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Cartwright Health Finance1 Capital Structure and the Cost of Capital Chapter 13.

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1 Cartwright Health Finance1 Capital Structure and the Cost of Capital Chapter 13

2 Cartwright Health Finance2 Introduction Choose between debt and equity –Risk and return implications –Introduce capital structure theory Cost of Capital –Estimation –Use as Hurdle Rate for projects –Interpretation

3 Cartwright Health Finance3 Does Debt Policy Matter? Value comes from the cash stream generated by the assets in the business Two streams debt and equity securities Is it worthwhile to establish a target value for the debt ratio?

4 Cartwright Health Finance4 Modigliani and Miller I In perfect capital market, cannot alter firm value by debt policy One should treat the investment decision and the financing decision separately Investors can also borrow and lend and undo any capital structure picked by the firm.

5 Cartwright Health Finance5 Modgiliani and Miller II The expected return on the common stock of a levered firm increases in proportion to the debt-equity ratio D/E. Any increase in expected return is exactly offset by an increase in risk, and in shareholders required rate of return

6 Cartwright Health Finance6 Debt Policy Matters Taxes (value for the tax shield) Costs of bankruptcy –20 percent of the market value equity Financial distress- conflict among management, board, shareholders, creditors Well functioning capital markets respond to these factors. Resuscitation for Trade-off Theory

7 Cartwright Health Finance7 Pecking Order Firms prefer internal finance Target dividend payout ratios to investment opportunities, while trying to avoid any sudden changes in dividends If cash flow is more than opportunities, will payoff debt or purchase its stock If external finance required, first start with debt than equity as last resort. S. C. Meyers idea

8 Cartwright Health Finance8 Capital Components Right-hand side of balance sheet –liabilities and equity (or fund capital) Focus on long term assets; long term debt and equity –might use short-term debt as bridge, e.g. construction loan until converted to L.T. Should short-term, non-interest bearing liabilities such as payables and accruals be included?

9 Cartwright Health Finance9 Risk and Return impacted by Capital Structure Consider Super Health a new for-profit walk in clinic Operating income is expected to be $50,000 –EBIT: Earnings Before Interest and Taxes We consider only two capital structures, NO debt or 50/50 mix, but EXCEL spreadsheet can handle any structure from 0 to 100% L.T. debt.

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13 Cartwright Health Finance13 Pro Forma Income Statements Based on net income should the clinic use debt financing? What is the total dollar return to investors, including both owners and creditors Where did this extra $4,000 come?

14 Cartwright Health Finance14 Conclusions Use of debt financing lowers net income, but it increases the ROE Debt financing permits more business operating income to flow to investors Debt financing is called Financial Leverage Levers up returns.

15 Cartwright Health Finance15 When uncertainty is not ignored Use of debt increases the equity holders risk The greater the amount of financial leverage, the greater the risk –Just examine the standard deviation as debt is added. Managers must tradeoff risk and return.

16 Cartwright Health Finance16 Business Risk Uncertainty about the businesss operating income (EBIT) Business risk is not influenced by the amount of debt financing use, Why?

17 Cartwright Health Finance17 Sources of Business Risk Volume Reimbursement rates Costs of providing services Liability insurance Claims costs The degree of operating leverage? –Higher DOL, higher business risk

18 Cartwright Health Finance18 Financial Risk When debt financing is used, additional risk is placed on equity owners. Or stakeholders of Not-for-Profit Business The greater the percentage of debt financing, the greater the financial risk.

19 Cartwright Health Finance19 Capital Structure Theory Strikes the optimal balance between risk and return and maximizes a stocks price. NonProfit-optimizes ability to perform mission. Trade-off Theory is the most widely accepted. –Cost savings of using debt (tax shelter) –Costs of financial distress.

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22 Cartwright Health Finance22 Trade-off Theory There is a Target Capital Structure Equal to the optimal structure In practice, there are many factors that influence the capital structure.

23 Cartwright Health Finance23 Factors in Capital Structure Inherent business risk Lender attitudes Rating Agency attitudes Reserve borrowing capacity Industry averages Current Asset structure

24 Cartwright Health Finance24 Not-for-Profits Use analogy –Debt financing has a benefit (lower cost) –But there is still financial distress Not for Profits do not have access to the equity markets which reduces there financial flexibility.

25 Cartwright Health Finance25 Cost of Capital Weighted average of a business long-term financing resources Very important benchmark rate of return to evaluate proposed projects (strategic)

26 Cartwright Health Finance26 Key Consideration What capital components to include? Handling of tax benefits Historical versus marginal costs

27 Cartwright Health Finance27 Debt Tax Benefits Not-for-profit -- direct incorporation For-profit firms -- after tax –Metro clinic has a 40% tax rate and a new bank loan would be at 10% interest rate. –Cost of debt would be 10% x (1-T) = 10% x.06 = 6.0% –Build this into the cost of capital formula. Issuance cost small and are ignored Component cost of debt is return required by debt suppliers

28 Cartwright Health Finance28 Cost of Debt Banker –Investment banker if bonds –Commercial banker if loan YTM on outstanding bond issues where actively traded Debt markets –Similar companies –Prime rate

29 Cartwright Health Finance29 Historical Versus Marginal Costs Past cost of funds –Reimbursement on cost bases New funds –Future acquisitions and capital financing Focus on marginal cost of new funds –Economic concept: opportunity cost

30 Cartwright Health Finance30 Cost of Debt Nonprofit –tax exempt bonds (15,20,30 year maturity) –Ask a bond department in bank –New issue - 30 year tax exempt, semiannual interest payment $30; par value $1,000. –ROR = 60/1,000 = 6.0% –Ignore flotation costs

31 Cartwright Health Finance31 Component Cost of Equity For profit: Cost of equity is ROR required by investor. Sell new common stock and retain earnings. –Do retained earnings have a cost? Reinvest in alternative investments of similar risk. Not for profit: contributions, government grants, earnings

32 Cartwright Health Finance32 Methods to estimate Equity Component Capital Asset Pricing Model CAPM Discounted Cash Flow Debt Cost Plus Risk Premium Method

33 Cartwright Health Finance33 CAPM Security Market Line R(R e ) = Risk Free + Risk premium RF + (R m - RF) x b Note (R m - RF) is market risk premium Note (R m - RF) x b is stock risk premium

34 Cartwright Health Finance34 Capital Asset Pricing Model CAPM Approach Investors compare the risk of the volatility of their stock returns to a well diversified market portfolio Beta is the measure of risk Market has a beta of 1. (e.g. S&P 500) A beta of.5 indicates stock is half as volatile A beta of 2 indicates stock is twice as volatile

35 Cartwright Health Finance35 Estimating Risk Free Rate Why is it impossible to find a risk free measure in the long term capital market? Use a rate that incorporates inflation expectations. T-bond is used the most (20 year maturity)

36 Cartwright Health Finance36 Estimating the Required Rate of Return on the market, R(R m ) Historical returns - expected future results = past results –average over a long series, starting point problems – RP m = R m - RF = 7.4% in Ibbotson Associates Forecasted Market Returns –variety of forecasts –use current forecast –ask your investment bank or advisors what to use

37 Cartwright Health Finance37 Estimating Beta Look up Betas in S&P Calculate your own regression Use similar companies –Drug –Hospital Corporations –Equipment

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39 Cartwright Health Finance39 Illustration of the CAPM Approach Assumptions beta is found by looking up current RF is 20 year bond rate Rm is RROR in market

40 Cartwright Health Finance40 Using SML Equation If RF = 6.0%, RP m = 7%, and market beta for Valley Clinic is 1.14, what is cost if equity? R(R e ) = RF + [R(R m) – RF] x b – 6.0% + (7.0% x 1.14) = 14.0% Note RP m stands for market risk premium

41 Cartwright Health Finance41 Discounted Cash Flow (DCF) Approach The intrinsic value of a stock is the present value of its own discounted dividend stream. Of course assumes a dividend is paid. Using constant growth assumption –Nonconstant is available with more complications.

42 Cartwright Health Finance42 DCF Method E(P 0 ) = E(D 1 )/[K s -E(g)] rewrite P 0 = E(D 1 )/[R(R e ) - E(g)] invoked equilibrium E(R e ) = R(R e ) = E(D 1 )/ P 0 + E(g) Under constant growth assumptions

43 Cartwright Health Finance43 Estimating the Current Price P 0 Look up current market price in the paper or the internet. Wall Street Journal for example

44 Cartwright Health Finance44 Estimating the Next Dividend Payment Insiders look at financial plans. Outsiders talk to brokerage houses and investment advisory services (Value line, S&P). Analysts estimates. The current dividend D 0 can be used to estimate the next period dividend by multiplying by [1+E(g)]. Weakest link?

45 Cartwright Health Finance45 Estimating the Dividend Growth Rate Historical growth rate –pick time period –point to point –average to average –compare Earnings Per Share and Dividend per share growth rate Always problems of starting point and lack of relevance to the future.

46 Cartwright Health Finance46 DCF Method Estimation Assume that P 0 = $40, E(D1) = $3.60, and E(g) = a constant 5.0% for Valley Clinic. What is the required rate of return? R(R e ) = E(D 1 )/ P 0 + E(g) = $3.60/$ % = 9.0% +5.0% = 14.0%

47 Cartwright Health Finance47 Debt Cost Plus Risk Premium Method Cost of equity – pre-tax cost if debt is a risk premium for bearing equity risk over creditors debt risk. This premium has been estimated in the range of 3 to 6 percent for large businesses Current estimate can be based on the premium for an average firm (A-rated, and b=1.0)

48 Cartwright Health Finance48 Dealing with Equity Issuance Costs Equity sales larger than debt. Adjust project costs Adjust cost of equity, which produces two costs: one for retained earnings and one for new stock sales. Ignore equity issuance costs here.

49 Cartwright Health Finance49 Final Judgment for Cost of Equity CAPM = 14.0% DCF = 14.0% Debt cost plus risk premium = 14.0% Lets take 14.0% If different must select one or average over estimates with the most confidence.

50 Cartwright Health Finance50 What is Valley Clinics Corporate Cost of Capital (CCC)? Target weights of 35% for debt and 65% for equity CCC = w d x R(R d ) x (1 – T) + w e x R(R e ) = (0.35 x 10% x 0.6) + (0.65 x 14.0%) = (0.35 x 6.0%) + (0.65 x 14.0%) = 2.1% + 9.1% = 11.2%

51 Cartwright Health Finance51 A business may be for profit, but has no publicly traded stock Equity estimate is the biggest problem Use similar business Use debt plus risk premium method

52 Cartwright Health Finance52 If Business is Not-for-Profit CCC = w d x R(R d ) + w e x R(R e ) Use cost of equity for similar traded business Use long run growth rate Use the R(R e) specified by rating agencies to maintain creditworthiness

53 Cartwright Health Finance53 Businesss Corporate Cost of Capital Market conditions –Interest rate levels –Risk Aversion The firms risk: –Business Risk – line of business and operating leverage –Financial risk – financial leverage (debt)

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55 Cartwright Health Finance55 Cost of Fund Capital Not for profits receive equity from contributions and government grants and by retained earnings. Retained earnings cannot be distributed to the board or managers.

56 Cartwright Health Finance56 What is the Cost of Fund Capital? Zero cost: Contributors do not expect a return. Community stakeholders and patients have no requirements. Opportunity cost is marketable securities such as a portfolio of low risk T-bills, use low rate. Should have a rate of return equal to its growth rate so that the firm may replenish capital and meet growing demand, and inflation. Same cost as equity funds since these represent the societys alternative investments. Use investor owned healthcare provider as alternative. Use stock values of similar activities.

57 Cartwright Health Finance57 Measuring the Cost of Fund Capital Use Hamadas equation to make adjustments b stock = bstock with no debt [1+(1-T)D/S)] Adjusts for capital structure and tax rate differentials Then use the CAPM with the b just calculated This is only approximate. Hard to compare such firms.

58 Cartwright Health Finance58 The Overall Cost of Capital General formula is a weighted average. Cost of Capital = w d K d (1-T) + w s (k s or K f ) –.6(10%)(1-.4) +.4(12.8%) – = 8.7% This is of course the average, new projects may of course require higher cost of capital at incremental or marginal cost.

59 Cartwright Health Finance59 Cost of Depreciation-Generated Funds Use overall cost of capital. Depreciation belongs to original capital suppliers. Would you invest depreciation charges in a business that could not return the going market rate?

60 Cartwright Health Finance60 Economic Interpretation of the Cost of Capital Opportunity costs of investors Business risk and capital structure Hurdle rate for investment decisions Cost of capital is an average rate based on average risk. Other projects may be risky and require higher rate

61 Cartwright Health Finance61 Divisional Cost of Capital (DCC) Subsidiaries of large corporations in different business lines Each division may have unique risk and capital structure Differential project risk measured on a divisional basis.

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