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