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FINANCE 7311

This finance outline covers topics such as optimal capital structure, cost of capital, risk, WACC, trade-off theory, and more. Learn how to maximize firm value and understand the relationship between investors' required return and the cost of capital.

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FINANCE 7311

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  1. FINANCE 7311 Optimal Capital Structure & Cost of Capital

  2. OUTLINE • Introduction • Cost of Capital - General • Required return v. cost of capital • Risk • WACC • Capital Structure • Costs of Capital

  3. CAPITAL STRUCTURE • NO TAXES • TAXES • BANKRUPTCY & OTHER COSTS • TRADE-OFF THEORY • PECKING ORDER HYPOTHESIS • OTHER CONSIDERATIONS

  4. COMPONENT COSTS • DEBT • PREFERRED • EQUITY • DISCOUNTED DIVIDENDS • CAPM • WACC Again

  5. Optimal Capital Structure • Goal: Maximize Value of Firm • See Lecture Note on Value of Firm • V = CF/R (In General) • We Can Max. Numerator or Min. Denominator • Optimal Capital Structure - that mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital

  6. Investors’ Required v. Cost of Capital • Investors: R = r + π + RP • 1st two same for most securities • RP => Risk Premium • Security’s required return depends on risk of the security’s cash flows • Cost of Capital => depends on risk of firm’s cash flows

  7. FIRM RISK V. SECURITY RISK • FIRM RISK => CIRCLE CF’S • SECURITY RISK => RECTANGLE CF’S • ALL EQUITY FIRM: SECURITY RISK = FIRM RISK • Ra = Re = WACC • DEBT => EQUITY RISKIER (WHY?)

  8. GOOD: SALES 100.00 COSTS 70.00 EBIT 30.00 INT 0.00 EBT 30.00 TAX 12.00 NI 18.00 ROE 18% BAD: SALES 82.50 COSTS 80.00 EBIT 2.50 INT 0.00 EBT 2.50 TAX 1.00 NI 1.50 ROE 1.5% Unlevered: Assets = Equity = 100

  9. GOOD: SALES 100.00 COSTS 70.00 EBIT 30.00 INT 5.00 EBT 25.00 TAX 10.00 NI 15.00 ROE 30% BAD: SALES 82.50 COSTS 80.00 EBIT 2.50 INT 5.00 EBT (2.50) TAX (1.00) NI (1.50) ROE (3%) Levered: A = 100: D = E = 50

  10. Example: • Cash Flows to Assets same (EBIT) • Cash Flows to Equity Differ

  11. COST OF CAPITAL, intro. • Cost of Capital is weighted average of cost of debt and the cost of equity (Why?) • CAPITAL IS FUNGIBLE • GRAIN EXAMPLE • BATHTUB EXAMPLE • WACC = Re*[E/(D+E)] + Rd(1-t)[D/D+E]

  12. Cost of Capital, cont. • Weights should be market; book may be ok • We can write Re as follows: • Re = Ra + (1 - Tc)(Ra - Rd) * D/E Business Financial • Risk Risk

  13. Business Risk • Sales/Input Price Variability • High operating leverage • Technology • Regulation • Management depth/breadth • Competition

  14. FINANCIAL RISK • The additional risk imposed on S/H from the use of debt financing. • Debt has a prior claim • S/H must stand in line behind B/H • Higher Risk ==> Higher Required Return

  15. Optimal Capital StructureBenchmark Case • No Taxes • No Transaction Costs • Information is symmetric • No other market imperfections

  16. Optimal Capital StructureNo Taxes • CF’s From Assets Unchanged • Value of Firm ==> Circle • Portfolio of Debt & Equity • ‘PIE’ Idea • Miller & Modigliani Proposition I (M&M I) • The Financing Decision is Irrelevant

  17. Optimal Capital StructureNo Taxes • BUT, Debt is Cheaper than Equity, so why doesn’t WACC fall? • WACC relates to the CIRCLE • Simply ‘repackaging’ same CF stream

  18. Cost of Capital, No Taxes • Re = Ra + (Ra - Rd)*D/E • Miller & Modigliani Prop. II (M&M II) • Re increases such that WACC is unchanged

  19. No Taxes - Summary • Value of Firm is INDEPENDENT of financing - M&M I • Re increases as D increases SUCH THAT WACC IS UNCHANGED - M&M II • EPS increase is offset by Re increase

  20. TAXES • Interest is deductible for tax purposes • Investors still require Rd • After-tax cost to firm: = Rd * (1 - Tc) • CF’s higher by amount of tax savings

  21. TAXES • Vl = Vu + PV (tax savings) • Value of levered Firm = • Value of unlevered + PV of tax advantage of debt • Vl = EBIT(1-t)/Ra + Tc x D

  22. TAXES, cont. • Now, • WACC < Re (all equity) = Ra • ==> Logical Conclusion: • ==> Use ‘all’ debt

  23. Why Not Use All Debt? • Other Tax Shields • COSTS OF FINANCIAL DISTRESS • DIRECT BANKRUPTCY COSTS • Accountants • Attorneys • Others • Who Pays?

  24. Costs of Financial Distress, cont. • INDIRECT COSTS: • DISRUPTION IN MANAGEMENT • Is B/R Management Specialty? • EMPLOYEE COSTS • Morale Low • Turnover increases

  25. Indirect Costs, cont. • CUSTOMERS • Quality concerns (airlines; insurance) • Serviceconcerns (autos; computers)

  26. TRADE-OFF THEORY • TRADE OFF TAX ADVANTAGE OF DEBT AGAINST COSTS OF FINANCIAL DISTRESS • PRACTICE: It is impossible to solve for precisely optimal capital structure • FLAT BOTTOM BOAT - None and too much important; between doesn’t matter

  27. Handout #1 - Notes • EBIT Unchanged - No effect on assets • Payments to B/H & S/H continually increase • Note that both Rd and Re increase • EPS continually increases • Share Price Maximized at 30% debt • WACC Minimized at 30% debt

  28. Handout #2 • Vl = Vu (No Taxes) • (M&M I) • Vl = Vu + Tc*D (Taxes) • Re = Ru + (Ru - Rd)*D/E*(1 - Tc) • (M&M II) • Pictures

  29. Simple Numerical Example • Vu = 500; Vl = $670 • E = 670 - 500 = 170 • Re = .20 + (.20 - .10)(1 - .34)(500/170) • = 39.41% • WACC = 14.92% • 100 / 14.92% = $670

  30. PECKING ORDER Hypothesis • Relaxes symmetric information assumption • Now assume that management knows more about the future prospects of the firm than do outsiders • The announcement to issue debt or equity is a SIGNAL

  31. PECKING ORDER Hypothesis • If management expects good prospects: • will not want to share with new S/H •  will not want to sell undervalued shares •  expects adequate CF’s to fund debt service • ===> WILL ISSUE DEBT

  32. Pecking Order Hypothesis, cont. • If management expects bad prospects: •  Will want to share with new S/H •  Will want to sell overvalued shares •  May not expect adequate CF’s for debt service • ===> WILL ISSUE EQUITY

  33. Market Reaction to Security Issue Announcements • Announcement of new Equity Issue • Negative reaction • 30% of new equity issue • 3% of existing equity • Announcement of new Debt Issue • Little or no reaction • Share repurchase ==> Positive reaction

  34. Pecking Order Summary • Firms use INTERNAL FUNDS first • Conservative dividend policy • If external funds, then DEBT FIRST (signaling problem) • When debt capacity is used, then EQUITY • Resulting capital structure is function of firm’s profitability relative to invest. needs

  35. OTHER FACTORS • CASH FLOW STABILITY • ASSET STRUCTURE • TANGIBLE V. INTANGIBLE • PROFITABILITY • AGENCY PROBLEMS • OVER & UNDER INVESTMENT PROBLEM • REMOVES CASH FROM MGMT

  36. OTHER FACTORS, cont. • CURRENT MARKET CONDITIONS • FINANCIAL FLEXIBILITY •  RESERVE OF BORROWING POWER •  TODAY’S DECISION AFFECTS FUTURE • MANAGERIAL FLEXIBILTIY •  DEBT COVENANTS •  CASH FLOW TAKEN FROM MGMT

  37. COST OF CAPITAL • DISCOUNT RATE DEPENDS ON RISK OF CASH FLOW STREAM • The Cost of Capital Depends on the USE of the money, not its SOURCE • When is WACC appropriate? •  Project has same risk as Firm

  38. COST OF CAPITAL • EXAMPLE: Project A has IRR of 13% and is financed with 8% debt; Project B has IRR of 15% & financed with 16% equity. WACC is 12%. Which should you do? • Both! ==> Why? • Both have IRR > Cost of Capital

  39. COMPONENT COSTS • DEBT => Return required by investor, Rd •  Capital market: YTM for O/S debt of firm •  YTM for debt of ‘similar’ firms • Similar: Business Risk & Financial Risk • Same Industry: controls for business risk •  YTM of different rating ‘classes’ • Standard &Poors, Moodys • Ratings: Business Risk & Financial Risk

  40. Debt, Bond Ratings • STANDARD & POORS • AAA => Highest rating • BBB => adequate capacity to repay P&I • BB => Speculative (below investment grade) • Junk • CCC, D (D = default)

  41. PREFERRED STOCK • Preferred is like a ‘perpetuity’ • Pp = D / Rp • ==> Rp = D / Pp • Cost of preferred = Dividend Yield

  42. COMMON STOCK • Three Methods •  Capital Asset Pricing Model (CAPM) •  Dividend Discount Model •  Risk Premium Method

  43. Capital Asset Pricing Model • 2 TYPES OF RISK: •  SYSTEMATIC (Market-wide; GDP) •  NONSYSTEMATIC (Firm specific) • Diversification => can virtually eliminate nonsystematic risk

  44. Common Stock, CAPM • Investors should only be rewarded for systematic risk, which is measured by Beta • Beta => a measure of the volatility of the stock relative to the market • Ri = Rf + B*(Rm - Rf) • Where: Rf = risk-free rate • Rm = market return • Rm - Rf = market ‘risk premium’

  45. BETA • Beta of Market = 1 • Portfolio Beta = weighted average of all betas in the portfolio • Where do we get Beta? •  Regression analysis •  Beta of firm if publicly traded •  Beta from portfolio of ‘similar’ firms •  Similar need not include financial risk

  46. Levered/Unlevered Beta • We can adjust Beta for Leverage as follows: • Bl = Bu * [1 + D/E*(1-t)] • and: • Bu = Bl / [1 + D/E*(1 - t)]

  47. Levered/Unlevered Beta • Take Levered Beta from sample portfolio • Unlever to find ‘unlevered’ or asset beta, using D/E of sample portfolio • ‘Relever’ unlevered beta using D/E of firm • Note: This is same process used to adjust Re to reflect additional financial risk.

  48. Cost of Equity: Discount Dividends • Recall: P0 = D1 / (R - g) • Expected returns = required in equilibrium • We can solve above for ‘expected’ return: • R = D1/P0 + g • The trick is to estimate g (Forecasts; history; SGR)

  49. Dividend Discount - New equity • If new equity is issued, there are transaction costs. • Not all proceeds go to firm. • Let c = % of proceeds as transaction costs • Then: R = D1/ [P0*(1-c)] + g

  50. Equity Cost: Risk Premium Method • Add risk premium to company’s marginal cost of debt • Re = Rd + Risk Premium • Problem: Where do you get risk premium

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