million(3 million outstanding shares of stock, each selling for $20

per share). The firm pays a 5 percent rate of interest on itsnew debt and has a beta of 1.41. The corporate tax rate is34 percent. (Assume that the security market line (SLM)holds, that the risk premium on the market is 9.5 percent(somewhat higher than the historical equity risk premium),and that the current Treasury bill rate is 1 percent.) What is

this firmsRWACC?


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Example 1 : WACC

To compute the RWACC, we must know (1) the after-tax cost of debt, RB x(1 tc), (2) the cost of equity, RS,and (3) the proportions of debt andequity used by the firm. These three values are determined next :

(1) The pretax cost of debt is 5 percent, implying an after-tax cost of 3.3percent (= 5% x (10.34)).

(2) We calculate the cost of equity capital by using the SML :

(3) We compute the proportions of debt and equity from the market valuesof debt and equity. Because the market value of the firm is $100 million(= $40 million + $60 million), the proportions of debt and equity are 40and 60 percent, respectively.


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Example 1 : WACC

The cost of equity, RS, is 14.40 percent, and the after-tax cost of debt,RB x (1 tc) is 3.3 percent. B is $40 million and S is $60 million.Therefore :

The above calculations are presented in table form below :


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Example 2 : Project Evaluation and the WACC

Suppose a firm has both a current and a target debt-equity ratio of 0.6,a cost of debt of 5.15 percent, and a cost of equity of 10 percent. Thecorporate tax rate is 34 percent. What is the firms weighted averagecost of capital?

Our first step calls for transforming the debt-equity (B/S) ratio to a debt-value ratio. A B/S ratio of 0.6 implies 6 parts debt for 10 parts equity.Because value is equal to the sum of the debt plus the equity, the debt-value ratio is 6/(6 + 10) = 0.375. Similarly, the equity-value ratio is10/(6+10) = 0.625. The RWACC will then be :


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Example 2 : Project Evaluation and the WACC

Suppose the firm is considering taking on a warehouse renovationcosting $60 million that is expected to yield cost savings of $12 million ayear for six years. Using the NPV equation and discounting the six

years of expected cash flows from the renovation at the RWACC,we have:

Should the firm take on the warehouse renovation? The project has anegative NPV using the firms RWACC. This means that the financialmarkets offer superior investments in the same risk class (namely, thefirms risk class). The answer is clear : The firm should reject theproject.


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A Model with Business Disruption and Tax-Deductible Interest

Leland (1994) and Leland and Toft (1996) have modeled the value of a firmassuming that the present value of business disruption costs and the presentvalue of lost interest tax shields are affected by the firms choice of capitalstructure. The result is an optimal capital structure that is defined by a trade-offbetween the value created by the present value of the interest tax shield, and

the value lost from the present value of business disruption costs as well as thepresent value of lost interest tax shields.

Optimal capital structure as a trade-off between the interest tax shieldand business disruption costs


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Business Disruption Costs : Evidence

Business disruption costs are incurred before as well as duringbankruptcy and include lost business and lost investment opportunities.

Evidence on business disruption costs is provided by Altman (1984).Altman provides an estimate (for a sample of 19 firms, 12 retailers, and7 industrials that went bankrupt between 1970 and 1978) that comparesexpected profits, computed from time-series regressions, with actualprofits. The arithmetic average indirect bankruptcy costs were 8.1% offirm value three years prior to bankruptcy and 10.5% the year ofbankruptcy. A second method uses unexpected earnings from analystsforecasts for a sample of 7 firms that went bankrupt in the 1980-1982interval. Average indirect bankruptcy costs were 17.5% of value oneyear prior to bankruptcy.

Altmans evidence suggests that total bankruptcy costs (direct andindirect) are sufficiently large to give credibility to a theory of optimalcapital structure based on the trade-off between gains from leverage-induced tax shields and expected bankruptcy costs.


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Agency Costs : Another Equilibrium Theory of Optimal Capital Structure

Optimal capital structure determined by minimizing total agency costs


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Agency Costs : Another Equilibrium Theory of Optimal Capital Structure

The figure illustrates the Jensen-Meckling argument for an optimalcapital structure based on the agency costs of external equity and debt

(in a world without taxes). Agency costs of external equity are assumedto decrease as the percentage of external equity decreases, and theagency costs of debt are assumed to increases.

The figure illustrates a case where total agency costs are minimizedwith an optimal capital structure between 0% and 100%-an interiorsolution. If the agency costs of external equity are low, as may be thecase for a widely held firm, then optimal capital structure can result as atrade-off between the tax shelter benefit of debt and its agency cost.

E i i l E id C i C it l St t


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Empirical Evidence Concerning Capital Structure

1. Cross-Sectional Studies

Modigliani and Miller (1958) use cross section equations on data takenfrom 43 electric utilities during 1947-1948 and 42 oil companies during

1953. They estimate the weighted average cost of capital as net operatingcash flows after taxes divided by the market value of the firm. Whenregressed against financial leverage (measured as the ratio of the marketvalue of debt to the market value of the firm), the results were :

where d is the financial leverage of the firm and r is the correlationcoefficient. These results suggest that the cost of capital is not affected bycapital structure (because the slope coefficients are not significantlydifferent from zero) and therefore that there is no gain to leverage.

E i i l E id C i C it l St t


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Weston (1963) criticizes the Modigliani-Miller results on two counts.First, the oil industry is not even approximately homogeneous inbusiness risk (operating leverage); second, the valuation model fromwhich the cost of capital is derived assumes that cash flows are

perpetuities that d not grow. When growth is added to the cross-sectionregression, the result for electric utilities becomes

whereAis the book value of assets (a proxy for firm size) and Eis thecompound growth in earnings per share (1949-1959). Since WACCdecreases with leverage, Westons results are consistent with theexistence of a gain to leverage.


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2. Evidence Based on Exchange Offers and Swaps

For a sample containing 106 leverage-increasing and 57 leverage-decreasing exchange offers during the period 1962 through 1976,

Masulis (1980) found highly significant announcement effects. For theWall Street Journal announcement date and the following day, theannouncement period return is 7.6% for leverage-increasingexchange offers and -5.4% for leverage-decreasing exchange offers.

These results are possibly consistent with three theories : (1) thatthere is a valuable tax shield created when financial leverage isincreased, (2) that debtholders wealth is being expropriated byshareholders in leverage increasing exchange offers, and (3) thathigher leverage is a signal of managementsconfidence in the futureof the firm.


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Empirical Evidence Concerning Capital Structure3. Time-Series Studies : Announcement Effects

It is interesting to take empirical results on dozens of differentcorporate events and compare them. Smith (1986) suggests that theybe compared in two different dimensions events that increase

financial leverage (a favorable signal) and those that imply favorablefuture cash flow changes.

All leverage-decreasing events have negative announcement effects,and all leverage-increasing events, save one, have positiveannouncement effects. The exception is the new issue of debtsecurities, where Dann and Mikkelson (1984), Eckbo (1986), and

Mikkelson and Partch (1986) found negative but insignificantannouncement effects. This result is also consistent with the peckingorder theory. The majority events with no leverage change hadinsignificant announcement effects.

Announcements with favorable (unfavorable) implications for the futurecash flows of the firm such as investment increases (decreases) anddividend increases (decreases) were accompanied by significant

positive (negative) effects on shareholderswealth.

bambang s (1406512732) - capital structure and the coc (theory and evidence)

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