Lec07_08_ch09 - Aswath Damodaran 0 Ca’ Foscari University...

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Unformatted text preview: Aswath Damodaran 0 Ca’ Foscari University of Venice MSc on Economics and Finance Advanced Corporate Finance Lecture 7/8 – Ch09 GETTING TO THE OPTIMAL: TIMING AND FINANCING CHOICES You can take it slow.. Or perhaps not… Big Picture… 1 Maximize the value of the business (firm) The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it. Aswath Damodaran The return should reflect the magnitude and the timing of the cashflows as welll as all side effects. The Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The optimal mix of debt and equity maximizes firm value The right kind of debt matches the tenor of your assets The Dividend Decision If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your business How much cash you can return depends upon current & potential investment opportunities How you choose to return cash to the owners will depend on whether they prefer dividends or buybacks 1 Now that we have an opTmal.. And an actual.. What next? 2 ¨  At the end of the analysis of financing mix (using whatever tool or tools you choose to use), you can come to one of three conclusions: 1.  2.  3.  ¨  The firm has the right financing mix It has too li^le debt (it is under levered) It has too much debt (it is over levered) The next step in the process is ¤  Deciding how much quickly or gradually the firm should move to its opTmal ¤  Assuming that it does, the right kind of financing to use in making this adjustment Aswath Damodaran 2 To change or not to change 3 Firms might choose not to converge toward the op/mal debt ra/o for several reasons: ¨  Need to maintain high bond raTng constraint ¨  Decision not to use excess debt capacity ¨  Value of flexibility in preserving debt capacity ¤  ¤  ¤  Limited access to capital markets PotenTal future projects with high excess return Uncertainty about future investment needs Factors affecTng gradual vs. immediate change: ¨  ¨  ¨  ¨  Degree of confidence in the opTmal leverage esTmate Comparability to industry Likelihood of a takeover Need for financial flexibility 3 Ways of changing the financing mix 4 1.  Recapitaliza/on: new equity to reTre debt or new debt to reTre equity n  n  n  2.  3.  Dives/ture and use of proceeds: sell assets and use the cash to pay debt or equity Financing new investments: disproporTonate use of debt or equity to finance new projects ¤  4.  Borrowing money and buying back stocks (or paying large dividend) éD/V, i.e. Leveraged recapitalizaTon Debt-­‐for-­equity swap éD/V RenegoTate debt agreements êD/V NOTE: not just a variaTon in financial structure, but a change in firm’s assets Changing dividend payout: increasing dividends or buybacks decreases the value of equity in favor of debt, i.e. éD/V The choice between the alternaTve depends on ¨  The urgency to move toward the opTmal D/V (1&2 faster than 3&4) ¨  The quality of potenTal new investment (see in parTcular #3) ¨  The marketability of exisTng investments (see #2) 4 The Mechanics of Changing Debt RaTo quickly… 5 To decrease the debt ratio Sell operating assets and use cash to pay down debt. Assets Issue new stock to retire debt or get debt holders to accept equity in the firm. Liabilities Debt Cash Opearing Assets in place Growth Assets Sell operating assets and use cash to buy back stock or pay or special dividend Equity Borrow money and buy back stock or pay a large special dividend To increase the debt ratio Aswath Damodaran 5 A Framework for Gekng to the OpTmal 6 Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Yes No Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes No Take good projects with 1. Pay off debt with retained new equity or with retained earnings. earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt. Is the firm a takeover target? Yes Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares. No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends Aswath Damodaran No Buy back stock 6 The mechanics of changing debt raTos over Tme… gradually… 7 ¨  To change debt raTos over Tme, you use the same mix of tools that you used to change debt raTos gradually: Dividends and stock buybacks: Dividends and stock buybacks will reduce the value of equity. ¤  Debt repayments: will reduce the value of debt. ¤  ¨  The complicaTon of changing debt raTos over Tme is that firm value is itself a moving target. If equity is fairly valued today, the equity value should change over Tme to reflect the expected price appreciaTon: ¤  Expected Price appreciaTon = Cost of equity – Dividend Yield ¤  Debt will also change over Tme, in conjuncTon as firm value changes. ¤  Aswath Damodaran 7 Designing Debt: The Fundamental Principle 8 The objecTve in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets. ¨  By doing so, we reduce our risk of default, increase debt capacity and increase firm value. ¨  Aswath Damodaran 8 Design the perfect financing instrument 9 ¨  The perfect financing instrument will ¤  Have all of the tax advantages of debt ¤  While preserving the flexibility offered by equity Start with the Cash Flows on Assets/ Projects Define Debt Characteristics Duration Duration/ Maturity Currency Currency Mix Effect of Inflation Uncertainty about Future Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Growth Patterns Straight versus Convertible - Convertible if cash flows low now but high exp. growth Cyclicality & Other Effects Special Features on Debt - Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Aswath Damodaran 9 Choosing the right financing instruments Matching liabiliTes to assets – why does it ma^er? 10 Firm with mismatched debt Firm Value Value of Debt Firm with matched debt Firm Value Value of Debt 10 Matching liabiliTes to assets 1. Financing maturity -­‐ duraTon 11 Measuring the cash flow lives of liability and assets Dura/on ¨  ¨  ¨  ¨  ¨  The duraTon of a straight bond or loan issued by a company can be wri^en in terms of the coupons (interest payments) on the bond (loan) and the face value of the bond to be – " t=N t*Coupon N*Face Value % t + $∑ ' t (1+r)N dP/P # t=1 (1+r) & Duration of Bond = = t=N " Coupon Face Value % dr/r t + $∑ ' t (1+r)N & # t=1 (1+r) The duraTon measures when, on average, the cash flows of the bond come due. The duraTon also measures how much the price of the bond changes for a unit change in interest rates. Holding other factors constant, the duraTon will increase with the maturity of the bond, and decrease with the coupon rate on the bond. DuraTon can be computed for any asset – security, considering the asset cash flow. 11 DuraTon: Comparing Approaches 12 Traditional Duration Measures Uses: 1. Projected Cash Flows Assumes: 1. Cash Flows are unaffected by changes in interest rates 2. Changes in interest rates are small. Aswath Damodaran δP/δr= Percentage Change in Value for a percentage change in Interest Rates Regression: δP = a + b (δr) Uses: 1. Historical data on changes in firm value (market) and interest rates Assumes: 1. Past project cash flows are similar to future project cash flows. 2. Relationship between cash flows and interest rates is stable. 3. Changes in market value reflect changes in the value of the firm. 12 DuraTon matching strategies 13 Match the duraTon of u  Individual assets with individual liabiliTes u  u  Expensive way, omen ignoring the interacTons among projects Firm assets with firm liabiliTes u  Simpler and cheaper Disney DuraTon of the Project = 62,355/3296 = 18.92 years The perfect debt for this theme park would have a duraTon of roughly 19 13 Matching liabiliTes to assets 2. Fixed vs. floaTng rate, the currency choice and the type of bond 14 Fixed vs. floa/ng rate FloaTng rate debt is be^er for firms that are uncertain about the duraTon of future projects and that have cash flows that move with the inflaTon rate. The currency choice Assets in foreign currency have currency risk that can be reduced financing these assets in foreign currency. Straight vs. conver/ble bonds Financing should not impose high payment in the short for growth firms (low iniTal CFs, becoming higher in the future when the growth pays off). 14 ConverTble bonds are be^er. Ensuring that you have not crossed the line drawn by the tax code 15 All of this design work is lost, however, if the security that you have designed does not deliver the tax benefits. ¨  In addiTon, there may be a trade off between mismatching debt and gekng greater tax benefits. ¨  Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough, you might override results of previous step Aswath Damodaran 15 While keeping equity research analysts, raTngs agencies and regulators applauding 16 ¨  ¨  ¨  ¨  RaTngs agencies want companies to issue equity, since it makes them safer. Equity research analysts want them not to issue equity because it dilutes earnings per share. Regulatory authoriTes want to ensure that you meet their requirements in terms of capital raTos (usually book value). Financing that leaves all three groups happy is nirvana. Consider ratings agency & analyst concerns Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Aswath Damodaran 16 Debt or Equity: The Strange Case of Trust Preferred 17 ¨  Trust preferred stock has ¤  A fixed dividend payment, specified at the Tme of the issue ¤  That is tax deducTble ¤  And failing to make the payment can give these shareholders voTng rights ¨  When trust preferred was first created, raTngs agencies treated it as equity. As they have become more savvy, raTngs agencies have started giving firms only parTal equity credit for trust preferred. Aswath Damodaran 17 Soothe bondholder fears 18 ¨  There are some firms that face skepTcism from bondholders when they go out to raise debt, because ¤  Of their past history of defaults or other acTons ¤  They are small firms without any borrowing history ¨  Bondholders tend to demand much higher interest rates from these firms to reflect these concerns. Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing If agency problems are substantial, consider issuing convertible bonds Aswath Damodaran Convertibiles Puttable Bonds Rating Sensitive Notes LYONs 18 And do not lock in market mistakes that work against you 19 ¨  RaTngs agencies can someTmes under rate a firm, and markets can under price a firm’s stock or bonds. If this occurs, firms should not lock in these mistakes by issuing securiTes for the long term. In parTcular, Issuing equity or equity based products (including converTbles), when equity is under priced transfers wealth from exisTng stockholders to the new stockholders ¤  Issuing long term debt when a firm is under rated locks in rates at levels that are far too high, given the firm’s default risk. ¤  ¨  What is the soluTon If you need to use equity? ¤  If you need to use debt? ¤  Aswath Damodaran 19 Designing Debt: Bringing it all together 20 Start with the Cash Flows on Assets/ Projects Define Debt Characteristics Duration Currency Effect of Inflation Uncertainty about Future Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Cyclicality & Other Effects Growth Patterns Straight versus Convertible - Convertible if cash flows low now but high exp. growth Special Features on Debt - Options to make cash flows on debt match cash flows on assets Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed Overlay tax preferences Consider ratings agency & analyst concerns Deductibility of cash flows for tax purposes Differences in tax rates across different locales Zero Coupons If tax advantages are large enough, you might override results of previous step Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Operating Leases MIPs Surplus Notes Can securities be designed that can make these different entities happy? Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing If agency problems are substantial, consider issuing convertible bonds Consider Information Aswath Damodaran Asymmetries Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt Convertibles Puttable Bonds Rating Sensitive Notes LYONs 20 Approaches for evaluaTng Asset Cash Flows 21 I. IntuiTve Approach ¤  ¤  ¤  Are the projects typically long term or short term? What is the cash flow pa^ern on projects? How much growth potenTal does the firm have relaTve to current projects? How cyclical are the cash flows? What specic factors determine the cash flows on projects? II. Project Cash Flow Approach ¤  ¤  EsTmate expected cash flows on a typical project for the firm Do scenario analyses on these cash flows, based upon different macro economic scenarios III. Historical Data ¤  ¤  OperaTng Cash Flows Firm Value Aswath Damodaran 21 I. IntuiTve Approach -­‐ Disney 22 Business Studio entertainment Media networks Project Cash Flow Characteristics Movie projects are likely to • Be short-term • Have cash outflows primarily in dollars (because Disney makes most of its movies in the U.S.), but cash inflows could have a substantial foreign currency component (because of overseas revenues) • Have net cash flows that are heavily driven by whether the movie is a hit, which is often difficult to predict Projects are likely to be 1. Short-term 2. Primarily in dollars, though foreign component is growing, especially for ESPN. 3. Driven by advertising revenues and show success (Nielsen ratings) Park resorts Projects are likely to be 1. Very long-term 2. Currency will be a function of the region (rather than country) where park is located. 3. Affected by success of studio entertainment and media networks divisions Consumer products Projects are likely to be short- to medium-term and linked to the success of the movie division; most of Disney’s product offerings and licensing revenues are derived from their movie productions Projects are likely to be short-term, with high growth potential and significant risk. While cash flows will initially be primarily in US dollars, the mix of currencies will shift as the business ages. Interactive Aswath Damodaran Type of Financing Debt should be 1. Short-term 2. Mixed currency debt, reflecting audience makeup. 3. If possible, tied to the success of movies. Debt should be 1. Short-term 2. Primarily dollar debt 3. If possible, linked to network ratings Debt should be 1. Long-term 2. Mix of currencies, based on tourist makeup at the park. Debt should be 1. Medium-term 2. Dollar debt Debt should be short-term, convertible US dollar debt. 22 II. Project Specific Financing 23 With project specific financing, you match the financing choices to the project being funded. The benefit is that the debt is truly customized to the project. ¨  Project specific financing makes the most sense when you have a few large, independent projects to be financed. It becomes both impracTcal and costly when firms have porpolios of projects with interdependent cashflows. ¨  Aswath Damodaran 23 III. Firm-­‐wide financing – Historical data 24 ¨  ¨  Rather than look at individual projects, you could consider the firm to be a porGolio of projects. The firm’s past history should then provide clues as to what type of debt makes the most sense. OperaTng Cash Flows The quesTon of how sensiTve a firm’s asset cash flows are to a variety of factors, such as interest rates, inflaTon, currency rates and the economy, can be directly tested by regressing changes in the operaTng income against changes in these variables. n  This analysis is useful in determining the coupon/interest payment structure of the debt. n  ¨  Firm Value The firm value is clearly a funcTon of the level of operaTng income, but it also incorporates other factors such as expected growth & cost of capital. n  The firm value analysis is useful in determining the overall structure of the debt, parTcularly maturity. n  Aswath Damodaran 24 Disney: Historical Data 25 Date Operating Income Enterprise Value (V) % Chg in OI % Chg in V 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 9450 8863 7781 6726 5697 $7,404 $6,829 $5,355 $4,107 $4,048 $2,713 $2,384 $2,832 $2,525 $3,264 $3,843 $3,945 $3,024 $2,262 $1,804 $1,560 $1,287 $1,004 $1,287 $1,109 $789 $707 $462 $369 $126,815 $104,729 $66,769 $73,524 $59,855 $73,091 $77,980 $75,720 $59,248 $57,776 $52,747 $43,791 $48,128 $88,355 $65,125 $69,213 $65,173 $55,116 $31,025 $22,200 $20,360 $19,049 $15,376 $12,155 $15,918 $7,883 $10,360 $5,640 $3,498 6.62% 13.91% 15.69% 18.06% -23.06% 8.42% 27.53% 30.39% 1.46% 49.21% 13.80% -15.82% 12.16% -22.64% -15.07% -2.59% 30.46% 33.69% 25.39% 15.64% 21.21% 28.19% -21.99% 16.05% 40.56% 11.60% 53.03% 25.20% 157.99% 21.09% 56.85% -9.19% 22.84% -18.11% -6.27% 2.98% 27.80% 2.55% 9.53% 20.45% -9.01% -45.53% 35.67% -5.91% 6.20% 18.25% 77.65% 39.75% 9.04% 6.88% 23.89% 26.50% -23.64% 101.93% -23.91% 83.69% 61.23% 24.37% 25 The Macroeconomic Data 26 Date 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 Change in T.Bond rate 1.07% -0.11% -1.37% -0.53% 1.29% -1.44% -0.65% 0.30% 0.16% 0.13% 0.05% -0.97% -0.18% -0.98% 1.56% -1.03% -0.63% 0.80% -2.09% 1.92% -0.83% -0.02% -1.26% 0.12% -1.11% 0.26% 1.53% -1.61% -2.27% % Chg in GDP % Change in CPI % Change in US $ 1.83% 2.20% 1.81% 2.39% -3.07% -1.18% 2.93% 3.40% 3.68% 3.72% 4.32% 2.80% -0.04% 2.24% 4.70% 4.51% 4.33% 4.43% 2.01% 4.12% 2.50% 4.15% 1.09% 0.65% 2.66% 3.66% 4.49% 2.83% 4.19% 1.18% -1.03% 1.48% 1.97% -3.98% -4.26% 2.19% -1.84% 0.66% 1.34% -0.65% 1.44% -2.50% 0.96% 1.04% 0.11% -1.43% 0.31% -0.08% 0.27% -0.72% 0.64% -2.89% 0.43% 0.51% 0.60% 2.54% -2.33% 3.89% 4.89% 2.75% -4.59% -3.64% 5.79% 10.88% -11.30% -2.28% 3.98% -3.92% -14.59% -11.17% 7.45% 7.73% 1.68% -4.08% 9.40% 4.14% -0.71% -5.37% 0.56% 6.89% 0.69% -8.00% 2.04% 1.05% -12.01% -15.26% -13.51% 26 I. SensiTvity to Interest Rate Changes 27 How sensiTve is the firm’s value and operaTng income to changes in th...
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