# 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.

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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 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 Weighted Average Cost of Capital Also called the hurdle rate Also called the hurdle rate D = Market Value of Debt D = Market Value of Debt E = Market Value of Equity E = Market Value of Equity P = Market Value of Preferred Stock P = Market Value of Preferred Stock V = D + E + P V = D + E + P

Costs of Financing Cost of Preferred Stock Cost of Preferred Stock Based on preset dividend rate (r = D/P) Based on preset dividend rate (r = D/P) Cost of Debt Cost of Debt YTM is good estimate YTM is good estimate Cost of Common Stock Cost of Common Stock Derived from current market data – Beta Derived from current market data – Beta Cost has 2 factors Cost has 2 factors Business or Asset Risk Business or Asset Risk Financing or Leverage Risk (Leverage increases common stock risk) Financing or Leverage Risk (Leverage increases common stock risk)

Cost of Equity Example Market risk premium = 9% Market risk premium = 9% Current risk-free rate = 6% Current risk-free rate = 6% Company beta = 1.5 Company beta = 1.5 Last dividend = \$2, dividend growth = 6%/year Last dividend = \$2, dividend growth = 6%/year Stock price = \$15.65 Stock price = \$15.65 What is our cost of equity? What is our cost of equity?

Example – WACC Equity Information Equity Information 50 million shares 50 million shares \$80 per share \$80 per share Beta = 1.15 Beta = 1.15 Market risk prem. = 9% Market risk prem. = 9% Risk-free rate = 5% Risk-free rate = 5% Debt Information \$1 billion Coupon rate = 10% YTM = 8% 20 years to maturity Tax rate = 40% Cost of equity? Cost of equity? R E = R E = Cost of debt? Cost of debt? R D = R D =

Example – WACC Capital structure weights? Capital structure weights? E = 50 million shares (\$80/share) = \$4 billion E = 50 million shares (\$80/share) = \$4 billion D = \$1 billion face D = \$1 billion face V = 4 + 1 = \$5 billion V = 4 + 1 = \$5 billion w E = E/V = w E = E/V = w D = D/V = w D = D/V = What is the WACC? What is the WACC? WACC = WACC =

Capital Restructuring Capital restructuring Capital restructuring Adjusting leverage without changing the firm’s assets Adjusting leverage without changing the firm’s assets Increase leverage Increase leverage Issue debt and repurchase outstanding shares Issue debt and repurchase outstanding shares Decrease leverage Decrease leverage Issue new shares and retire outstanding debt Issue new shares and retire outstanding debt Choose capital structure to max stockholder wealth Choose capital structure to max stockholder wealth Maximizing firm value Maximizing firm value Minimizing the WACC Minimizing the WACC

Ex: Effect of Leverage CurrentProposed Assets\$5,000,000 Debt\$0\$2,500,000 Equity\$5,000,000\$2,500,000 D/E01 Share \$\$10 # Shares500,000250,000 Int. RateN/A10%

EBIT \$650,000 D = \$0 D = \$0 Interest = 0, Net Income = \$650,000 Interest = 0, Net Income = \$650,000 EPS = \$650,000/500,000 = \$1.30 EPS = \$650,000/500,000 = \$1.30 D = \$2.5 mil (D/E = 1) D = \$2.5 mil (D/E = 1) Interest = Interest = Net Income = Net Income = EPS = /250,000 = EPS = /250,000 =

EBIT \$300,000 D = \$0 D = \$0 Interest = 0, Net Income = \$300,000 Interest = 0, Net Income = \$300,000 EPS = \$300,000/500,000 = \$0.60 EPS = \$300,000/500,000 = \$0.60 D = \$2.5 mil (D/E = 1) D = \$2.5 mil (D/E = 1) Interest = \$2,500,000 * 10% = \$250,000 Interest = \$2,500,000 * 10% = \$250,000 Net Income = Net Income = EPS = /250,000 = EPS = /250,000 =

Break-Even EBIT EBIT where EPS is the same under both the current and proposed capital structures EBIT where EPS is the same under both the current and proposed capital structures If EBIT > break-even point If EBIT > break-even point then leverage is beneficial to our stockholders If EBIT < break-even point If EBIT < break-even point then leverage is detrimental to our stockholders

Ex: Break-Even 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 r e.

Impact of Leverage Pre-taxTaxesNet DemandProbEBITInterestIncome40%IncomeROEEPS Terrible0.05(\$60,000)\$0(\$60,000)(\$24,000)(\$36,000)-18.00%(\$3.60) Poor0.2(\$20,000)\$0(\$20,000)(\$8,000)(\$12,000)-6.00%(\$1.20) Normal0.5\$40,000\$0\$40,000\$16,000\$24,00012.00%\$2.40 Good0.2\$100,000\$0\$100,000\$40,000\$60,00030.00%\$6.00 Great0.05\$140,000\$0\$140,000\$56,000\$84,00042.00%\$8.40 E(value):\$40,000\$0\$40,000\$16,000\$24,00012.00%\$2.40 Std Dev:14.82%\$2.96 \$200,000 in assets, all equity, 10,000 shares

Impact of Leverage Pre-taxTaxesNet DemandProbEBITInterestIncome40%IncomeROEEPS Terrible0.05(\$60,000)\$12,000(\$72,000)(\$28,800)(\$43,200)-43.20%(\$8.64) Poor0.2(\$20,000)\$12,000(\$32,000)(\$12,800)(\$19,200)-19.20%(\$3.84) Normal0.5\$40,000\$12,000\$28,000\$11,200\$16,80016.80%\$3.36 Good0.2\$100,000\$12,000\$88,000\$35,200\$52,80052.80%\$10.56 Great0.05\$140,000\$12,000\$128,000\$51,200\$76,80076.80%\$15.36 E(value):\$40,000\$12,000\$28,000\$11,200\$16,80016.80%\$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 Proposition I Firm value is NOT affected by the capital structure Firm value is NOT affected by the capital structure Since cash flows don’t change, value doesn’t change Since cash flows don’t change, value doesn’t change Proposition II Proposition II Firm WACC is NOT affected by capital structure Firm WACC is NOT affected by capital structure

M&M – Perfect Market Assumes no taxes or bankruptcy costs Assumes no taxes or bankruptcy costs WACC = (E/V)R E + (D/V)R D WACC = (E/V)R E + (D/V)R D No taxes No taxes R E = R A + (R A – R D )(D/E) R E = R A + (R A – R D )(D/E) R A : “cost” of the firm’s business risk R A : “cost” of the firm’s business risk (R A – R D )(D/E): “cost” of the firm’s financial risk (R A – R D )(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 R A = 16%, R D = 10%; % debt = 45% R A = 16%, R D = 10%; % debt = 45% Cost of equity? Cost of equity? R E = 16 + (16 - 10)(.45/.55) = 20.91% R E = 16 + (16 - 10)(.45/.55) = 20.91% If the cost of equity is 25%, what is D/E? If the cost of equity is 25%, what is D/E? 25 = 16 + (16 - 10)(D/E) 25 = 16 + (16 - 10)(D/E) D/E = D/E = Then, what is the % equity in the firm? Then, what is the % equity in the firm? E/V = E/V =

Capital Structure Example Balance Sheet Balance Sheet Assets (A)100 Debt Value (D)40 Equity Value (E) 60 Equity Value (E) 60 Assets100 Firm Value (V) 100 r debt =8% & r equity =15% r debt =8% & r equity =15% WACC = r assets =(D/V)* r debt + (E/V)* r equity WACC =

Capital Structure Example New capital structure New capital structure Assets (A)100 Debt Value (D)30 Equity Value (E)70 Equity Value (E)70 Assets100 Firm Value (V)100 Has the risk of the project changed? Has the risk of the project changed? Is the go-ahead decision different? Is the go-ahead decision different?

After Refinancing Before Before WACC =.4 (8%) +.6 (15%) = 12.2% WACC =.4 (8%) +.6 (15%) = 12.2% After After Imagine cost of debt dropped to 7.3% Imagine cost of debt dropped to 7.3% WACC =.3 (7.3%) +.7 (r equity ) = 12.2% WACC =.3 (7.3%) +.7 (r equity ) = 12.2% r equity = r equity =

Example Debt/equity mix doesn’t affect the project’s inherent risk Debt/equity mix doesn’t affect the project’s inherent risk Required return on the package of debt and equity is unaffected Required return on the package of debt and equity is unaffected However reducing debt level changes the required returns However reducing debt level changes the required returns Reduced debtholder risk (r debt fell) Reduced debtholder risk (r debt fell) Reduced equityholder risk (r equity fell) Reduced equityholder risk (r equity fell) How is it, then, that reducing firm risk did not reduce the required rate of return? How is it, then, that reducing firm risk did not reduce the required rate of return? Project risk is the same. Project risk is the same. Weights changed. Weights changed.

Corporate Taxes Interest is tax deductible Interest is tax deductible Effectively, govt subsidizes part of interest payment Effectively, govt subsidizes part of interest payment Adding debt can reduce firm taxes Adding debt can reduce firm taxes Reduced taxes increases the firm cash flows Reduced taxes increases the firm cash flows

Ex: Taxes UnleveredLevered EBIT50005000 Interest (\$6250 @ 8%) 0500 Taxable Income 50004500 Taxes (34%) 17001530 Net Income 33002970 Bondholders 0 500 Equityholders3300 2970 Total Cash Flows3300 3470

Interest Tax Shield Annual interest tax shield Annual interest tax shield Tax rate times interest payment Tax rate times interest payment \$6250 *.08 = \$500 in interest expense \$6250 *.08 = \$500 in interest expense Annual tax shield =.34(500) = 170 Annual tax shield =.34(500) = 170 PV of annual interest tax shield PV of annual interest tax shield Assume perpetual debt Assume perpetual debt PV = PV = PV = D(R D )(T C ) / R D = DT C = PV = D(R D )(T C ) / R D = DT C =

Taxes – Firm Value Firm value increases by value of tax shield Firm value increases by value of tax shield V L = V U + PV (interest tax shield) V L = V U + PV (interest tax shield) If perpetuity, V U = EBIT(1-.t) / r A If perpetuity, V U = EBIT(1-.t) / r A Value of equity = Value of the firm – Value of debt Value of equity = Value of the firm – Value of debt Ex: Unlevered cost of capital (r A )= 12%; t = 35%; EBIT = 25 mil; D = \$75 mil; r D = 9%; Ex: Unlevered cost of capital (r A )= 12%; t = 35%; EBIT = 25 mil; D = \$75 mil; r D = 9%; V U = V U = V L = V L = E = E =

Taxes - WACC WACC decreases as D/E increases WACC decreases as D/E increases WACC = (E/V)R E + (D/V)(R D )(1-T C ) WACC = (E/V)R E + (D/V)(R D )(1-T C ) R E = R A + (R A – R D )(D/E)(1-T C ) R E = R A + (R A – R D )(D/E)(1-T C ) r A = 12%; t = 35%; D = \$75 mil; r D = 9%; V U = \$135.42 mil; V L = \$161.67 mil; E = \$86.67 mil r A = 12%; t = 35%; D = \$75 mil; r D = 9%; V U = \$135.42 mil; V L = \$161.67 mil; E = \$86.67 mil R E = R E = WACC= WACC=

Example: Proposition II - Taxes Firm restructures its capital so D/E = 1 Firm restructures its capital so D/E = 1 r A = 12%; t = 35%; r D = 9% r A = 12%; t = 35%; r D = 9% New cost of equity? New cost of equity? R E = R E = New WACC? New WACC? WACC = WACC =

Taxes + Bankruptcy Probability of bankruptcy increases with debt Probability of bankruptcy increases with debt Increases the expected bankruptcy costs Increases the expected bankruptcy costs Eventually, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost 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 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 Bond borrowed ratio ratio rating r d \$ 0 0 0 -- -- 2500.1250.1429 AA 8.0% 5000.2500.3333 A 9.0% 7500.3750.6000 BBB 11.5% 1,0000.5001.0000 BB 14.0%

Times Interest Earned TIE = EBIT / Interest EBIT = \$400,000 t=40% 80,000 shares outstanding, with price of \$25

EPS & TIE: D = \$250,000, r d = 8%

EPS & TIE D = \$500,000, r d = 9%

Bankruptcy Costs Direct costs Direct costs Legal and administrative costs Legal and administrative costs Additional losses for bondholder Additional losses for bondholder Indirect bankruptcy or financial distress costs Indirect bankruptcy or financial distress costs Preoccupies management Preoccupies management Reduces sales Reduces sales Lose valuable employees Lose valuable employees

Options of Distress The right to go bankrupt The right to go bankrupt Valuable Valuable Protects creditors from further loss of assets Protects creditors from further loss of assets Creditors will renegotiate – why? Creditors will renegotiate – why? Avoid bankruptcy costs Avoid bankruptcy costs Voluntary debt restructuring Voluntary debt restructuring

Tradeoff Theory Tradeoff between the tax benefits and the costs of distress. Tradeoff determines optimal capital structure V L = V U + t C *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 Tax benefit matters only if there’s a large tax liability Risk and costs of financial distress vary Risk and costs of financial distress vary Capital structure does differ by industries Capital structure does differ by industries Increased risk of financial distress Increased risk of financial distress Increased cost of financial distress Increased cost of financial distress Lowest levels of debt Lowest levels of debt Pharma, Computers Pharma, Computers Highest levels of debt Highest levels of debt Steel, Department stores, Utilities 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 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 6 Divisions Commercial Finance – loans, leases, insurance Commercial Finance – loans, leases, insurance Healthcare – medical technology, drug discovery Healthcare – medical technology, drug discovery Industrial – appliances, lighting, equipment services Industrial – appliances, lighting, equipment services Infrastructure – aviation, water, oil & gas technology Infrastructure – aviation, water, oil & gas technology Money – consumer finance (credit cards, auto loans) Money – consumer finance (credit cards, auto loans) NBC Universal – entertainment and news NBC Universal – entertainment and news

Project WACC  Using 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 for projects that mirror the overall firm risk Only be used if the new financing has the same proportion of debt, preferred, and equity Only be used if the new financing has the same proportion of debt, preferred, and equity Otherwise, use the project cost of capital Otherwise, use the project cost of capital

Pure Play Find several publicly traded companies exclusively in project’s business Find several publicly traded companies exclusively in project’s business Use pure play betas to proxy for project’s beta Use pure play betas to proxy for project’s beta May be difficult to find such companies May be difficult to find such companies Note if the pure play is levered 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 = Equity risk = business risk (operating leverage) + financial risk (financial leverage) financial risk (financial leverage)  L =  U (1+(1-t)D/E)  L =  U (1+(1-t)D/E)  L =  E = Equity beta = Levered beta  L =  E = Equity beta = Levered beta  U =  A = Asset beta = Unlevered beta  U =  A = Asset beta = Unlevered beta t = Company’s marginal tax rate t = Company’s marginal tax rate

Capital Structure & Beta Beta varies with capital choice Beta varies with capital choice  assets (U) =  portfolio = (D/V)  debt + (E/V)  equity  assets (U) =  portfolio = (D/V)  debt + (E/V)  equity Original Capital Structure Original Capital Structure  debt =.2  equity = 1.2  debt =.2  equity = 1.2 (40/100)*.2 + (60/100)*1.2 =  assets =.8 (40/100)*.2 + (60/100)*1.2 =  assets =.8 Debt drops to 30% Debt drops to 30% Suppose the debt beta falls to.1 Suppose the debt beta falls to.1 Then,  assets(U) =.8 = (.3 *.1) + (.7 *  equity ) so  equity = 1.1 Then,  assets(U) =.8 = (.3 *.1) + (.7 *  equity ) so  equity = 1.1 Unlever betas, we move from an observed  equity to  asset 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. Firm with no debt decides to issue \$100 million in bonds and retire some outstanding stock. Historically, β L =.75 Historically, β L =.75 Value of the equity after \$100 million is retired is \$235 million. The tax rate is 35%. Value of the equity after \$100 million is retired is \$235 million. The tax rate is 35%. What is β after the transaction? What is β after the transaction?  L =  U (1+(1-t)D/E), where  L = lev,  U = unlev  L =  U (1+(1-t)D/E), where  L = lev,  U = unlev  L =  L =

Post-Acquisition Beta 1995: Disney announced it was acquiring Capital Cities for \$120/share 1995: Disney announced it was acquiring Capital Cities for \$120/share At acquisition, Disney At acquisition, Disney  equity (L) = 1.15 E = \$31.1 bil D = \$3.186 bil  equity (L) = 1.15 E = \$31.1 bil D = \$3.186 bil Based on \$120 offer price, Capital Cities Based on \$120 offer price, Capital Cities  equity(L) = 0.95 E = \$18.5 bilD = \$615 mil  equity(L) = 0.95 E = \$18.5 bilD = \$615 mil Corporate tax rate was 36% Corporate tax rate was 36%

Disney/Capital Cities Step 1 Step 1 Find unlevered betas for each company Find unlevered betas for each company Step 2 Step 2 Use market values of DIS & CC to find unlevered beta of combined firm Use market values of DIS & CC to find unlevered beta of combined firm Step 3 Step 3 Find levered beta using leverage of combined firm Find levered beta using leverage of combined firm

1) Unlevered Betas

2) Combined Beta

3) Levered Beta

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