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12-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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12-2 Key Concepts and Skills Know how to determine: –A firm’s cost of equity capital –A firm’s cost of debt –A firm’s overall cost of capital Understand pitfalls of overall cost of capital and how to manage them

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12-3 Cost of Capital Basics The cost to a firm for capital funding = the return to the providers of those funds –The return earned on assets depends on the risk of those assets –A firm’s cost of capital indicates how the market views the risk of the firm’s assets –A firm must earn at least the required return to compensate investors for the financing they have provided –The required return is the same as the appropriate discount rate

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12-4 Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Two major methods for determining the cost of equity - Dividend growth model - SML or CAPM

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12-5 The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for R E

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12-6 Advantages and Disadvantages of Dividend Growth Model Advantage – easy to understand and use Disadvantages –Only applicable to companies currently paying dividends –Not applicable if dividends aren’t growing at a reasonably constant rate –Extremely sensitive to the estimated growth rate –Does not explicitly consider risk

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11-7 Risk and Return Risk: –Uncertanity –Stand alone risk –Systematic Reisk Return: –Expected Return, based on expected outcomes and probabilities –Required Return, based on the level of risk

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11-8 Expected Returns Expected returns are based on the probabilities of possible outcomes Where: p i = the probability of state “i” occurring R i = the expected return on an asset in state i

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11-9 Variance and Standard Deviation Variance and standard deviation measure the volatility of returns Variance = Weighted average of squared deviations Standard Deviation = Square root of variance

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11-10 Portfolios Portfolio = collection of assets An asset’s risk and return impact how the stock affects the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

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11-11 Portfolio Expected Returns The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio Weights (w j ) = % of portfolio invested in each asset

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11-12 Portfolio Risk Variance & Standard Deviation Portfolio standard deviation is NOT a weighted average of the standard deviation of the component securities’ risk –If it were, there would be no benefit to diversification.

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11-13 of n-Stock Portfolio Subscripts denote stocks i and j i,j = Correlation between stocks i and j σ i and σ j =Standard deviations of stocks i and j σ ij = Covariance of stocks i and j

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11-14 Correlation Coefficient Correlation Coefficient = ρ (rho) Scales covariance to [-1,+1] –-1 = Perfectly negatively correlated – 0 = Uncorrelated; not related –+1 = Perfectly positively correlated

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11-15 Systematic Risk Factors that affect a large number of assets “Non-diversifiable risk” “Market risk” Examples: changes in GDP, inflation, interest rates, etc.

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11-16 Unsystematic Risk = Diversifiable risk Risk factors that affect a limited number of assets Risk that can be eliminated by combining assets into portfolios “Unique risk” “Asset-specific risk” Examples: labor strikes, part shortages, etc.

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11-17 The Principle of Diversification Diversification can substantially reduce risk without an equivalent reduction in expected returns –Reduces the variability of returns –Caused by the offset of worse-than- expected returns from one asset by better- than-expected returns from another Minimum level of risk that cannot be diversified away = systematic portion

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11-18 Total Risk = Stand-alone Risk Total risk = Systematic risk + Unsystematic risk –The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small Total risk for a diversified portfolio is essentially equivalent to the systematic risk

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11-19 Systematic Risk Principle There is a reward for bearing risk There is no reward for bearing risk unnecessarily The expected return (market required return) on an asset depends only on that asset’s systematic or market risk.

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11-20 Market Risk for Individual Securities The contribution of a security to the overall riskiness of a portfolio Relevant for stocks held in well-diversified portfolios Measured by a stock’s beta coefficient Measures the stock’s volatility relative to the market

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11-21 The Beta Coefficient i = ( i,M i ) / M = iM / M 2 Where: ρ i,M = Correlation coefficient of this asset’s returns with the market σ i = Standard deviation of the asset’s returns σ M = Standard deviation of the market’s returns σ M 2 = Variance of the market’s returns σ iM = Covariance of the asset’s returns and the market

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11-22 Interpretation of beta If = 1.0, stock has average risk If > 1.0, stock is riskier than average If < 1.0, stock is less risky than average Most stocks have betas in the range of 0.5 to 1.5 Beta of the market = 1.0 Beta of a T-Bill = 0

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11-23 Beta and the Risk Premium Risk premium = E(R ) – R f The higher the beta, the greater the risk premium should be Can we define the relationship between the risk premium and beta so that we can estimate the expected return? –YES!

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11-24 SML and Equilibrium Figure 11.4

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11-25 Reward-to-Risk Ratio Reward-to-Risk Ratio: = Slope of line on graph In equilibrium, ratio should be the same for all assets When E(R) is plotted against β for all assets, the result should be a straight line

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11-26 Market Equilibrium In equilibrium, all assets and portfolios must have the same reward-to-risk ratio Each ratio must equal the reward-to-risk ratio for the market

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11-27 Security Market Line The security market line (SML) is the representation of market equilibrium The slope of the SML = reward-to-risk ratio: (E(R M ) – R f ) / M Slope = E(R M ) – R f = market risk premium –Since of the market is always 1.0

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11-28 The SML and Required Return The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM) R f = Risk-free rate (T-Bill or T-Bond) R M = Market return ≈ S&P 500 RP M = Market risk premium = E(R M ) – R f E(R i ) = “Required Return”

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11-29 Capital Asset Pricing Model The capital asset pricing model (CAPM) defines the relationship between risk and return E(R A ) = R f + (E(R M ) – R f )β A If an asset’s systematic risk ( ) is known, CAPM can be used to determine its expected return

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11-30 Factors Affecting Required Return R f measures the pure time value of money RP M = (E(R M )-R f ) measures the reward for bearing systematic risk i measures the amount of systematic risk

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11-31 Portfolio Beta β p = Weighted average of the Betas of the assets in the portfolio Weights (w i ) = % of portfolio invested in asset i

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12-32 The SML Approach Use the following information to compute the cost of equity –Risk-free rate, R f –Market risk premium, E(R M ) – R f –Systematic risk of asset,

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12-33 Advantages and Disadvantages of SML Advantages –Explicitly adjusts for systematic risk –Applicable to all companies, as long as beta is available Disadvantages –Must estimate the expected market risk premium, which does vary over time –Must estimate beta, which also varies over time –Relies on the past to predict the future, which is not always reliable

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12-34 Example: Cost of Equity Data: –Beta = 1.5 –Market risk premium = 9% –Current risk-free rate = 6%. –Analysts’ estimates of growth = 6% per year –Last dividend = $2. –Currently stock price =$15.65 –Using SML: R E = 6% + 1.5(9%) = 19.5% –Using DGM: R E = [2(1.06) / 15.65] +.06 = 19.55%

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12-35 Cost of Debt The cost of debt = the required return on a company’s debt Method 1 = Compute the yield to maturity on existing debt Method 2 = Use estimates of current rates based on the bond rating expected on new debt The cost of debt is NOT the coupon rate

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12-36 Component Cost of Debt Use the YTM on the firm’s debt Interest is tax deductible, so the after-tax (AT) cost of debt is: If the corporate tax rate = 40%:

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12-37 Weighted Average Cost of Capital Use the individual costs of capital to compute a weighted “average” cost of capital for the firm This “average” = the required return on the firm’s assets, based on the market’s perception of the risk of those assets The weights are determined by how much of each type of financing is used

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12-38 Determining the Weights for the WACC Weights = percentages of the firm that will be financed by each component Always use the target weights, if possible –If not available, use market values

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12-39 Capital Structure Weights Notation E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price V = market value of the firm = D + E Weights E/V = percent financed with equity D/V = percent financed with debt

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12-40 WACC WACC = (E/V) x R E + (P/V) x R P + (D/V) x R D x (1- T C ) Where: ( E/V) = % of common equity in capital structure (P/V) = % of preferred stock in capital structure (D/V) = % of debt in capital structure R E = firm’s cost of equity R P = firm’s cost of preferred stock R D = firm’s cost of debt T C = firm’s corporate tax rate Weights Component costs

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12-41 Estimating Weights Given: Stock price = $50 3m shares common stock $25m preferred stock $75m debt 40% Tax rate Weights: E/V = $150/$250= 0.6 (60%) P/V = $25/$250 = 0.1 (10%) D/V = $75/$250 = 0.3 (30%) Component Values: V E = $50 x (3 m) = $150m V P = $25m V D = $75m V F = $150+$25+$75=$250m

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12-42 WACC WACC = 0.6(14%)+0.1(9%) +0.3(10%)(1-.40) WACC = 8.4% + 0.9% + 1.8% = 11.1% ComponentWR Debt (before tax)0.3010% Preferred Stock0.109% Common equity0.6014% WACC = E/V x R E + P/V x R P + D/V x R D (1- T C )

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12-43 Table 12.1

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12-44 Factors that Influence a Company’s WACC Market conditions, especially interest rates, tax rates and the market risk premium The firm’s capital structure and dividend policy The firm’s investment policy –Firms with riskier projects generally have a higher WACC

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12-45 Risk-Adjusted WACC A firm’s WACC reflects the risk of an average project undertaken by the firm –“Average” risk = the firm’s current operations Different divisions/projects may have different risks –The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure

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12-46 Subjective Approach Consider the project’s risk relative to the firm overall –If the project is riskier than the firm, use a discount rate greater than the WACC –If the project is less risky than the firm, use a discount rate less than the WACC

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13-47 Key Concepts and Skills (Session 8) Understand: –The effect of financial leverage on cash flows and cost of equity –The impact of taxes and bankruptcy on capital structure choice –The basic components of the bankruptcy process

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13-48 Capital Structure Capital structure = percent of debt and equity used to fund the firm’s assets –“Leverage” = use of debt in capital structure Capital restructuring = changing the amount of leverage without changing the firm’s assets –Increase leverage by issuing debt and repurchasing outstanding shares –Decrease leverage by issuing new shares and retiring outstanding debt

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13-49 Capital Structure & Shareholder Wealth The primary goal of financial managers: –Maximize stockholder wealth Maximizing shareholder wealth = –Maximizing firm value –Minimizing WACC Objective: Choose the capital structure that will minimize WACC and maximize stockholder wealth

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13-50 “Financial leverage” = the use of debt Leverage amplifies the variation in both EPS and ROE We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock? The Effect of Financial Leverage

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13-51 Trans Am Corporation Example

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13-52 Trans Am Corp With and Without Debt

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13-53 Leverage Effects Variability in ROE –Current: ROE ranges from 6.25% to 18.75% –Proposed: ROE ranges from 2.50% to 27.50% Variability in EPS –Current: EPS ranges from $1.25 to $3.75 –Proposed: EPS ranges from $0.50 to $5.50 The variability in both ROE and EPS increases when financial leverage is increased

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13-54 Trans Am Corp Conclusions 1.The effect of leverage depends on EBIT When EBIT is higher, leverage is beneficial 2.Under the “Expected” scenario, leverage increases ROE and EPS 3.Shareholders are exposed to more risk with more leverage ROE and EPS more sensitive to changes in EBIT

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13-55 Capital Structure Theory Modigliani and Miller –M&M Proposition I – The Pie Model –M&M Proposition II – WACC The value of the firm is determined by the cash flows to the firm and the risk of the firm’s assets Changing firm value –Change the risk of the cash flows –Change the cash flows

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13-56 Capital Structure Theory Three Special Cases Case I – Assumptions –No corporate or personal taxes –No bankruptcy costs Case II – Assumptions –Corporate taxes, but no personal taxes –No bankruptcy costs Case III – Assumptions –Corporate taxes, but no personal taxes –Bankruptcy costs

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13-57 Case I – Propositions I and II Proposition I –The value of the firm is NOT affected by changes in the capital structure –The cash flows of the firm do not change; therefore, value doesn’t change Proposition II –The WACC of the firm is NOT affected by capital structure

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13-58 Case I - Equations WACC = R A = (E/V) x R E + (D/V) x R D R E = R A + (R A – R D ) x (D/E) R A = the “cost” of the firm’s business risk (i.e., the risk of the firm’s assets) (R A – R D )(D/E) = the “cost” of the firm’s financial risk (i.e., the additional return required by stockholders to compensate for the risk of leverage)

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13-59 M&M Propositions I & II Figure 13.3 The change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity (R E ), so the WACC stays the same.

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13-60 Business and Financial Risk R E = R A + (R A – R D ) x (D/E) Business Risk Financial Risk Proposition II: the systematic risk of the stock depends on: –Systematic risk of the assets, R A, (business risk) –Level of leverage, D/E, (financial risk)

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13-61 Case II – Corporate Taxes Interest on debt is tax deductible When a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm The reduction in taxes reduces net income

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13-62 Case II - Example Interest Tax Shield = $24 per year

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13-63 Interest Tax Shield Annual interest tax shield Tax rate times interest payment $1,000 in 8% debt = $80 in interest expense Annual tax shield =.30($80) = $24 Present value of annual interest tax shield Assume perpetual debt PV = $24 /.08 = $300 PV = D(R D )(T C ) / R D = D*T C = $1,000(.30) = $300

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13-64 M&M Proposition I with Taxes Figure 13.4

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13-65 Case II – Graph of Proposition II

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13-66 M&M Summary Table 13.4

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13-67 Bankruptcy Costs Direct costs –Legal and administrative costs Enron = $1 billion; WorldCom = $600 million –Bondholders incur additional losses –Disincentive to debt financing Financial distress –Significant problems meeting debt obligations –Most firms that experience financial distress do not ultimately file for bankruptcy

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13-68 Indirect Bankruptcy Costs Indirect bankruptcy costs –Larger than direct costs, but more difficult to measure and estimate –Stockholders wish to avoid a formal bankruptcy –Bondholders want to keep existing assets intact so they can at least receive that money –Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business –Lost sales, interrupted operations, and loss of valuable employees, low morale, inability to purchase goods on credit

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13-69 Case III With Bankruptcy Costs D/E ratio → probability of bankruptcy probability → expected bankruptcy costs At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costs At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

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13-70 Optimal Capital Structure Figure 13.5

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13-71 Conclusions Case I – no taxes or bankruptcy costs –No optimal capital structure Case II – corporate taxes but no bankruptcy costs –Optimal capital structure = 100% debt –Each additional dollar of debt increases the cash flow of the firm Case III – corporate taxes and bankruptcy costs –Optimal capital structure is part debt and part equity –Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

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13-72 The Capital Structure Question Figure 13.6

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13-73 Additional Managerial Recommendations Taxes –The tax benefit is only important if the firm has a large tax liability –Higher tax rate → greater incentive to use debt Risk of financial distress –The greater the risk of financial distress, the less debt will be optimal for the firm –The cost of financial distress varies across firms and industries

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13-74 Observed Capital Structures Capital structure differs by industries Differences according to Cost of Capital 2008 Yearbook by Ibbotson Associates, Inc. –Lowest levels of debt Computers= 5.31% Drugs = 6.76% debt –Highest levels of debt Cable television= 61.84% Airlines = 56.30% debt

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13-75 Financial Distress Defined Business failure – business terminated with a loss to creditors Legal bankruptcy – petition filed in federal court for bankruptcy Technical insolvency – firm unable to meet debt obligations Accounting insolvency – book value of equity is negative

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13-76 Financial Management & Bankruptcy The right to file bankruptcy has strategic value –Immediate “stay” on creditors –Ability to terminate labor agreements –Ability to lay off large numbers of workers –Ability to reduce wages “Workouts” and “Cram-downs” –Pre-packaged filings –Negotiated filings and extensions –Court-ordered plan acceptance

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