Lecture 3- Cost os Capital- Capital Structure

# Lecture 3- Cost os Capital- Capital Structure - Topics...

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Unformatted text preview: Topics Covered Company and Project Costs of Capital Measuring the Cost of Equity Setting Discount Rates w/o Beta Certainty Equivalents Discount Rates for International Projects Company Cost of Capital A firm's value can be stated as the sum of the value of its various assets Firm value = PV(AB) = PV(A) + PV(B) Company Cost of Capital Category Speculative Ventures New products Discount Rate 30% 20% Expansion of existing business 15% (Company COC) Cost improvement, known technology 10% Company Cost of Capital A company's cost of capital can be SML compared to the CAPM required return Required return 13 Company Cost of Capital 5.5 0 1.26 Project Beta Measuring Betas The SML shows the relationship between return and risk CAPM uses Beta as a proxy for risk Other methods can be employed to determine the slope of the SML and thus Beta Regression analysis can be used to find Beta Company Cost of Capital simple approach Company Cost of Capital (COC) is based on the average beta of the assets The average Beta of the assets is based on the % of funds in each asset Company Cost of Capital simple approach Company Cost of Capital (COC) is based on the average beta of the assets The average Beta of the assets is based on the % of funds in each asset Example 1/3 New Ventures B=2.0 1/3 Expand existing business B=1.3 1/3 Plant efficiency B=0.6 AVG B of assets = 1.3 Capital Structure Capital Structure the mix of debt & equity within a company Expand CAPM to include CS becomes R = rf + B ( rm rf ) Requity = rf + B ( rm rf ) Capital Structure & COC COC = rportfolio = rassets rassets = WACC = rdebt (D) + requity (E) (V) (V) Bassets = Bdebt (D) + Bequity (E) (V) (V) requity = rf + Bequity ( rm - rf ) IMPORTANT E, D, and V are all market values Topics Covered Leverage in a Competitive Tax Free Environment Financial Risk and Expected Returns The Weighted Average Cost of Capital A Final Word on After Tax WACC M&M (Debt Policy Doesn't Matter) Modigliani & Miller When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. M&M (Debt Policy Doesn't Matter) Assumptions By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives M&M (Debt Policy Doesn't Matter) Dollar Investment .01VU Dollar Return .01 Profits Debt Equity Total Dollar Investment .01D L .01E L .01(D L + E L ) = .01VL Dollar Return .01 Interest .01 ( Profits - Interest) .01 Profits M&M (Debt Policy Doesn't Matter) Dollar Investment .01E L = .01(VL - DL ) Dollar Return .01 ( Profits - interest) Dollar Investment Borrowing Equity Total -.01D L .01VU .01(VU + D L ) Dollar Return - .01 Interest .01 Profits .01 ( Profits - Interest) M&M (Debt Policy Doesn't Matter) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares Price per share 1,000 \$10 Market Value of Shares \$ 10,000 Outcomes Operating Income Earnings per share Return on shares (%) A B C D \$500 1,000 1,500 2,000 \$.50 5% 1.00 10 1.50 15 2.00 20 Expected outcome M&M (Debt Policy Doesn't Matter) Example cont. 50% debt Data Number of shares Price per share Market Value of Shares Market value of debt Outcomes Operating Income Interest Equity earnings Earnings per share Return on shares (%) A \$500 \$500 \$0 \$0 0% B 1,000 500 500 1 10 C 1,500 500 1,000 2 20 D 2,000 500 1,500 3 30 500 \$10 \$ 5,000 \$ 5,000 M&M (Debt Policy Doesn't Matter) Example - Macbeth's - All Equity Financed - Debt replicated by investors Outcomes A Earnings on two shares LESS : Interest @ 10% Net earnings on investment Return on \$10 investment (%) B C D \$1.00 2.00 3.00 4.00 \$1.00 1.00 1.00 1.00 \$0 0% 1.00 10 2.00 3.00 20 30 No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio. AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole. Proposition I and Macbeth Macbeth continued Expected earnings per share (\$) Price per share (\$) Expected return per share (%) Cuttent Structure : Proposed Structure : All Equity Equal Debt and Equity 1.50 2.00 10 10 15 20 Leverage and Returns expected operating income Expected return on assets = ra = market value of all securities D E rA = rD + rE D+E D+E M&M Proposition II D rE = rA + ( rA - rD ) V Macbeth continued expected operating income rE = rA = market value of all securities 1500 = = .15 10,000 M&M Proposition II rE ( rA - rD ) D = rA + V rE = rA = Macbeth continued expected operating income market value of all securities 1500 = = .15 10,000 5000 rE = .15 + ( .15 - .10) 5000 = .20 or 20% Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating Income All equity Earnings per share (\$) \$1,500 to \$500 1.50 0.50 15% 2 20% 5% 0 0 Change - \$1.00 - 10% - \$2.00 - 20% Return on shares 50 % debt : Earnings per share (\$) Return on shares Leverage and Returns Market Value Balance Sheet example Asset Value 100 Debt (D) Equity (E) Asset Value 100 Firm Value (V) 40 60 100 rd = 7.5% re = 15% D E rA = rD + rE D +E D +E 40 60 rA = .075 + .15 =12.75% 100 100 Leverage and Returns What happens to Re when debt costs rise? Asset Value 100 Market Value Balance Sheet example continued Debt (D) Equity (E) 40 60 100 Asset Value 100 Firm Value (V) rd = 7.5% changes to 7.875% re = ?? 40 60 .1275 = .07875 + re 100 100 re = 16.0% Leverage and Returns D E BA = BD + BE V V D BE = B A + ( B A - BD ) V WACC WACC is the traditional view of capital structure, risk and return. D E WACC = rA = rD + rE V V WACC r rE rE =WACC rD D V M&M Proposition II r rE rA rD Risk free debt Risky debt D E WACC (traditional view) r rE WACC rD D V WACC (M&M view) r rE WACC rD D V After Tax WACC The tax benefit from interest expense deductibility must be included in the cost of funds. This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate. D E WACC = rD + rE V V Old Formula After Tax WACC Tax Adjusted Formula E D WACC = rD (1 - Tc) + rE V V After Tax WACC Example Union Pacific The firm has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC? After Tax WACC Example Union Pacific continued Balance Sheet (Market Value, billions) Assets 22.6 7.6 Debt 15 Equity Total assets 22.6 22.6 Total liabilities MARKET VALUES After Tax WACC Example Union Pacific continued Debt ratio = (D/V) = 7.6/22.6= .34 or 34% Equity ratio = (E/V) = 15/22.6 = .66 or 66% E D WACC = rD (1 -Tc ) + rE V V After Tax WACC Example Union Pacific continued E D WACC = rD (1 -Tc ) + rE V V WACC = .055 (1 - .35)( .34 ) + .10( .66) = .078 = 7.8% Capital Structure & Corporate Taxes Financial Risk Risk to shareholders resulting from the use of debt. Financial Leverage Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield Tax savings resulting from deductibility of interest payments. Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders. Income Statement of Firm U Earnings before interest and taxes Interest paid to bondholders Pretax income Tax at 35% Net income to stockholders Total income to both bondholders and stockholders Interest tax shield (.35 x interest) \$1,000 1,000 350 650 \$0+650=\$650 \$0 Income Statement of Firm L \$1,000 80 920 322 598 \$80+598=\$678 \$28 Capital Structure & Corporate Taxes Example You own all the equity of Space Babies Diaper Co. The company has no debt. The company's annual cash flow is \$900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of \$2,000,000. Should you do this and why? Capital Structure & Corporate Taxes Example You own all the equity of Space Babies Diaper Co. The Example You own all the equity of Space Babies Diaper Co. The company has no debt. The company's annual cash flow is \$900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of \$2,000,000. Should you do this and why? (\$ 1,000 s) EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow All Equity 900 0 900 315 585 1/2 Debt 900 100 800 280 520 Total Cash Flow All Equity = 585 *1/2 Debt = 620 (520 + 100) Capital Structure & Corporate Taxes D x r x Tc D PV of Tax Shield = (assume perpetuity) Example: = D x Tc rD Tax benefit = 2,000,000 x (.05) x (.35) = \$35,000 PV of \$35,000 in perpetuity = 35,000 / .05 = \$700,000 PV Tax Shield = \$2,000,000 x .35 = \$700,000 Capital Structure & Corporate Taxes Firm Value = Example Value of All Equity Firm + PV Tax Shield All Equity Value = 585 / .05 = 11,700,000 PV Tax Shield = 700,000 Firm Value with 1/2 Debt = \$12,400,000 Capital Structure & Corporate Taxes Balance Sheet, March 2004 (figures in \$millions) Pfizer Book values 10,752 7,144 21,460 86,900 69,048 97,652 97,652 Market values 10,752 7,144 2,500 21,460 283,373 268,021 296,625 296,625 Net working capital Long-term assets Total assets Long-term debt Other long-term liabilities Equity Total value Net working capital PV interest tax shield Long-term assests Total assets Long-term debt Other long-term liabilities Equity Total value Capital Structure & Corporate Taxes Balance Sheet, March 2004 (figures in \$millions) Pfizer (w/ \$1 billion Debt for Equity Swap) Net working capital Long-term assets Total assets Book values 10,752 8,144 21,460 86,900 68,048 97,652 97,652 Market values 10,752 8,144 2,850 21,460 283,373 267,371 296,975 296,975 Long-term debt Other long-term liabilities Equity Total value Net working capital PV interest tax shield Long-term assests Total assets Long-term debt Other long-term liabilities Equity Total value Weighted Average Cost of Capital without taxes (traditional view) Includes Bankruptcy Risk r rE WACC rD D V Financial Distress Costs of Financial Distress Costs arising from bankruptcy or distorted business decisions before bankruptcy. Financial Distress Costs of Financial Distress Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Distress Value if all Equity Financed + PV Tax Shield PV Costs of Financial Financial Distress Market Value of The Firm PV of interest tax shields Maximum value of firm Costs of financial distress Value of levered firm Value of unlevered firm Optimal amount of debt Debt Conflicts of Interest Circular File Company has \$50 of 1year debt. Circular File Company (Book Values) Net W.C. 20 50 Bonds outstanding Fixed assets 80 50 Common stock Total assets 100 100 Total liabilities Conflicts of Interest Circular File Company has \$50 of 1year debt. Circular File Company (Market Values) Net W.C. 20 25 Bonds outstanding Fixed assets 10 5 Common stock Total assets 30 30 Total liabilities Why does the equity have any value ? Shareholders have an option they can obtain the rights to the assets by paying off the \$50 debt. Conflicts of Interest Circular File Company has may invest \$10 as follows. Now Possible Payoffs Next Year \$120 (10% probability) \$0 (90% probability) Invest \$10 Assume the NPV of the project is (-\$2). What is the effect on the market values? Conflicts of Interest Circular File Company value (post project) Circular File Company (Market Values) Net W.C. 10 20 Bonds outstanding Fixed assets 18 8 Common stock Total assets 28 28 Total liabilities Firm value falls by \$2, but equity holder gains \$3 Conflicts of Interest Circular File Company value (assumes a safe project with NPV = \$5) Circular File Company (Market Values) Net W.C. 20 33 Bonds outstanding Fixed assets 25 12 Common stock Total assets 45 45 Total liabilities While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value. Financial Distress Games Cash In and Run Playing for Time Bait and Switch Financial Choices Tradeoff Theory Theory that capital structure is based on a tradeoff between tax savings and distress costs of debt. Pecking Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Trade Off Theory & Prices 1. Stockfordebt exchange offers Debtforstock exchange offers Stock price falls Stock price rises 2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact. Issues and Stock Prices Why do security issues affect stock price? The demand for a firm's securities ought to be flat. Any firm is a drop in the bucket. Plenty of close substitutes. Large debt issues don't significantly depress the stock price. Pecking Order Theory Consider the following story: The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance. Pecking Order Theory Some Implications: Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth). ...
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## This note was uploaded on 07/10/2009 for the course FIN FIN taught by Professor Dr. during the Spring '09 term at Baptist College of Health Sciences.

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