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Optimal Capital Structure The Cost of Capital Approach P.V. Viswanath Based on Damodaran’s Corporate Finance.

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Presentation on theme: "Optimal Capital Structure The Cost of Capital Approach P.V. Viswanath Based on Damodaran’s Corporate Finance."— Presentation transcript:

1 Optimal Capital Structure The Cost of Capital Approach P.V. Viswanath Based on Damodaran’s Corporate Finance

2 P.V. Viswanath2 Cost of Capital Approach  We have already seen that FCFF = EBIT(1-t) – (Capital Expenditures – Dep) – Change in Noncash Working Capital  The Value of the firm is the sum of the discounted present values of FCFF plus current cash.  If we can assume that the cashflows are unaffected by the choice of financing mix, then Max Firm Value = Min WACC

3 P.V. Viswanath3 Cost of Equity Capital  We compute WACC at different debt/capital ratios and pick the lowest WACC.  Three inputs needed: Cost of equity After-tax cost of debt Weights on debt and equity  Start with the current equity beta and compute the firm’s asset beta.  Compute the firm’s levered beta for different debt ratio levels and use this to figure out the cost of equity capital at the different debt ratio levels.

4 P.V. Viswanath4 Cost of debt capital  Estimate the firm’s dollar debt and interest exp at each debt ratio.  At each debt ratio, compute a financial ratio(s) such as the interest coverage ratio (EBIT/Interest expenses) to measure default risk; use that ratio(s) to estimate a synthetic bond rating for the firm. Add on a default spread based on the estimated rating to the risk-free rate to get the pre-tax cost of debt. Apply the marginal tax rate to get the after-tax cost of debt, keeping in mind that the marginal tax rate might decrease as we increase the amount of debt-related income deductions for tax purposes.  Weight the costs of debt and equity based on the proportions used of each type.  Choose the debt ratio that minimizes the WACC.

5 P.V. Viswanath5 Interest Coverage Ratios and Spreads If interest coverage ratio is >≤ toRating isSpread is -1000000.199999D20.00% 0.20.649999C12.00% 0.650.799999CC10.00% 0.81.249999CCC8.00% 1.251.499999B-6.00% 1.51.749999B4.00% 1.751.999999B+3.25% 22.2499999BB2.50% 2.252.49999BB+2.00% 2.52.999999BBB1.50% 34.249999A-1.00% 4.255.499999A0.85% 5.56.499999A+0.70% 6.58.499999AA0.50% 8.50100000AAA0.35%

6 P.V. Viswanath6 Constrained Approach  The unconstrained approach is problematic because agency costs are going to increase as the debt ratio goes up and as the bond rating goes down.  To keep a limit on these costs, the firm might want to put a constraint on the lowest bond rating allowed.  Use normalized operating income to estimate bond ratings so that temporarily depressed income does not yield an overly low optimal debt ratio.  Lower estimates of operating income for higher debt ratios due to indirect bankruptcy costs.

7 P.V. Viswanath7 Example  Problem 12, Chapter 19 from Damodaran, Corporate Finance, Theory and Practice  You have been asked by JJ Corporation, a California-based firm that manufactures and services digital satellite television systems, to evaluate its capital structure. They currently have 70 million shares outstanding trading at $10 per share. In addition, it has 500,000 ten-year convertible bonds, with a coupon rate of 8%, trading at $1000 per bond. JJ Corporation is rated BBB, and the interest rate on BBB straight bonds is currently 10%. The beta for the company is 1.2, and the current risk-free rate is 6%. The tax rate is 40%.

8 P.V. Viswanath8 Debt-Equity Ratio computation  a. What is the firm's current debt-equity ratio?  Solution: The market value of the common stock is 70m. x $10 = $700m. The 500,000 convertible bonds would sell at a yield of 10% if they were straight. Hence the straight bond component of the convertibles =  Since the convertibles trade at $1000 per bond, the equity component = $124.63 per convertible bond. Hence total equity = 700+124.63(0.5m.) = 762.32m. The market value of the debt component of the convertibles = 875.37(0.5) = 437.69m. Hence the debt-equity ratio = 437.69/762.32 = 57.41%.

9 P.V. Viswanath9 WACC Computation  b. What is the firm's current weighted average cost of capital?  Solution: The required rate of return on the equity, using the CAPM is.06 + 1.2(0.055) = 12.6%.  The WACC = (.5741/1.5741)(1-0.4)10% + (1/1.5741)12.6% = 10.192%, using the data from the previous section.

10 P.V. Viswanath10 Cost of equity after borrowing  JJ Corporation is proposing to borrow $250 million to use for the following purposes: Buy back $100 million Pay $100 million in dividends Invest $50 million in a project with a NPV of $25 million. The effect of this additional borrowing will be a drop in the bond rating to B, which currently carries an interest rate of 11%.  c. What will be the firm's cost of equity after this additional borrowing?

11 P.V. Viswanath11 Cost of equity after borrowing  Solution: After this borrowing, the market value of equity will be $762.32m - $200m + $25m. = $586.5m. The market value of debt will be 437.69+250=687.69m.  Hence the debt-equity ratio will be 1.17. The unlevered beta = Hence the levered beta will be equal to 0.89(1+(1-0.4)1.17) = 1.52.  Hence, the cost of equity =.06+1.52(0.055) = 14.36%.

12 P.V. Viswanath12 WACC after borrowing  d. What will the firm's weighted average cost of capital be after this additional borrowing?  Solution: The WACC =

13 P.V. Viswanath13 Value of firm after borrowing  e. What will the value of the firm be after this additional borrowing?  Solution: The original firm value was $1200. The WACC has decreased from 10.192% to 10.17%; hence the annual savings in financing costs equal (1200)(.10192-.1017).  Discounting these at the new cost of capital of 10.17%, we get (762.32+437.68)(.10192-.1017)/(0.1017) = $2.36m.  New Firm Value= $ 1,200 (original firm value) + $ 50 (net increase in capital after capital structure changes)+ $ 25 (NPV of new project) + $ 2.36 (increase in firm value due to capital structure change) = $ 1277.36 million.

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