FIN 600: Financial Management Lecture 7: Cost of Capital and Capital Structure

1. FIN 600: Financial Management • Lecture 7: Cost of Capital and Capital Structure Anton Miglo Summer 2012

2. Topics • Financing in a perfect market • Modigliani-Miller proposition • Perfect market and real data • Cost of Financial Distress • Bankruptcy • Direct and Indirect Bankruptcy Cost • Corporate Tax and Financial Structure • Trade-off Theory • Cost of Equity and Cost of Debt • Cost of Capital and WACC • Additional readings: M ch. 7,8

3. Perfect Market vs. Imperfect Market

4. Arbitrage • The law of one price • MM proposition is an application of arbitrage to corporate finance

5. Arbitrage example • What is the price of financial asset C, if it will pay to its holder $ 1,000 in one year and $ 5,000 in two years? • Two assets are traded on the market • A (current price = $ 400) • $ 500 In one Year • B ( current price = $ 3000) • $ 1,000 In 2 years

6. The Miller-Modigliani Theorem • In an environment, where there are no taxes, bankruptcy costs or agency costs, capital structure is irrelevant. • The value of a firm is independent of its debt ratio.

8. Capital Structure & Corporate Taxes

9. Tax Benefits of Debt • The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment: • Tax benefit each year = Tax Rate * Interest Payment

10. Implications • The debt ratios should be higher for firms with higher tax rates (Interesting: historical tax rates and capital structure; countries with different tax rates and capital structure!) • The debt ratios should be lower for firms with substantial non-debt tax shields, such as depreciation

11. Example: Debt tax shield • A firm generates $ 100M in profits for sure every period in perpetuity. This is the only cash flow the firm has. • Risk-free rate is 10% • Corporate tax rate (TC) is 40%. • If the firm is 100% equity financed, what is the value of the firm? • Now the firm takes of $ 500M of debt.

12. Bankruptcy

13. Example: Air Canada

14. Bankruptcy Costs Direct Bankruptcy Costs Indirect Bankruptcy Costs ?

15. Bankruptcy Cost • Other things being equal, the greater the indirect bankruptcy cost and/or probability of bankruptcy in the operating cashflows of the firm, the less debt the firm can afford to use.

16. Implications • Firms that sell durable products with long lives that require replacement parts and service should probably have high indirect bankruptcy costs • If an external entity, such as the government or an agency of the government, provides protection against bankruptcy through either insurance or bailouts for troubled firms, firms will tend to borrow more. • Firms operating in businesses with volatile earnings and cash flows should use debt less than otherwise similar firms with stable cash flows.

17. Indirect bankruptcy costs, 1997-2004 t-3 t-2 t-1 Consumer Products 3.03% (4.58%) 10.83% (6.77%) 13.78% (11.11%) Financial 4.51% (-0.41%) 5.72% (4.82%) 12.80%(15.17%) Manufacturing 2.54% (2.41%) 3.00% (2.91%) 8.97% (10.24%) Retail 6.27% (4.81%) 15.19% (10.26%) 22.99% (14.11%) Services 6.27% (4.81%) 15.19% (10.26%) 22.99% (14.11%) Technology 0.42% (0.99%) 3.02% (5.14%) 27.04% (26.17%) Transportation -3.79% (-10.50%) 3.39% (5.14%) 11.72% (11.63%) Overall 2.00% (1.79%) 6.21% (5.11%) 14.95% (12.83%)

18. Bankruptcy costs, 1994-2004 SIC 0.1 0.3 0.5 0.7 0.9 L Oil & Gas 13 0.005 0.043 0.121 0.237 0.391 0.030 Builders 15 0.004 0.034 0.094 0.184 0.305 0.076 Food 20 0.012 0.104 0.288 0.565 0.934 0.032 Paper 26 0.004 0.037 0.102 0.200 0.330 0.038 Publishing 27 0.016 0.141 0.391 0.766 1.266 0.064 Chemicals 28 0.019 0.171 0.475 0.930 1.538 0.021 Petroleum Products 29 0.005 0.047 0.131 0.256 0.423 0.008 Primary Metals 33 0.002 0.019 0.052 0.102 0.168 0.018 Machinery 35 0.007 0.067 0.186 0.365 0.603 0.055 Electric Equipment 36 0.016 0.147 0.408 0.800 1.323 0.027 Cars 37 0.007 0.064 0.177 0.347 0.574 0.163 Instruments 38 0.007 0.065 0.180 0.353 0.584 0.017 Transport (Air) 45 0.006 0.050 0.140 0.275 0.454 0.129 Telecom 48 0.005 0.043 0.120 0.236 0.390 0.030 Utilities 49 0.003 0.025 0.070 0.138 0.228 0.058 Wholesale (Non-dur) 51 0.006 0.053 0.147 0.289 0.477 0.027 Retail (Misc) 53 0.008 0.068 0.188 0.368 0.609 0.031 Banks 60 0.003 0.024 0.068 0.133 0.220 0.073 Insurance 63 0.005 0.044 0.123 0.242 0.399 0.057 Hotels 70 0.003 0.030 0.083 0.164 0.270 0.034 Equipment Services 73 0.008 0.071 0.198 0.389 0.642 0.019 Health 80 0.005 0.042 0.116 0.227 0.376 0. 038 Average - 0.007 0.061 0.171 0.335 0.553 0.048 4

19. Trade-off Theory of Capital Structure Value of Firm= Value if all equity financed+ +PV of tax shield- -PV of costs of financial distress

20. Trade-off Theory Maximum value of firm Costs of financial distress PV of interest tax shields Market Value of The Firm Value of levered firm Value of unlevered firm Optimal amount of debt Debt

21. Debt Ratios for some Industries IndustryDebt to Value Ratio Internet .0218 Educational Services .0224 Drugs&Cosmetics .0907 Instruments .1119 Metal Mining .1347 Electronics .1579 Machinery .1957 Food .2056 Construction .2384 Petroleum Refining .2436 Chemicals .2544 Apparel .2603 Motor Vehicles Parts .2714 Paper .2895 Textile Mill Products .3257 Retail Dept Stores .3433 Trucking* .3730 Steel .3819 Telephone* .5150 Elec. & Gas Utilities* .5309 Airlines* .5825

22. Assets Liabilities & Equity Short-term assets Short-term debt Fixed assets Long-term debt Preferred Stock Common Equity

23. Weighted Average Cost of Capital

24. Abracadabra’s WACC • The firm’s stock has a beta  = 1.4. • The expected market return is E(rM ) = 10% • The risk-free rate rf = 4%. • Abracadabra’s equity has a market value E = $10,000 • Abracadabra’s debt has a market value D = $15,000 • Abracadabra can borrow new funds at a cost of rD = 6%. • Abracadabra’s corporate tax rate is TC = 40%.

25. Example

26. Example (cont.) • Equity Information • Common equity: • 1 million shares • Market price $20 per share • Beta = 0.8 • Market risk premium = 10% • Preferred shares • Par value $20 • Dividend per share: $2 • Debt Information • YTM=9% • Coupon rate = 8%, annual coupons • 10 years to maturity • Spread between risk-free and expected rate of return is 3% • Risk-free rate = 6%

27. WACC Approach (MICROSOFT, 2004)