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Capital Structure & Cost of Capital

Capital Structure & Cost of Capital. Introduction. Capital budgeting affects the firm’s well-being Discount rate is based on the risk of the cash flows Errors in capital budgeting can be serious Need to compensate investors for financing Project Expect Return Project Cash Flows . WACC.

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Capital Structure & Cost of Capital

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  1. Capital Structure & Cost of Capital

  2. Introduction • Capital budgeting affects the firm’s well-being • Discount rate is based on the risk of the cash flows • Errors in capital budgeting can be serious • Need to compensate investors for financing • Project Expect Return • Project Cash Flows

  3. WACC • Weighted Average Cost of Capital • Also called the hurdle rate • D = Market Value of Debt • E = Market Value of Equity • P = Market Value of Preferred Stock • V = D + E + P

  4. Costs of Financing • Cost of Preferred Stock • Based on preset dividend rate (r = D/P) • Cost of Debt • YTM is good estimate • Cost of Common Stock • Derived from current market data – Beta • Cost has 2 factors • Business or Asset Risk • Financing or Leverage Risk (Leverage increases common stock risk)

  5. Cost of Equity Example • Market risk premium = 9% • Current risk-free rate = 6% • Company beta = 1.5 • Last dividend = $2, dividend growth = 6%/year • Stock price = $15.65 • What is our cost of equity?

  6. Equity Information 50 million shares $80 per share Beta = 1.15 Market risk prem. = 9% Risk-free rate = 5% Debt Information $1 billion Coupon rate = 10% YTM = 8% 20 years to maturity Tax rate = 40% Example – WACC • Cost of equity? • RE = • Cost of debt? • RD=

  7. Example – WACC • Capital structure weights? • E = 50 million shares ($80/share) = $4 billion • D = $1 billion face • V = 4 + 1 = $5 billion • wE = E/V = • wD = D/V = • What is the WACC? • WACC =

  8. Capital Restructuring • Capital restructuring • Adjusting leverage without changing the firm’s assets • Increase leverage • Issue debt and repurchase outstanding shares • Decrease leverage • Issue new shares and retire outstanding debt • Choose capital structure to max stockholder wealth • Maximizing firm value • Minimizing the WACC

  9. Ex: Effect of Leverage

  10. EBIT $650,000 • D = $0 • Interest = 0, Net Income = $650,000 • EPS = $650,000/500,000 = $1.30 • D = $2.5 mil (D/E = 1) • Interest = • Net Income = • EPS = /250,000 =

  11. EBIT $300,000 • D = $0 • Interest = 0, Net Income = $300,000 • EPS = $300,000/500,000 = $0.60 • D = $2.5 mil (D/E = 1) • Interest = $2,500,000 * 10% = $250,000 • Net Income = • EPS = /250,000 =

  12. Break-Even EBIT • EBIT where EPS is the same under both the current and proposed capital structures • If EBIT > break-even point then leverage is beneficial to our stockholders • If EBIT < break-even point then leverage is detrimental to our stockholders

  13. Ex: Break-Even EBIT

  14. Cost of Equity Varies • If the level of debt increases, the riskiness of the firm increases. • Increases the cost of debt. • However, the riskiness of the firm’s equity also increases, resulting in a higher re.

  15. Impact of Leverage • $200,000 in assets, all equity, 10,000 shares

  16. Impact of Leverage • $200,000 in assets, half equity, 5,000 shares

  17. M&M – Perfect Market • Miller and Modigliani (1958) • Fathers of capital structure theory • Proposition I • Firm value is NOT affected by the capital structure • Since cash flows don’t change, value doesn’t change • Proposition II • Firm WACC is NOT affected by capital structure

  18. M&M – Perfect Market • Assumes no taxes or bankruptcy costs • WACC = (E/V)RE + (D/V)RD • No taxes • RE = RA + (RA – RD)(D/E) • RA: “cost” of the firm’s business risk • (RA – RD)(D/E): “cost” of the firm’s financial risk

  19. Risks • Business risk: • Uncertainty in future EBIT • Depends on business factors such as competition, industry trends, etc. • Level of systematic risk in cash flows • Financial risk: • Extra risk to stockholders resulting from leverage • Depends on the amount of leverage • NOT the same as default risk

  20. M&M – Perfect Market

  21. Ex: Perfect Market • RA = 16%, RD = 10%; % debt = 45% • Cost of equity? • RE = 16 + (16 - 10)(.45/.55) = 20.91% • If the cost of equity is 25%, what is D/E? • 25 = 16 + (16 - 10)(D/E) • D/E = • Then, what is the % equity in the firm? • E/V =

  22. Capital Structure Example • Balance Sheet Assets (A) 100 Debt Value (D) 40 Equity Value (E) 60 Assets 100 Firm Value (V) 100 • rdebt=8% & requity=15% WACC = rassets =(D/V)* rdebt + (E/V)* requity WACC =

  23. Capital Structure Example • New capital structure Assets (A) 100 Debt Value (D) 30 Equity Value (E) 70 Assets 100 Firm Value (V) 100 • Has the risk of the project changed? • Is the go-ahead decision different?

  24. After Refinancing • Before • WACC = .4 (8%) + .6 (15%) = 12.2% • After • Imagine cost of debt dropped to 7.3% • WACC = .3 (7.3%) + .7 (requity) = 12.2% • requity =

  25. Example • Debt/equity mix doesn’t affect the project’s inherent risk • Required return on the package of debt and equity is unaffected • However reducing debt level changes the required returns • Reduced debtholder risk (rdebt fell) • Reduced equityholder risk (requity fell) • How is it, then, that reducing firm risk did not reduce the required rate of return? • Project risk is the same. • Weights changed.

  26. Corporate Taxes • Interest is tax deductible • Effectively, govt subsidizes part of interest payment • Adding debt can reduce firm taxes • Reduced taxes increases the firm cash flows

  27. Ex: Taxes Bondholders 0 500 Equityholders 3300 2970 Total Cash Flows 3300 3470

  28. Interest Tax Shield • Annual interest tax shield • Tax rate times interest payment • $6250 * .08 = $500 in interest expense • Annual tax shield = .34(500) = 170 • PV of annual interest tax shield • Assume perpetual debt • PV = • PV = D(RD)(TC) / RD = DTC =

  29. Taxes – Firm Value • Firm value increases by value of tax shield • VL = VU + PV (interest tax shield) • If perpetuity, VU = EBIT(1-.t) / rA • Value of equity = Value of the firm – Value of debt • Ex: Unlevered cost of capital (rA)= 12%; t = 35%; EBIT = 25 mil; D = $75 mil; rD = 9%; • VU = • VL = • E =

  30. Taxes - WACC • WACC decreases as D/E increases • WACC = (E/V)RE + (D/V)(RD)(1-TC) • RE = RA + (RA – RD)(D/E)(1-TC) • rA= 12%; t = 35%; D = $75 mil; rD = 9%; VU = $135.42 mil; VL = $161.67 mil; E = $86.67 mil • RE = • WACC=

  31. Example: Proposition II - Taxes • Firm restructures its capital so D/E = 1 • rA= 12%; t = 35%; rD = 9% • New cost of equity? • RE = • New WACC? • WACC =

  32. Taxes + Bankruptcy • Probability of bankruptcy increases with debt • Increases the expected bankruptcy costs • Eventually, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost • At this point, the value of the firm will start to decrease and the WACC will start to increase

  33. Cost of Debt Varies Amount D/V D/E Bond borrowed ratio ratio rating rd $ 0 0 0 -- -- 250 0.125 0.1429 AA 8.0% 500 0.250 0.3333 A 9.0% 750 0.375 0.6000 BBB 11.5% 1,000 0.500 1.0000 BB 14.0%

  34. Times Interest Earned TIE = EBIT / Interest EBIT = $400,000 t=40% 80,000 shares outstanding, with price of $25

  35. EPS & TIE: D = $250,000, rd = 8%

  36. EPS & TIED = $500,000, rd = 9%

  37. Bankruptcy Costs • Direct costs • Legal and administrative costs • Additional losses for bondholder • Indirect bankruptcy or financial distress costs • Preoccupies management • Reduces sales • Lose valuable employees

  38. Options of Distress • The right to go bankrupt • Valuable • Protects creditors from further loss of assets • Creditors will renegotiate – why? • Avoid bankruptcy costs • Voluntary debt restructuring

  39. Tradeoff Theory • Tradeoff between the tax benefits and the costs of distress. • Tradeoff determines optimal capital structure • VL = VU + tC*D - PV (cost of distress) • With higher profits, what should happen to debt?

  40. In Practice • Tax benefit matters only if there’s a large tax liability • Risk and costs of financial distress vary • Capital structure does differ by industries • Increased risk of financial distress • Increased cost of financial distress • Lowest levels of debt • Pharma, Computers • Highest levels of debt • Steel, Department stores, Utilities

  41. WACC Review • Capital budgeting affects the firm’s well-being • Discount rate is based on the risk of the cash flows • Errors in capital budgeting can be serious • Need to compensate investors for financing • Project Expect Return > Cost of Capital • Project Cash Flows > Return to Investors

  42. General Electric • 6 Divisions • Commercial Finance – loans, leases, insurance • Healthcare – medical technology, drug discovery • Industrial – appliances, lighting, equipment services • Infrastructure – aviation, water, oil & gas technology • Money – consumer finance (credit cards, auto loans) • NBC Universal – entertainment and news

  43. Project WACC • Using a general industry or company cost of capital will lead to bad decisions.

  44. Using Firm WACC • Only for projects that mirror the overall firm risk • Only be used if the new financing has the same proportion of debt, preferred, and equity • Otherwise, use the project cost of capital

  45. Pure Play • Find several publicly traded companies exclusively in project’s business • Use pure play betas to proxy for project’s beta • May be difficult to find such companies • Note if the pure play is levered • Betas are non-stationary over time • Cross-sectional variation of betas, even within the same industry

  46. Leverage & Beta • Equity risk = business risk (operating leverage) + financial risk (financial leverage) • L = U(1+(1-t)D/E) • L = E= Equity beta = Levered beta • U = A = Asset beta = Unlevered beta • t = Company’s marginal tax rate

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