Capital Structure: The Optimal Financial Mix

1. Capital Structure: The Optimal Financial Mix 05/21/08 Ch. 8

2. The search for an optimal financing mix • The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm. • Unconstrained and constrained optimals

3. The search for an optimal financing mix • The Cost of Capital Approach: • The optimal debt ratio (D/D+E) is chosen to minimize cost of capital and is calculated based on the weights and costs of each component of capital. • Why does the cost of capital matter? • Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. • If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

4. Mechanics of cost of capital estimation • Estimate the equity and debt weights at different debt levels • Estimate the Cost of Equity at different levels of debt: • Estimate the levered beta for different levels of debt • The cost of equity will increase with the debt ratio since the levered beta increases • Estimate the Cost of Debt at different levels of debt: • Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. • To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense) • Estimate the Cost of Capital at different levels of debt

5. Estimating the equity and debt weights • In estimating the weights of equity and debt at different levels of debt, we can assume • that the firm maintains its current value and issues equity / pays off debt to reduce the debt ratio or buys back equity / issues debt to increase the debt ratio • OR that the firm increases firm market value by taking on additional debt.

6. Estimating the cost of equity • Calculate the unlevered beta for the firm • Use this unlevered beta and different D/E levels to estimate the levered beta at different debt levels • The CAPM is then used to estimate a cost of equity at each debt ratio.

7. Estimating the cost of debt • To estimate the cost of debt at different debt levels, we construct synthetic ratings for our firm at different debt levels. • Cost of debt is estimated by the following process: • Calculate the firm’s current EBIT • Estimate the firm’s interest coverage ratio at various levels of debt • Interest expense for each debt level must be calculated to determine the interest coverage ratio at that debt level • Using interest coverage ratio estimates, obtain firm ratings at different debt levels • Calculate the after-tax costs of debt using the current treasury bond rate, the default spread and marginal tax rate • There is a circularity to these calculations. Without a starting assumption, we cannot calculate costs of debt. Our starting assumption is that at the lowest level of debt considered, the company is AAA-rated.

8. Estimating cost of capital • With the estimated costs of equity, after-tax costs of debt and debt/equity weights at different debt levels, we can estimate the cost of capital at these different debt levels.

9. Effect of moving to the optimal on firm value • Re-estimate firm value at the optimal debt ratio, using the optimal cost of capital. • For a stable growth firm, this would be Firm Value = CF to Firm (1 + g) / (WACC -g) • For a high growth firm, this would require that the cash flows during the high growth phase be estimated and discounted back. • The increase in firm value of moving to the optimal cost of capital: Firm Valueopt WACC- Firm Valueorig WACC

10. Firm value inputs • Cash flow to firm: CF to firm = EBIT(1-t) + Depr.&Amort. – Chg in WC – Cap Exp • Growth rate (g): • The estimate of growth used in valuing a firm can clearly have significant implications for the final number. • One way to bypass this estimation is to estimate the growth rate implied in today’s market value. For instance, assuming a perpetual growth model,

11. Constrained cost of capital • Management often specifies a 'desired Rating' below which they do not want to fall. • The rating constraint is driven by two factors • it is one way of protecting against downside risk in operating income • a drop in ratings might affect operating income • Caveat: Every Rating Constraint Has A Cost. • To understand the cost we need to compare the value of the firm with and without the constraint.