CORPORATE FINANCE REVIEW FOR QUIZ 1B Aswath Damodaran

2 Basic Skills Tested  What are the fundamentals that drive beta and why might they change? - What is the relationship between leverage and beta? - How do you estimate a new beta if a firm changes its leverage? - In general, how is the unlevered beta related to the businesses that a firm is in? What effect do acquisitions and divestitures have on this unlevered beta?  What is the cost of debt and how is related to default risk?  How do you measure default risk in a company?  How do you get from a default risk measure to a cost of debt?  How does the tax code drive the cost of borrowing?  How do you get from costs of debt & equity to a cost of capital?  What are the weights to attach to debt and equity?

3 Betas and Fundamentals  The beta of a firm reflects three fundamental decisions a firm makes a. The type of business it is in, and the products and services it provides. The more discretionary these products or services, the higher the beta. b. The cost structure of the business as measured by the operating leverage c. The financial leverage that the firm takes on; higher financial leverage leads to higher equity betas  Rather than trust a regression beta, you can estimate a bottom up beta by doing the following: 1. Take a weighted average of the betas of the businesses, with the weights based upon value. 2. Lever this beta up by using the market debt to equity ratio for the company.

4 Bottom up Beta: Example  Melia Coffee is a company that operates espresso cafes and produces coffee pods and espresso machines for sale. The following table summarizes the revenues that the company generated from each business and relevant statistics from publicly traded companies in each business.  Melia Coffee had debt outstanding of $ 50 million at the end of the most recent year and the marginal tax rate for all companies is 40%. The company has no cash.

5 A good use for a financial balance sheet  When faced with multiple businesses, it is generally a good idea to convert that information into a financial balance sheet, which looks like this. Note that the values for the businesses are estimated market values obtained by multiplying revenues by the revenue multiple (EV/Sales). The equity is computed as the difference between the value of the business and outstanding debt

6 Step 1: Estimating an unlevered beta for Melia Note that the unlevered beta for the company is a weighted average of the unlevered betas of the businesses. The regression betas for the industries are irrelevant.

7 Step 2: Getting a levered beta  The equation for the levered beta is as follows: Levered Beta = Unlevered Beta (1+ (1- tax rate) (Market D/E ratio)) The tax rate should be the marginal tax rate.  Estimated market values  Debt = 50  Equity = 150  D/E Ratio = 50/150 = 33.33%  Tax rate = 40%  Levered beta = 0.90 (1 + (1-.4) (.3333)) = 1.08

8 Changing business mix and betas: An acquisition example  You have been asked to assess the impact of Microsoft’s attempted acquisition of Yahoo! and have collected the following information (in billions) on the two companies:  While you believe that the regression beta is a reasonable estimate of the beta for Microsoft as a company, you do not trust the regression beta for Yahoo! The average unlevered beta for the internet services business is 2.00 and the marginal tax rate for all firms is 40%.

9 Getting to an unlevered beta for a business  Assuming that cash as a percent of Microsoft’s value has remained unchanged over the last two years (the regression period) and that the firm has never used debt, estimate the unlevered beta of just being in the software business.  Value of Microsoft as a firm = $  Cash as % of value = 60/ 300 = 20.00%  Microsoft's beta = 1.20  Beta of software = 120 / (1-.20) = 1.50

10 Estimate the unlevered beta after the asset redeployment  Key principles  Work with unlevered betas for the individual businesses, since you are looking at business risk  Use the “values” of the businesses to get to the weight of the businesses.  Assume that Microsoft plans to use its entire cash balance to buy Yahoo! Estimate the beta for Microsoft after the transaction.

11 An Aside: Changing financial leverage complicates matter…  In some cases, an asset redeployment will be accompanied by a change in financial leverage. For instance, Microsoft could have borrowed money to do its acquisition or a divestiture of a division can be followed by a stock buyback.  If financial leverage is changing along with the asset mix, it is best to approach your estimation in two parts. 1. Estimate the unlevered beta for the company after the asset redeployment. 2. Estimate the new debt to equity ratio after the asset redeployment 3. Estimate a new levered beta for the compny

12 The cost of debt and capital  The cost of debt is the rate at which a company can borrow money long term, today. It is therefore a “current” cost of borrowing. To estimate it, you need to start with a risk free rate and add a default spread for the company.  Pre-tax Cost of debt = Risk free Rate + Default Spread  To get the default spread, you either need a measure of default risk (bond rating, for instance) or estimate one on your own (based upon financial ratios).  To get to the after-tax cost of debt, you need to adjust the cost of debt for the tax savings. Since these tax savings occur on the last dollars of your income, it is best to use a marginal tax rate.  After-tax cost of debt = Pre-tax cost of debt (1- marginal tax rate)

13 The weights in the cost of capital computation  The weights on equity and debt should reflect their estimated market values, not just the book value.  With equity, especially in publicly traded firms, this should just be the market capitalization.  With debt, estimating market value can be problematic for two reasons:  A significant portion of the debt may not be traded (example: bank debt) and you may have only book value for this debt.  Some of the debt may take the form of “commitments” that are not shown as debt on the balance sheet.

14 Estimating cost of capital: Example  The unlevered beta for paper & pulp companies is 1.05  There are 100 million shares outstanding, trading at $20/share, and the book value of equity is $ 1 billion.  The firm has $ 1 billion in debt outstanding (in book value terms), with interest expenses of $ 40 million a year. The debt has a weighted average maturity of 8 years.  The company also has $ 50 million in operating lease commitment, each year for the next 6 years.  The bond rating for the company is A+, with a default spread of 1.50% over the riskfree rate.  The risk free rate is 3.5% and the equity risk premium is 6%. The marginal tax rate for all firms is 40% but the effective tax rate is 25%.

15 Estimating market value of debt  Step 1: Get the market value of interest bearing debt  Book value of debt = $1,  Interest expenses = $40.00  Weighted average maturity = 8  Market interest rate for debt = 3.5% + 1.5% = 5.00%  Market value of debt = 40 (PV of annuity, 8 years, 5%) /1.05^8 = $  Step 2: Get the PV (also market value) of operating leases  Operating lease commitment = 50  Number of years = 6  Market interest rate on debt = 5%  PV of lease commitments = 50 (PV of annuity, 6 years, 5%) = $ Total market value of debt = $ $ = $1,189.15

16 Compute weights and cost of capital  Step 1: Compute market value weighted debt ratios  Market value of equity = 2000  Market value of debt = $1,  Market D/Capital ratio = 1189/ ( ) = 37.29%  Market D/E ratio = 1189/2000 = 59.46%  Step 2: Compute the levered beta  Unlevered beta= 1.05  Levered beta = 1.05 (1+ (1-.4) (.5946) =  Step 3: Compute cost of equity and capital  Cost of equity = 3.5% (6%) = 12.05%  After-tax cost of debt =5% (1-.4) = 3.00%  Cost of capital = 12.05% ( ) + 3% (.3729) = 8.67%