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FINANCE 7311FINANCE 7311

Optimal Capital Structure & Cost of Capital

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OUTLINEOUTLINE

IntroductionCost of Capital - General

– Required return v. cost of capital– Risk– WACC

Capital StructureCosts of Capital

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CAPITAL STRUCTURECAPITAL STRUCTURE

NO TAXESTAXESBANKRUPTCY & OTHER COSTSTRADE-OFF THEORYPECKING ORDER HYPOTHESISOTHER CONSIDERATIONS

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COMPONENT COSTSCOMPONENT COSTS

DEBTPREFERREDEQUITY

– DISCOUNTED DIVIDENDS– CAPM

WACC Again

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Optimal Capital StructureOptimal Capital Structure

Goal: Maximize Value of FirmSee 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

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Investors’ Required v. Cost of Investors’ Required v. Cost of CapitalCapital

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

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FIRM RISK V. SECURITY FIRM RISK V. SECURITY RISKRISK

FIRM RISK => CIRCLE CF’SSECURITY RISK => RECTANGLE

CF’S

ALL EQUITY FIRM: SECURITY RISK = FIRM RISK

Ra = Re = WACCDEBT => EQUITY RISKIER (WHY?)

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Unlevered: Assets = Equity = 100Unlevered: Assets = Equity = 100

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%

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Levered: A = 100: D = E = 50Levered: A = 100: D = E = 50

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%)

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Example:Example:

Cash Flows to Assets same (EBIT)

Cash Flows to Equity Differ

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COST OF CAPITAL, intro.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]

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Cost of Capital, cont.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/EBusiness Financial

Risk Risk

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Business RiskBusiness Risk

Sales/Input Price VariabilityHigh operating leverageTechnologyRegulationManagement depth/breadthCompetition

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FINANCIAL RISKFINANCIAL 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

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Optimal Capital StructureOptimal Capital StructureBenchmark CaseBenchmark Case

No Taxes

No Transaction Costs

Information is symmetric

No other market imperfections

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Optimal Capital StructureOptimal Capital StructureNo TaxesNo 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

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Optimal Capital StructureOptimal Capital StructureNo TaxesNo Taxes

BUT, Debt is Cheaper than Equity, so why doesn’t WACC fall?

WACC relates to the CIRCLE

Simply ‘repackaging’ same CF stream

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Cost of Capital, No TaxesCost of Capital, No Taxes

Re = Ra + (Ra - Rd)*D/E

Miller & Modigliani Prop. II (M&M II)

√ Re increases such that WACC is unchanged

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No Taxes - SummaryNo 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

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TAXESTAXES

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

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TAXESTAXES

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

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TAXES, cont.TAXES, cont.

Now, WACC < Re (all equity) = Ra

==> Logical Conclusion:

==> Use ‘all’ debt

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Why Not Use All Debt?Why Not Use All Debt?

Other Tax ShieldsCOSTS OF FINANCIAL DISTRESSDIRECT BANKRUPTCY COSTS Accountants Attorneys Others

Who Pays?

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Costs of Financial Distress, Costs of Financial Distress, cont.cont.

INDIRECT COSTS: DISRUPTION IN MANAGEMENT Is B/R Management Specialty?

EMPLOYEE COSTS Morale Low Turnover increases

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Indirect Costs, cont.Indirect Costs, cont.

CUSTOMERS Quality concerns (airlines;

insurance)

Service concerns (autos; computers)

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TRADE-OFF THEORYTRADE-OFF THEORYTRADE 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

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Handout #1 - NotesHandout #1 - Notes

EBIT Unchanged - No effect on assetsPayments to B/H & S/H continually

increaseNote that both Rd and Re increaseEPS continually increasesShare Price Maximized at 30% debtWACC Minimized at 30% debt

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Handout #2Handout #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

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Simple Numerical ExampleSimple Numerical Example

Vu = 500; Vl = $670E = 670 - 500 = 170Re = .20 + (.20 - .10)(1 - .34)(500/170)

= 39.41%

WACC = 14.92%100 / 14.92% = $670

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PECKING ORDER HypothesisPECKING 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

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PECKING ORDER HypothesisPECKING 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

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Pecking Order Hypothesis, Pecking Order Hypothesis, cont.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

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Market Reaction to Security Market Reaction to Security Issue AnnouncementsIssue 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 reactionShare repurchase ==> Positive reaction

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Pecking Order SummaryPecking 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

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OTHER FACTORSOTHER FACTORS

CASH FLOW STABILITYASSET STRUCTURE

– TANGIBLE V. INTANGIBLEPROFITABILITYAGENCY PROBLEMS

– OVER & UNDER INVESTMENT PROBLEM

– REMOVES CASH FROM MGMT

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OTHER FACTORS, cont.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

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COST OF CAPITALCOST 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

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COST OF CAPITALCOST 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

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COMPONENT COSTSCOMPONENT COSTSDEBT => 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

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Debt, Bond RatingsDebt, Bond Ratings

STANDARD & POORS

AAA => Highest rating

BBB => adequate capacity to repay P&I

BB => Speculative (below investment grade) Junk

CCC, D (D = default)

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PREFERRED STOCKPREFERRED STOCK

Preferred is like a ‘perpetuity’Pp = D / Rp

==> Rp = D / Pp

Cost of preferred = Dividend Yield

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COMMON STOCKCOMMON STOCK

Three Methods

Capital Asset Pricing Model (CAPM)

Dividend Discount Model

Risk Premium Method

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Capital Asset Pricing ModelCapital Asset Pricing Model

2 TYPES OF RISK:

SYSTEMATIC (Market-wide; GDP) NONSYSTEMATIC (Firm specific)

Diversification => can virtually eliminate nonsystematic risk

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Common Stock, CAPMCommon 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’

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BETABETABeta of Market = 1Portfolio Beta = weighted average of all

betas in the portfolioWhere do we get Beta? Regression analysis Beta of firm if publicly traded Beta from portfolio of ‘similar’ firms Similar need not include financial risk

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Levered/Unlevered BetaLevered/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)]

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Levered/Unlevered BetaLevered/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.

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Cost of Equity: Discount Cost of Equity: Discount DividendsDividends

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)

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Dividend Discount - New equityDividend 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

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Equity Cost: Risk Premium Equity Cost: Risk Premium MethodMethod

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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WACC SUMMARYWACC SUMMARY

WACC = Re*[E/(D+E)] + Rd*(1-t)[D/(D+E)]

Required return depends on firm risk.

Capital budgeting: Assumes project has same risk as firm.