1. 1 Capital Structure: The Case of Walt Disney Co. Cost of Capital Debt level and cost of capital Firm value Managerial decisions (if time permits)

2. 2 Purpose of this case To integrate MM propositions with firm valuation To integrate Chapter 21 as well One of the key assumptions in Chapters 16-18 is that interest rate is constant However, when there is default probability, firm’s interest rate will change –In Chapter 21, default probability is tied to firm’s credit rating –In general, when firms increase leverage, default probability increases, credit rating worsens, and interest rate rises How does this dynamics affect firm cost of capital and firm value? –This lecture provides a rough estimate based on knowledge covered in Chapters 12-21.

3. 3 Disney’s 2006 Statements Reveneue34,285 -cost of revenue28,807 EBIT6,153 -interest expenses706 Income before Taxes5,447 -Taxes1,890 Income3,374 Price, 2006 FY close (Sept. 30, 2006)$30.91 Shares outstanding2,090 million Market equity64,602 Debt13,817 short-term debt2,682 long-term debt11,135 S&P Credit ratingA- Interest coverage ratio8.7

4. 4 Estimating Cost of Capital 1.Estimating cost of equity Use CAPM Note that CAPM says EXPECTED return equals beta times expected risk premium A reasonable estimate for expected value is to use historical average 2.Estimating cost of debt For a firm with rating, opportunity cost of debt can be estimated with default spread based on its credit rating. Cost of debt = Corresponding gov’t bond rate + default spread Empirical analysis shows that credit ratings can be modeled well with three factors: industry, size, and interest coverage. For simplicity, we will assume that interest coverage ratio is the only determinant for credit rating 3.Estimating cost of capital WACC Tax rate can be estimated based on either current tax code or historical tax payouts.

5. 5 Equations that we need Beta and leverage; (MM-II with corporate taxes) CAPM; Cost of capital with taxes

6. 6 Estimating Cost of Debt: The Ratings Table If interest coverage ratio is(see bondsonline.com for more ratings info.) greater than≤ toSpread is -1000000.5D20.00% 0.50.8C12.00% 0.81.2CC10.00% 1.251.5CCC8.00% 1.52.0B-6.00% 22.5B4.00% 2.53.0B+3.25% 33.5BB2.50% 3.54.0BB+2.00% 44.5BBB1.50% 4.56.0BBB+1.00% 67.5A-0.85% 7.59.5A0.70% 9.512.5A+0.50% 12.5100000.0>AA0.35%

7. 7 Current Cost of Capital (1) Equity –Cost of equity = riskfree rate + beta * market risk premium = 2.14 + 1.05 * (9.78 - 2.14) = 10.16 (%) Notes: (1) Use past 5-year average for expected riskfree rate and risk premium; (2) Beta is also estimated using past 5-year monthly stock and market return. –Market value of equity = $ 30.91*2,090 = $64,062 Million –Leverage: Equity / (Debt + Equity) = 64,062/(64,062+ 13,817) = 82.26% Note: Book value of debt (long-term debt + short-term debt) is used as an estimate for market value of debt.

8. 8 Current Cost of Capital (2) Debt –After-tax cost of debt = (Gov’t bond rate + default spread) (1-t) = (4.4% + 0.85%) (1-0.35) = 3.41% Note 1: (1) Past 5-year average of 10-year T-bond yield is used as gov’t bond rate. (2) Tax rate is based on tax code. 2006 FY actual tax rate is consistent with the tax code. (3) current credit rating: A-, corresponding to a spread of 0.85%. Note 2: I deviate from the Rating Table by using Disney’s actual credit rating. If we follow the Table strictly, Disney’s rating associated with its coverage ratio should be A (with a default spread of 0.70%). WACC = 10.16% (.8226) + 3.41% (1-.8226) = 8.96%

9. 9 The Question: Is there money left on the table for Disney? If Disney alters its current debt structure, how does it affect the firm value? Motivation: In his famous article, “How Big Are the Tax Benefits of Debt?”, Professor John Graham of Duke estimates that on average, the typical (US) firm could double tax benefits by issuing debt until the point that the marginal tax benefit begins to decline. –The paper is attached on the course webpage for your reference.

10. 10 The procedures 1. Estimate the cost of equity at different levels of debt 2. Estimate the cost of debt at different levels of debt The more debt you take, the lower your interest coverage ratio, and the higher the interest rate. 3. Estimate the weighted average cost of capital at different levels of debt 4. Calculate the effect on firm value and stock price –Since firm value is inversely related to WACC, once we know WACC we know the firm value. –Consider bankruptcy costs as well

11. 11 Estimating Cost of Equity Current Beta = 1.05 Current debt/value ratio: 17.74% Expected Market premium = 7.64% T-bill rate = 2.14% t = 35% (1) Calculate unlevered beta and cost of unlevered equity (r 0 ) (2) Calculate beta and cost of equity when B/V = 30%.

12. 12 Table 1: Cost of equity schedule B/(B+S) 0%0%10%20%30%40%50%60%70%80%90% B/S 0%0%11%25%43%67%100%150%233%400%900% $ Debt $0 $0 $7,842$15,684$23,526$31,368$39,210$47,051$54,893$62,735$70,577 Beta 0.920.920.991.071.181.321.521.822.323.326.31 Cost of Equity 9.18%9.18% 9.69 % 10.33 % 11.14 % 12.23 % 13.76 % 16.05 % 19.86 % 27.49 % 50.38 %

13. 13 Cost of equity

14. 14 Can you do the 30% level? The chain effect: As you take more debt, your interest payment is likely to be higher, which lowers your interest coverage ratio, which lowers your rating, which increases your interest rate. You need to find an interest rate that matches the resulting coverage ratio and the rating. (Trial and error.) B/(B+S)10%30% B/S11%43% $ Debt$1,102$3,307 EBIT$6,153 Interest372.51270.4 Interest Coverage Likely Rating Pre-tax cost of debt After-tax cost of debt Cost of Capital

15. 15 Table 2 Estimating cost of debt D/(D+E)0%10%20%30%40%50%60% D/E0%11%25%43%67%100%150% $ Debt$0$1,102$2,205$3,307$4,409$5,512$6,614 EBIT$6,153 Interest0.0372.5799.91270.42007.54077.86775.4 Interest Coverage∞16.527.694.843.061.510.91 Likely RatingAAA ABBB+BB+B-CC Pre-tax cost of debt4.75% 5.10%5.40%6.40%10.40%14.40% After-tax cost of debt3.09% 3.32%3.51%4.16%6.76%9.36%

16. 16 Cost of Capital Table 1 + Table 2  WACC

17. 17 The U-Shape of Cost of Capital Cost of capital goes down at first, then goes up with debt. This is because of the interest rate dynamics –If you take more debt, debt becomes riskier –Therefore, interest rate increases with debt. –Taking more debt has two effects: Higher proportion of lower cost of debt capital Interest grows with proportion of debt At first, the first effect is dominant; then the second effect will dominate, resulting in U-shape of cost of capital. If interest rate remains constant, then we are back to MM world with corporate taxes –The optimal debt is then close to 100%.

18. 18 WACC and Firm Value (when there is no growth) Firm value = UCF/WACC where UCF is the cash flow to the unlevered firm. –You can verify this from Chapter 18. View Value * WACC as the annual costs of running the company. Change in WACC then changes the costs of running the company. –Assume this change is perpetual for simplicity. –Discount the $ change by the new WACC you’ll arrive at the changes in firm value. –i.e., if there is a change in WACC New firm value = old firm value - old firm value *(WACC new –WACC old )/ WACC new

19. 19 Effect on Firm Value Firm Value before the change = 13.8 + 64.6 = 78.4 billion B/V = 17.74%. WACC 0 = 9.18%. Annual Cost = $78.4 *9.18%= $7.20 billion Change to 30% debt (B/V = 30%) –WACC 1 = 30%* 3.51% + 70%*11.14% = 8.85% –Annual Cost = $78.4 *8.85%= $6.94 billion –Δ WACC = 0.33%, Change in Annual Cost = $ 0.26 billion If there is no growth in the firm value –Increase in firm value = $0.26/.0885 = $2.94 billion –Change in Stock Price = $2.94billion/2.09 billion = $1.41 per share

20. 20 If there is growth in firm value over time Estimate first the implied growth rate, g, through the following perpetual growth formula: Firm value Today = UCF(1+g)/(WACC 0 -g), where UCF is the cash flow to the unlevered firm. Solve for g. Increase in firm value is then change in annual cost * (1+g) /(WACC 1 -g) Attribute this increase in value to stockholders and derive increase in stock price With growth, change in value is more sensitive to change in leverage. UCF = 6,153 (1-0.35) 78.4 = UCF (1+g) /(0.0918-g) g= 0.0388 Increase in firm value = 0.26 (1+0.0388)/(0.0885-0.0388) = 5.43 Increase in share price = 5.43/2.09 = $2.60/share

21. 21 Firm Value B/(B+S)10%20%30%40%50%60%70% Cost of Capital9.03%8.92%8.85%9.00%10.26%12.04%13.42% Value (no growth)77,82778,75479,38175,33568,50358,39852,369

22. 22 Firm Value as a function of Debt ratio

23. 23 A Managerial Decision: The Repurchase Price Let us suppose that the CFO approached you asking about buying back stocks. The fund for stock buyback (repurchases) will be raised from the bond market. Assume that the bond issuing costs are negligible. The current price is $30.91. Assuming that firm operating income will remain constant at the current level. (1)Realizing that the current debt ratio is relatively low, he wants to double the debt size. He wants to know the maximum price for the stock buyback.

24. 24 Cont’d (2) Will your answer change if the firm value will be estimated to grow by 4% a year?

25. 25 Integrating the Bankruptcy Costs: Estimating Expected Bankruptcy Cost Probability of Bankruptcy Estimate the rating that the firm will have at each level of debt Estimate the probability that the firm will go bankrupt over time, at that level of debt (Use studies that have estimated the empirical probabilities of this occurring over time - Altman does an update every year)

26. 26 Cost of Bankruptcy The direct bankruptcy cost is the easier component. It is generally between 5-10% of firm value, based upon empirical studies. Let’s take 10% for Disney (Why?). The indirect bankruptcy cost is much tougher. It should be higher for sectors where operating income is affected significantly by default risk (like airlines) and lower for sectors where it is not (like groceries). Let’s take 15% for Disney.

27. 27 Ratings and Default Probabilities Rating Default Risk AAA 0.01% AA 0.28% A+ 0.40% A 0.53% A-1.41% BBB 2.30% BB 12.20% B+ 19.28% B 26.36% B-32.50% CCC 46.61% CC 52.50% C 60% D 75%

28. 28 Estimating Bankruptcy Costs Current rating: –A-, default risk: 1.41% –Costs on firm value: –New firm value: Change to 30% debt/V ratio –Rating: BBB+, default risk: –Costs on firm value: –New firm value:

29. 29 Exercise Find a new firm, say, RIM, and give a rough estimate on how its firm value will change if it assumes a 10% of debt.