The Borrowing Mix 02/21/08 Ch. 8

2 What is the Borrowing Mix? The Borrowing Mix The funds used to finance the operations and the sources of the funds Debt Bank Loans Bonds Hybrid Stock – Preferred Stock Equity Shares Owner’s Money

3 Objective of the Firm The objective of the firm Maximize Shareholder/Owner Wealth Wealth is the future cash flow of the firm discounted back to today at the appropriate weight Debt holders paid first Debt is leverage and can increase the wealth of the owner Objective is to find the borrowing mix that maximizes the value of the firm

4 Value of the Firm Value of the company “claimed” by owners Think of company as a project Value is NPV = -Inv + Σ Cash Flow i / (1+ r) I And r is the cost of capital, hurdle rate, or WACC

5 If Cash Flow is fixed… Lowest cost of capital maximizes the value of the firm Find borrowing mix that results in the lowest cost of capital This is the optimal capital structure of the firm Ways to find optimal capital structure Operating Income Approach Cost of Capital Approach Adjusted Present Value Approach

6 Operating Income Approach What operating income is the firm capable of producing (distribution) What different levels of debt will the firm be able to make payments on debt (probability of default) Select an acceptable probability of default Compare probability of default at different borrowing amounts… If you can handle more debt, add debt If you can not handle more debt, reduce debt Difficult part of the task…distribution of operating income

7 Operating Income Approach Personal Example…How big a house can you buy? You estimate your annual income Cash you have on hand (down payment) Percent of your income you want to commit to the house payment (P&I, Insurance, PMI, Taxes) Rule of thumb is 35% of income Same concept for a corporation, how much debt can it handle?

8 Operating Income Approach Average Income and standard deviation of income (normal distribution assumption) Estimate the cash outflow per year for the debt (principal (sinking fund) and interest) Adjust cost of debt as you borrow more Find probability of default (find the t-statistic and look up the probability) Compare probability of default to Company’s acceptable level Borrow until you hit the acceptable level…

9 Example from the book… Disney’s average income $2,713 Disney’s standard deviation on income 19.54% Disney’s acceptable level of default, 5% Break-even debt level ($2,713 – X) / ( x $2,713) = is the t-statistic where you have 5% probability of default X = $1,841 million

10 Cost of Capital Approach Want to find the lowest WACC Lowest WACC is the combination of borrowing that produces the highest firm value As you add debt Cost of equity rises

11 Calculating WACC Cost of Equity Security Market Line Cost of Debt YTM on an outstanding bond Multiply by 1 minus the tax rate Market value of Equity and Debt Equity + Debt = Value of the Firm Adjusting from current D/E to Optimal D/E

12 Increasing Leverage – Impact on WACC Beta increases as more debt is added and thus equity holders require higher return Beta LEV = Beta UNLEV / (1+ [1-tax rate] x [D/e]) Cost of debt (Yield) increases with more debt… Bond ratings fall as you increase debt Bond ratings correlated with yields How to estimate bond rating from interest coverage ration

13 Interest Coverage Ratio Measure of how many times over the current (or projected) EBIT can cover the interest expense of the debt Interest Coverage Ratio = EBIT / Interest Expense Table 8.3 for Bond Rating (page 351) Table 8.4 for yield by Bond Rating (page 352) Market interest rate is a function of current risk free rate and the default spread This is R D

14 Table of Cost of Capital With the levered beta and the current risk free rate and market premium… Find the cost of equity at different D/E Your increasing beta as you increase D/E Calculate Interest Coverage Ratio as you add more debt (Interest Expense increases and EBIT is constant) Find bond rating at the Interest Coverage Ratio Find the yield based on spread and risk free rate

15 Table Cost of Capital Find the Market Value of Equity Find the Market Value of debt Find WACC at the different D/E ratios… Look for the lowest WACC This is the optimal D/E ratio Adjustment to tax rate at higher levels of debt The (1 – tax rate) in WACC assumes you can use all of the tax shield from debt Benefit only up to the EBIT of the company

16 Application of Lowest WACC Once you find the optimal debt structure of the firm You can estimate the value of the firm Dividend growth model

17 What is Cash Flow to the Firm EBIT (Earnings before interest and taxes) + Depreciation (non cash flow expense) - Taxes - Capital Spending (funds used to buy PPE) - Change in Net Working Capital = Free Cash Flow to Owners With Market Value of Equity (outstanding shares x price) and Market Value of Debt (bonds outstanding x price of bonds) Find the growth rate in the company…

18 Moving to Optimal D/E Once we know the WACC at the optimal D/E Once we find the Cash Flow to Firm Once we find growth rate We can use the “Dividend Growth Model” to find the new firm value at the optimal D/E Increase in firm value goes to the owners Recall debt is a fixed claim Calculate new stock price

19 Disney Example – page 357 Cash Flow to Firm = $1,722 Market Value of Equity = $55,101 Market Value of Debt = $14,668 Growth Rate = 5.98% Lowest WACC = 8.50% Firm Value = $72,420 at optimal D/E Increase in Firm Value = $2,651 Increase in price of stock = $1.29 per share

20 Adjustments to Cost of Capital Approach Growth rate...what is a sustainable growth rate? Is 5.98% too high…should it match risk free rate? Is the firm willing to accept low bond ratings? If not the highest D/E may not be the optimal D/E Is Cash Flow to the Firm at the appropriate level…was this a good year or a bad year Was capital spending high or low for the year?

21 Adjusted Present Value Approach Start with an all equity firm… Find its value Find the marginal benefit of the tax shield Find the marginal cost of bankruptcy (distress) Add debt to the firm as long as the marginal benefit of the tax shield is greater than the marginal cost of bankruptcy (distress)

22 Marginal Benefits of Debt The interest payment on debt is an expense and reduces the taxes of the firm as long as the interest expense is equal to or less than the EBIT (there are carry forwards…but skip that for now) Value of Tax Shield Marginal Tax Rate times Amount of Debt This is the present value of the Tax Shield

23 Marginal Cost of Bankruptcy This is very difficult to estimate but it is the cost if you fall into default and those indirect costs that you incur to stay out of default Assess the probability of default (again, not easy to do…book suggests a probit regression of past sinners) Cost to firm is probability of default times the present value of the cost of bankruptcy

24 Value of the Firm APV Find Current Value Discounted Cash Flows, “Dividend growth model” etc. Starting point for value then start adding debt Add in the present value of the tax shield Subtract the present value of bankruptcy Does Firm Value Increase? Yes, add more debt No, subtract debt

25 Tuesday Homework Problem #1 Problem #2 a and b only Problem #3 a, b, c and d only Problem #7 Problem #10 Problem #13 Problem #21 a and b only