IBM

Capital Structure: How Much Debt? IBM Capital Structure: How Much Debt? Prof. Ian Giddy New York University

First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. This is the second component of corporate finance. Firms have to choose both the right financing mix and right type of financing for their needs.

What determines the optimal mix of debt and equity for a company? The Agenda What determines the optimal mix of debt and equity for a company? How does altering the mix of debt and equity affect the value of a company? What is the right kind of debt for a company? These are the basic questions that we will try to answer in this part of the discussion.

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&A TOOLS

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&A TOOLS

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&A TOOLS

IBM: How Much Debt? Source: biz.yahoo.com

IBM: How Much Debt is Right? Source: morningstar.com

IBM: Changes in Debt Mix Source: morningstar.com

Getting the Financing Right Step 1: The Proportion of Equity & Debt Achieve lowest weighted average cost of capital May also affect the business side Debt Equity

Getting the Financing Right Step 2: The Kind of Equity & Debt Short term? Long term? Baht? Dollar? Yen? Debt Bonds? Asset-backed? Convertibles? Hybrids? Equity Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs? Ownership & control?

IBM: What Kind of Debt? Source: IBM Annual Report 2003

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E COST OF CAPITAL Optimal debt ratio? DEBT RATIO

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO

Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs

Costs and Benefits of Debt Tax Benefits Adds discipline to management Costs of Debt Bankruptcy Costs Agency Costs Loss of Future Flexibility This summarizes the trade off that we make when we choose between using debt and equity.

Tax Benefits of Debt Tax Benefits: Interest on debt is tax deductible whereas cash flows on equity (like dividends) are not. Tax benefit each year = t r B After tax interest rate of debt = (1-t) r Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure. The tax benefit of debt will be lower if the tax code allows some or all of the cash flows to equity to be tax deductible, as well. For instance, in Germany, dividends paid to stockholders are taxed at a lower rate than retained earnings. In these cases, the tax advantage of debt will be lower. If you do not pay taxes, debt becomes a lot less attractive. Carnival Cruise Lines, which gets most of its business from US tourists pays no taxes because it is domiciled in Liberia. We would expect it to have less debt in its capital structure than a competitor in the US which pays taxes.

Debt Adds Discipline to Management Equity is a cushion; Debt is a sword; The management of firms which have high cash flows left over each year are more likely to be complacent and inefficient. This is a quote from Bennett Stewart. Managers of firms with substantial cash flows and little debt are much more protected from the consequences of their mistakes (especially when stockholders are powerless and boards toothless). Left to themselves, managers (especially lazy ones) would rather run all-equity financed firms with substantial cash reserves.

The expected bankruptcy cost is a function of two variables-- the cost of going bankrupt direct costs: Legal and other Deadweight Costs indirect costs: Lost Sales... durable versus non-durable goods (cars) quality/safety is important (airlines) supplementary services (copiers) the probability of bankruptcy Studies (see Warner) seem to indicate that the direct costs of bankruptcy are fairly smal. The indirect cost of going bankrupt comes from the perception that you are in financial trouble, which in turn affects sales and the capacity to raise credit. As an example, when Apple Computer was perceived to be in financial trouble in early 1997, first-time buyers and businesses stopped buying Apples and software firms stopped coming up with upgrades for products. Similarly, Kmart found that suppliers started demanding payments in 30 days instead of 60 days, when it got into financial trouble. The probability of bankruptcy should be a function of the predictability (or variability) of earnings.

The Bankruptcy Cost Proposition Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cash flows of the firm, the less debt the firm can afford to use. Both the cost of bankruptcy and the probability of bankruptcy go into the expected cost. A firm can have a high expected bankruptcy cost when either or both is high. If governments step in and provide protection to firms that get into financial trouble, they are reducing the expected cost of bankruptcy. Under that scenario, you would expect firms to borrow more money. (See South Korea)

Stockholders incentives are different from bondholder incentives Agency Cost Stockholders incentives are different from bondholder incentives Taking of Risky Projects Paying large dividends Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use. What is good for equity investors might not be good for bondholders and lenders…. A risky project, with substantial upside, may make equity investors happy, but they might cause bondholders, who do not share in the upside, much worse off. Similarly, paying a large dividend may make stockholders happier but they make lenders less well off.

Loss of Future Financing Flexibility When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. Firms like to preserve flexibility. The value of flexibility should be a function of how uncertain future investment requirements are, and the firm’s capacity to raise fresh capital quickly. Firms with uncertain future needs and the inability to access markets quickly will tend to value flexibility the most, and borrow the least.

Kodak Source: Bloomberg.com

Kodak Source: morningstar.com

Merck Merck: P/E 16 Market Cap $112b Source: morningstar.com

Nokia Nokia: P/E 34 Market Cap $70b Source: morningstar.com

ABB ABB: P/E N/A Market Cap $5.7b Source: morningstar.com

TDI Source: moneycentral.msn.com

TDI Twin Disc: P/E 18.8 Market Cap $39m Source: morningstar.com

See Saw Business Uncertainty Operating Leverage Financial Risk Financial Leverage Financial Risk

Young and Old Size Maturity Financial Leverage Operating Leverage

Capital Structure: Actual vs Optimal Nestle Loewen VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO

Capital Structure: East vs West Intel Sammi VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO

Case Study: Sammi Steel 1989 Acquisition of Atlas The main advantage from expansion through acquisition was that 500,000 tones of production capacity were purchased for $ 210.6 mm Vs. building 300,000 tones at $ 500mm. The $ 280mm saved through acquisition was invested in modernization of existing Korean plants so that total production capacity at Sammi Steel rose from 240,000 in 1988 to 750,000 in 1991. Domestic and Foreign investors supported Sammi’s move to acquire the Atlas group of factories as a good strategic move and the Sammi share price rose from 21,489 Korean won on 12/31/88 to 25700 on 12/31/89.

How Much Debt?

Profits: Zero ~ Risks: High How Much Debt? A $19.95 company...an “ISP” Profits: Zero ~ Risks: High

Financing Growth Companies: The Agenda Where can we get the initial equity financing we need to grow? Do we want money, management, or more? When do we want to sell out, and how? When is the right time for debt for a growth company? What kind? These are the basic questions that we will try to answer in this part of the discussion.

What Kind of Equity? Sources of Equity And Kinds Private investors Strategic investors Interventionist investors Public market And Kinds Common stock Stock with restricted voting rights Hybrids, including convertibles This summarizes the trade off that we make when we choose between using debt and equity.

Case Study: Photronics

1997: Should Photronics Finance its Growth with Debt? Benefits of Debt Tax Benefits Adds discipline to management Costs of Debt Bankruptcy Costs Agency Costs Loss of Future Flexibility This summarizes the trade off that we make when we choose between using debt and equity.

Photronics

Minimizing the Cost of Capital Choice Cost 1. Equity Cost of equity - Retained earnings - depends upon riskiness of the stock - New stock issues - will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. Debt Cost of debt - Bank borrowing - depends upon default risk of the firm - Bond issues - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

Estimating the Cost of Debt If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate. If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated, and it has recently borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

Ratings and Spreads

The Cost of Equity Standard approach to estimating cost of equity: Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf) where, Rf = Riskfree rate E(Rm) = Expected Return on the Market Index (Diversified Portfolio) In practice, Long term government bond rates are used as risk free rates Historical risk premiums are used for the risk premium Betas are estimated by regressing stock returns against market returns

Equity Betas and Leverage The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio L = u (1+ ((1-t)D/E) where L = Levered or Equity Beta u = Unlevered Beta t = Corporate marginal tax rate D = Market Value of Debt E = Market Value of Equity While this beta is estimated on the assumption that debt carries no market risk (and has a beta of zero), you can have a modified version: L = u (1+ ((1-t)D/E) - debt (1-t) D/(D+E)

Cost of Capital and Leverage: Method Equity Debt Estimated Beta With current leverage From regression Leverage, EBITDA And interest cost Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Interest Coverage EBITDA/Interest Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Rating (other factors too!) Cost of equity With different leverage E(R)=Rf+Bl(Rm-Rf) Cost of debt With different leverage Rate=Rf+Spread+?

The Cost of Capital Choice Cost 1. Equity Cost of equity - Retained earnings - depends upon riskiness of the stock - New stock issues - will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. Debt Cost of debt - Bank borrowing - depends upon default risk of the firm - Bond issues - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

Next, Minimize the Cost of Capital by Changing the Financial Mix The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm. Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt. But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.

Siderar: Optimal Debt Ratio Question: If Siderar’s current debt ratio is 60%, what do you recommend?

Siderar: Optimal Debt Ratio

Case Study: SAP

Case Study: SAP Should SAP take on additional debt? If so, how much? What is the weighted average cost of capital before and after the additional debt? What will be the estimated price per share after the company takes on new debt?

Case Study: IBM

Case Study: IBM

A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Actual < Optimal Overlevered Underlevered Is the firm under bankruptcy threat? Is the firm a takeover target? Yes No Yes No Reduce Debt quickly Increase leverage Does the firm have good 1. Equity for Debt swap quickly Does the firm have good 2. Sell Assets; use cash projects? 1. Debt/Equity swaps projects? to pay off debt ROE > Cost of Equity 2. Borrow money& ROE > Cost of Equity ROC > Cost of Capital 3. Renegotiate with lenders buy shares. ROC > Cost of Capital Yes No Yes No Take good projects with 1. Pay off debt with retained new equity or with retained earnings. Take good projects with earnings. 2. Reduce or eliminate dividends. debt. Do your stockholders like 3. Issue new equity and pay off dividends? debt. Yes No Pay Dividends Buy back stock

First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. This completes our discussion of the second leg of corporate finance.

Links Useful Links Company information: biz.yahoo.com/ifc Industry ratios: www.stern.nyu.edu/~adamodar Debt ratings and spreads: bondsonline.com

www.stern.nyu.edu

www.giddy.org

Contact NYU Stern School of Business 44 West 4th Street New York, NY 10012, USA 212-998-0426 ian.giddy@nyu.edu http://giddy.org