Post on 30-Apr-2020
Giddy/SIM Capital Structure /1
Prof. Ian GiddyNew York University
Capital Structure Planning
SIM/NYUThe Job of the CFO
Copyright ©2001 Ian H. Giddy Capital Structure 3giddy.org
Why Financial Restructuring?
l The Asian Bet
l The Solution, Part I: Recapitalizationl The Solution, Part II: Financial
Restructuring
l The Solution, Part III: Corporate Restructuring
Giddy/SIM Capital Structure /2
Copyright ©2001 Ian H. Giddy Capital Structure 4giddy.org
The Asian Bet
l High growth disguised speculative financing structures
l Governments shielded companies and banks from capital market discipline
l Too much debt
l Too much foreign-currency debt
l Closely held ownership relying on reinvested earnings
Copyright ©2001 Ian H. Giddy Capital Structure 5giddy.org
The Asian Bet
l High growth disguised speculative financing structures
l Governments shielded companies and banks from capital market discipline
l Too much debt
l Too much foreign-currency debt
l Closely held ownership relying on reinvested earnings
The three excessesn Too much debtn Too much laborn Too much capacity
The three excessesn Too much debtn Too much laborn Too much capacity
Example: Hyundai G
roup
Giddy/SIM Capital Structure /3
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How the Bet was Lost
l Vulnerable economies, newly liberalized, succumbed to currency crises
l Economic downturns followed
l Companies were unable to service even domestic debt, never mind foreign currency debt
l Still unreformed, many Asian companies remain misfinanced
Example: Hyundai G
roup
Copyright ©2001 Ian H. Giddy Capital Structure 7giddy.org
What is Corporate Restructuring?
l Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.
l Designed to increase the value of the firm Restructuring
Improvecapitalization
Change ownershipand control
Improvedebt composition
Giddy/SIM Capital Structure /4
Copyright ©2001 Ian H. Giddy Capital Structure 8giddy.org
It’s All About Value
l How can corporate and financial restructuring create value?
Operating
Cash
Flows
Debt
Equity
Assets Liabilities
Fix the business
Or fix the financing
Copyright ©2001 Ian H. Giddy Capital Structure 9giddy.org
Restructuring
What mix of debt is best suited to this business?
Fix the kind of debt or hybrid financing
What can be done to make the equity more valuable to investors?
Fix the kind of equity
Value the changes new control would produce
Fix management or control
Revalue firm under different leverage assumptions – lowest WACC
Fix the financing – improve D/E structure
Value the merged firm with synergies
Fix the business – strategic partner or merger
Value assets to be soldFix the business mix – divestitures
Use valuation model – present value of free cash flows
Figure out what the business is worth now
Giddy/SIM Capital Structure /5
Copyright ©2001 Ian H. Giddy Capital Structure 10giddy.org
Getting the Financing RightStep 1: The Proportion of Equity & Debt
Debt
Equity
n Achieve lowest weighted average cost of capital
n May also affect the business side
Copyright ©2001 Ian H. Giddy Capital Structure 11giddy.org
Getting the Financing RightStep 2: The Kind of Equity & Debt
Debt
Equity
n Short term? Long term?n Baht? Dollar? Yen?
n Short term? Long term?n Baht? Dollar? Yen?
n Bonds? Asset-backed?n Convertibles? Hybrids?
n Bonds? Asset-backed?n Convertibles? Hybrids?
n Debt/Equity Swaps?n Private? Public?n Strategic partner?n Domestic? ADRs?
n Debt/Equity Swaps?n Private? Public?n Strategic partner?n Domestic? ADRs?
n Ownership & control?n Ownership & control?
Giddy/SIM Capital Structure /6
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Does Capital Structure Matter?
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
You cannot change the value of thereal business just by shuffling paper
- Modigliani-Miller
Copyright ©2001 Ian H. Giddy Capital Structure 13giddy.org
Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
COSTOF
CAPITAL
DEBTRATIO
Optimal debt ratio?
Giddy/SIM Capital Structure /7
Copyright ©2001 Ian H. Giddy Capital Structure 14giddy.org
Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
VALUE OFTHE
FIRM
DEBTRATIO
Optimal debt ratio?
Copyright ©2001 Ian H. Giddy Capital Structure 15giddy.org
Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
Value of Firm= PV(Cash Flows) + PV(Tax Shield) - Distress Costs
Giddy/SIM Capital Structure /8
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Managing the capital base
l Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000
l Flexibility to redeem non-voting shares and buy back ordinary shares
l Flexibility to dispose remaining non-core assets
l Utilizing excess capital for organic growth and acquisitions
Copyright ©2001 Ian H. Giddy Capital Structure 17giddy.org
Changing Financial Mix
l Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt.
l Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.
Giddy/SIM Capital Structure /9
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Debt: Pros and Cons
Advantages of Borrowing Disadvantages of Borrowing
1. Tax Benefit:
Higher tax rates --> Higher tax benefit
1. Bankruptcy Cost:
Higher business risk --> Higher Cost
2. Added Discipline:
Greater the separation between managers
and stockholders --> Greater the benefit
2. Agency Cost:
Greater the separation between stock-
holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
Copyright ©2001 Ian H. Giddy Capital Structure 19giddy.org
See Saw
Business Uncertainty
Financial Risk
Operating Leverage
Financial Leverage
Giddy/SIM Capital Structure /10
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Young and Old
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
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Disney
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
WA
CC
9.40%
9.60%9.80%
10.00%
10.20%10.40%
10.60%10.80%
11.00%11.20%11.40%
0
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Giddy/SIM Capital Structure /11
Copyright ©2001 Ian H. Giddy Capital Structure 22giddy.org
Siderar: Steel Company in Argentina
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,001
50% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
0
200
400
600
800
1000
1200
0% 20% 40% 60% 80% 100%
Debt Percentage
Val
ue
($m
illio
ns)
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
0% 20% 40% 60% 80% 100%
Debt Percentage
Co
st o
f C
apit
al
Copyright ©2001 Ian H. Giddy Capital Structure 23giddy.org
Capital Structure: East vs West
VALUE OFTHE
FIRM
DEBTRATIO
Optimal debt ratio?
Intel TPI
Giddy/SIM Capital Structure /12
Copyright ©2001 Ian H. Giddy Capital Structure 24giddy.org
Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas
Copyright ©2001 Ian H. Giddy Capital Structure 25giddy.org
Perceived Benefits to Sammi From Acquisition of Atlas Steel
l Achieve $280mm savings by acquiring Atlas Steel and related companiesuCost of setting up own production facility
would have been $500 mm
uSavings were channeled into restructuring production facilities at existing plants
l Sammi’s share price rose 9% on news of strategic acquisitions
Giddy/SIM Capital Structure /13
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How Should the Acquisition Have Been Financed?
Assets added:$210 million
Assets added:$210 million
Debt added:$210 million
(C$250m)
Debt added:$210 million
(C$250m)
Copyright ©2001 Ian H. Giddy Capital Structure 27giddy.org
How Should the Acquisition Have Been Financed?
Assets added:$210 million
Assets added:$210 million
Debt added:$210 million
(C$250m)Loan: C$180m
Ret earn: C$70mPlus w.cap.:
Eurobond withwarrants US$50m
Debt added:$210 million
(C$250m)Loan: C$180m
Ret earn: C$70mPlus w.cap.:
Eurobond withwarrants US$50m
Giddy/SIM Capital Structure /14
Copyright ©2001 Ian H. Giddy Capital Structure 28giddy.org
Problems faced by Sammi from the Acquisition
l Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages
l Future refinancing of debt caused earnings after interest costs to fall 17%
l Purchase price of $210.6 mm found to have been excessive
l The acquisition was ill-timed
l Existing and new plants suffered from low capacity utilization of around 65%
Copyright ©2001 Ian H. Giddy Capital Structure 29giddy.org
Sammi Steel in 1995
l Sammi Atlas pushed to raise productivity by 15%l A leaner organization: Work force had shrunk by
19.4% since 1988l 4 year freezes on salaries to limit labor costsl Unrelated and unprofitable businesses have
been sold off
l New export zones identified in China and South-East Asia
l Conversion of debt into equity to reduce interest costs by 6%;
l Result: dilution in EPS, unless offset by increased volume of sales
Giddy/SIM Capital Structure /15
Copyright ©2001 Ian H. Giddy Capital Structure 30giddy.org
Analysis of Change in Value of Sammi Steel
( Billions of Korean Won) 1989 1994
Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027
( Billions of Korean Won) 1989 1994
Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027
Copyright ©2001 Ian H. Giddy Capital Structure 31giddy.org
March 1997
Sammi Steel is bankrupt!
ALTO
Giddy/SIM Capital Structure /16
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March 1997
Sammi Steel is bankrupt!
ALTODr F R Structuringn Diagnosisn Preventionn and Cure
Dr F R Structuringn Diagnosisn Preventionn and Cure
Copyright ©2001 Ian H. Giddy Capital Structure 33giddy.org
Financing Choices
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
From
How much debt?
to
What kind of debt?
and
What kind of equity?
You can make a difference- Pepper-Giddy
Giddy/SIM Capital Structure /17
Copyright ©2001 Ian H. Giddy Capital Structure 34giddy.org
Corporate Finance
CORPORATE FINANCEDECISONS
CORPORATE FINANCEDECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Case Study: “Intralinks”Case Study: “Intralinks”
Prof. Ian GiddyNew York University
Financing Growth Companies
Giddy/SIM Capital Structure /18
Copyright ©2001 Ian H. Giddy Capital Structure 36giddy.org
Corporate Finance
CORPORATE FINANCEDECISONS
CORPORATE FINANCEDECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©2001 Ian H. Giddy Capital Structure 37giddy.org
The CFO Questions
l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
l How much (cheap) debt should we have?
l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
l How should we manage our financial risks?
Giddy/SIM Capital Structure /19
Copyright ©2001 Ian H. Giddy Capital Structure 38giddy.org
Financing X Inc
Copyright ©2001 Ian H. Giddy Capital Structure 39giddy.org
Financing X Inc
Giddy/SIM Capital Structure /20
Copyright ©2001 Ian H. Giddy Capital Structure 40giddy.org
Financing X Inc
Copyright ©2001 Ian H. Giddy Capital Structure 41giddy.org
Corporate Financing Life-Cycle
Growth companies Mature companies
Leverage
Giddy/SIM Capital Structure /21
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Firm Characteristics as Growth Changes
Variable High Growth Firms tend to Stable Growth Firms tend toRisk be above-average risk be average risk Dividend Payout pay little or no dividends pay high dividendsNet Cap Ex have high net cap ex have low net cap exReturn on Capital earn high ROC (excess return) earn ROC closer to WACCLeverage have little or no debt higher leverage
Earnings
Gearing(Leverage)
0
Copyright ©2001 Ian H. Giddy Capital Structure 43giddy.org
Financing Growth Companies:The Agenda
l Where can we get the initial equity financing we need to grow?
l Do we want money, management, or more?
l When do we want to sell out, and how?
l When is the right time for debt for a growth company? What kind?
Giddy/SIM Capital Structure /22
Copyright ©2001 Ian H. Giddy Capital Structure 44giddy.org
What Kind of Equity?
l Sources of EquityuPrivate investors
uStrategic investors
uInterventionist investors
uPublic market
l And KindsuCommon stock
uStock with restricted voting rights
uHybrids, including convertibles
Copyright ©2001 Ian H. Giddy Capital Structure 45giddy.org
.comfax (now Messageclick)
l Started in September 1997, .comfax enables users to send faxes and receive faxes over the internet at a low cost.
l By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day.
l Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money.
l What form of equity financing would be appropriate for .comfax?
Giddy/SIM Capital Structure /23
Copyright ©2001 Ian H. Giddy Capital Structure 46giddy.org
Pre-IPO Equity Financing
l Friends and family
l Angell Venture capital
l Strategic partners
Copyright ©2001 Ian H. Giddy Capital Structure 47giddy.org
Pre-IPO Equity Financing
l Friends and family
l Angell Venture capital
l Strategic partners
asiajack.com
Giddy/SIM Capital Structure /24
Copyright ©2001 Ian H. Giddy Capital Structure 48giddy.org
Private Equity Funds
l Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring.
l The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.
Copyright ©2001 Ian H. Giddy Capital Structure 49giddy.org
Silipos Inc
Giddy/SIM Capital Structure /25
Copyright ©2001 Ian H. Giddy Capital Structure 50giddy.org
Silipos Inc, 1999
Where do you want
to go?
Debt?Debt?
Acquisition?Acquisition?
IPO?IPO?
Sell?Sell?
Copyright ©2001 Ian H. Giddy Capital Structure 51giddy.org
IntraLinks
Giddy/SIM Capital Structure /26
Copyright ©2001 Ian H. Giddy Capital Structure 52giddy.org
IntraLinks’ Choices
Ø Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.
Ø Seek out one or more private equity investors, ones who believed in the company’s product and its management.
Ø Do an initial public offering (IPO).Ø Find another corporation who would be willing to
acquire IntraLinks.
Copyright ©2001 Ian H. Giddy Capital Structure 53giddy.org
Why Venture Capitalists Prefer Preferred
l Senior status in bankruptcy
l Does not put a value on the sharesl Is convertible into common stock before
the IPO
l Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero)
Giddy/SIM Capital Structure /27
Copyright ©2001 Ian H. Giddy Capital Structure 54giddy.org
Case Study: Photronics
Copyright ©2001 Ian H. Giddy Capital Structure 55giddy.org
Case Study: Photronics
Photronics is the world's leading and fastestgrowing manufacturer of photomasks.Photomasks are high precision quartz plates thatcontain microscopic images of electroniccircuits. A key element and enabling technologyin the manufacture of semiconductors,photomasks are used to transfer circuit patternsonto semiconductor wafers during the fabricationof integrated circuits. They are produced inaccordance with circuit designs provided bycustomers at strategically located manufacturingfacilities in North America, Europe and Asia.
Giddy/SIM Capital Structure /28
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Case Study: Photronics
Sales, 1994-99
Balance Sheet, end-1999USD millionsAssets Liabilities & EquityCash 7.6 Current liabilities 50.2Other current assets 59.9 Long term liabilities 132.7Long term assets 319.6 Shareholder's equity 204.2Total 387.1 Total 387.1
Market capitalization 720 P/E 26xEBIT/Int cost 5.77
Book MarketD/E 0.90 0.25D/(D+E) 0.47 0.20
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The Company’s Debt
Giddy/SIM Capital Structure /29
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Should Photronics Have More Debt?
l Benefits of DebtuTax Benefits
uAdds discipline to management
l Costs of DebtuBankruptcy Costs
uAgency Costs
uLoss of Future Flexibility
Copyright ©2001 Ian H. Giddy Capital Structure 59giddy.org
The CFO Questions
l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
l How much (cheap) debt should we have?
l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
l How should we manage our financial risks?
Giddy/SIM Capital Structure /30
Copyright ©2001 Ian H. Giddy Capital Structure 60giddy.org
Some Useful Websites
l giddy.org/jcfo.htm
l giddy.orgl giddyonline.com
l shareinvestor.com
l dialpad.com
l onebox.com
Copyright ©2001 Ian H. Giddy Capital Structure 61giddy.org
Measuring the Cost of Capital
l Cost of funding equal return that investors expect
l Expected returns depend on the risks investors face (risk must be taken in context)
l Cost of capitaluCost of equity
uCost of debt
uWeighted average (WACC)
Giddy/SIM Capital Structure /31
Copyright ©2001 Ian H. Giddy Capital Structure 62giddy.org
A $1 Investment in Different Types of Portfolios: 1926-1996
0.1
1
10
100
1000
10000
1925 1935 1945 1955 1965 1975 1985 1995
Index ($)
$4,495.99
$33.73
$13.54$8.85
$1,370.95
Small Company Stocks
Large Company Stocks
Long-Term Government Bonds
Treasury BillsInflation Year-End
Copyright ©2001 Ian H. Giddy Capital Structure 66giddy.org
Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF
Expected GrowthReinvestment Rate* Return on Capital
FCFF1 FCFF2 FCFF3 FCFF4 FCFF5
Forever
Firm is in stable growth:Grows at constant rateforever
Terminal Value= FCFFn+1/(r-gn)FCFFn
.........
Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)
WeightsBased on Market Value
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity
Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows
+Beta- Measures market risk X
Risk Premium- Premium for averagerisk investment
Type of Business
Operating Leverage
FinancialLeverage
Base EquityPremium
Country RiskPremium
DISCOUNTED CASHFLOW VALUATION
Giddy/SIM Capital Structure /32
Copyright ©2001 Ian H. Giddy Capital Structure 67giddy.org
Let’s Start With the Cost of Debt
l The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components-u(a) The general level of interest rates
u(b) The default premium
u(c) The firm's tax rate
Copyright ©2001 Ian H. Giddy Capital Structure 71giddy.org
Interest Coverage Ratios, Ratings and Default Spreads
If Interest Coverage Ratio is Estimated Bond Rating Default Spread> 8.50 AAA 0.20%6.50 - 8.50 AA 0.50%5.50 - 6.50 A+ 0.80%4.25 - 5.50 A 1.00%3.00 - 4.25 A– 1.25%2.50 - 3.00 BBB 1.50%2.00 - 2.50 BB 2.00%1.75 - 2.00 B+ 2.50%1.50 - 1.75 B 3.25%1.25 - 1.50 B – 4.25%0.80 - 1.25 CCC 5.00%0.65 - 0.80 CC 6.00%0.20 - 0.65 C 7.50%< 0.20 D 10.00%
Giddy/SIM Capital Structure /33
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Other Factors Affecting RatiosMedians of Key Ratios : 1993-1995
AAA AA A BBB BB B CCCPretax Interest Coverage 13.50 9.67 5.76 3.94 2.14 1.51 0.96
EBITDA Interest Coverage 17.08 12.80 8.18 6.00 3.49 2.45 1.51Funds from Operations / Total Debt
(%) 98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%
Free Operating Cashflow/ TotalDebt (%) 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%
Pretax Return on Permanent Capital(%) 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%
Operating Income/Sales (%) 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%Long Term Debt/ Capital 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%
Copyright ©2001 Ian H. Giddy Capital Structure 73giddy.org
Estimating Siderar’s Cost of Debt (in $)
l Riskfree Rate = 6%l Country default spread = 5.25%
(Argentine default spread)uI am assuming that all Argentine
companies have to pay at least this spread.
l Rating for Siderar = A-l Default spread = 1.25%l Pre-tax cost of borrowing for first 5
years= 6% + 5.25% + 1.25% = 12.50%
Giddy/SIM Capital Structure /34
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The Cost of Equity
Equity is not free!
Expected return = Risk-free rate + Risk Premium
E(RRisky) = RRisk-free -+ Risk Premium
Copyright ©2001 Ian H. Giddy Capital Structure 75giddy.org
The Cost of Equity
l Consider the standard approach to estimating cost of equity:Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,Rf = Riskfree rateE(Rm) = Expected Return on the Market Index (Diversified Portfolio)
l In practice,u Short term government security rates are used as risk free
ratesu Historical risk premiums are used for the risk premium
u Betas are estimated by regressing stock returns against market returns
Giddy/SIM Capital Structure /35
Copyright ©2001 Ian H. Giddy Capital Structure 76giddy.org
Private Business: Owner hasall his wealth invested in thebusiness
Venture Capitalist: Haswealth invested in a numberof companies in one sector
Publicly traded companywith investors who are diversified domesticallyorIPO to investors who aredomestically diversified
Publicly traded companywith investors who are diverisified globallyorIPO to global investors
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
TotalRisk
Risk added to sectorportfolio
Risk added to domestic portfolio
Risk added to global portfolio
StandardDeviation
Beta relative to sector
Beta relative to local index
Beta relative to global index
40%
25%
15%
10%
100/.4=250
100/.25=400
100/.15=667
100/.10=1000
Investor Type Cares about Risk Measure Cost ofEquity
Firm Value
Valuing a Firm from Different Risk PerspectivesFirm is assumed to have a cash flow of 100 each year forever.
Copyright ©2001 Ian H. Giddy Capital Structure 80giddy.org
The Cost of Capital
Choice Cost1. Equity Cost of equity- Retained earnings - depends upon riskiness of the stock- New stock issues - will be affected by level of interest rates- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt- Bank borrowing - depends upon default risk of the firm- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity andCapital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Giddy/SIM Capital Structure /36
Copyright ©2001 Ian H. Giddy Capital Structure 81giddy.org
Estimating Cost of Capital: Siderar
l EquityuCost of Equity = 6.00% + 0.71 (16.03%) = 17.38%uMarket Value of Equity = 3.20* 310.89 = 995 million
(94.37%)
l DebtuCost of debt = 6.00% + 5.25% + 1.25% (default spread)
= 12.5%uMarket Value of Debt = 59 Mil (5.63%)
l Cost of CapitalCost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563))
= 17.38%(.9437) + 8.32%(.0563) = 16.87%
Copyright ©2001 Ian H. Giddy Capital Structure 82giddy.org
Next, Minimize the Cost of Capital by Changing the Financial Mix
l The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm.
l Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt.
l But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.
Giddy/SIM Capital Structure /37
Copyright ©2001 Ian H. Giddy Capital Structure 83giddy.org
This is What We’re Trying to Do
D/(D+E) ke kd After-tax Cost of Debt WACC
0 10.50% 8% 4.80% 10.50%
10% 11% 8.50% 5.10% 10.41%
20% 11.60% 9.00% 5.40% 10.36%
30% 12.30% 9.00% 5.40% 10.23%
40% 13.10% 9.50% 5.70% 10.14%
50% 14% 10.50% 6.30% 10.15%
60% 15% 12% 7.20% 10.32%
70% 16.10% 13.50% 8.10% 10.50%
80% 17.20% 15% 9.00% 10.64%
90% 18.40% 17% 10.20% 11.02%
100% 19.70% 19% 11.40% 11.40%
Copyright ©2001 Ian H. Giddy Capital Structure 84giddy.org
Cost of Capital and Leverage: Method
Estimated BetaWith current leverage
From regression
Unlevered BetaWith no leverage
Bu=Bl/(1+D/E(1-T))
Levered BetaWith different leverage
Bl=Bu(1+D/E(1-T))
Cost of equityWith different leverage
E(R)=Rf+Bl(Rm-Rf)
Equity
Leverage, EBITDAAnd interest cost
Interest CoverageEBITDA/Interest
Rating(other factors too!)
Cost of debtWith different leverage
Rate=Rf+Spread+?
Debt
Giddy/SIM Capital Structure /38
Copyright ©2001 Ian H. Giddy Capital Structure 85giddy.org
Siderar: Optimal Debt Ratio
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
Question: If Siderar’s current debt ratio is 60%, what do you recommend?
Copyright ©2001 Ian H. Giddy Capital Structure 86giddy.org
Siderar: Optimal Debt Ratio
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,001
50% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
0
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Debt Percentage
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ue
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illio
ns)
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apit
al
Giddy/SIM Capital Structure /39
Copyright ©2001 Ian H. Giddy Capital Structure 87giddy.org
A Framework for Getting to the Optimal
Is the actual debt rat io greater than or lesser than the opt imal debt rat io?
Actual > Opt imalOver levered
Actual < Opt imalUnder levered
Is the f i rm under bankruptcy threat? Is the f i rm a takeover target?
Yes No
Reduce Debt qu ick ly1. Equi ty for Debt swap2. Sel l Assets; use cashto pay of f debt3. Renegot ia te wi th lenders
Does the f i rm have good projects?ROE > Cost o f Equi tyROC > Cost o f Capi ta l
Yes
Take good pro jects wi thnew equi ty or wi th retainedearnings.
No
1. Pay of f debt wi th retainedearnings.2. Reduce or e l iminate d iv idends.3 . Issue new equ i ty and pay o f f debt.
Yes No
Does the f i rm have good projects?ROE > Cost o f Equi tyROC > Cost o f Capi ta l
YesTake good pro jects wi thdebt.
No
Do your s tockholders l ikediv idends?
YesPay Div idends No
Buy back stock
Increase leveragequickly1. Debt /Equi ty swaps2 . Bor row money&buy shares.
Copyright ©2001 Ian H. Giddy Capital Structure 92giddy.org
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Ian GiddyNYU Stern School of Business
Tel 212-998-0332
Fax 917-463-7629
ian.giddy@nyu.edu
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