Financing Decisions and The Cost of Capital

Where do Firms Get Their Money?

Self Financing (using internal cash flow)– Accounts for 80% (avg.) of financing– Difficult for start-up companies

External Financing– Borrowing from banks or issuing bonds– Sharing the business with investors by

issuing stock

The Long-Term Financial Deficit (in 1999)

Sources of Cash Flow (100%)

Internal cash flow (retained earnings plus depreciation)

70%

Long-term debt and

equity 30%

Uses of Cash Flow (100%)

Capital spending

80%

Net working

capital plus other uses

20%

Internal cash flow

External cash flow

Financial deficit

Where Do Small Businesses Get Money?

0 10 20 30 40 50 60

Owner

Financial Companies

Banks

Family

Other Businesses

Fraction of Funds Raised (%)

Source: 1987 SBA survey of firms with less than $500,000 in assets.

What Happens As Firms Get Larger?

Firm Size

InformationVery small, no track record Small with growth potential Medium-sized Large with Track record

Inside seed money

Short-term commercial loans

Intermediate-term commercial loans

Commercial paper

Medium-term Notes

Bonds

Public EquityVenture Capital

Mezzanine Finance Private Placements

Self

Short Debt

Inter-mediate

DebtLong-Term

Debt

Outside Equity

Source: FRB Report on Private Placements, Rea et. al., 1993

What is the Difference Between Debt and Equity?

Fixed Promised payments

Senior to equity Interest is

deductible Only get control

rights in default

Uncertain residual cash flows

Subordinated Dividends are not

deductible Comes with

control rights (can vote)

Debt Equity

Recent Trends in Financing This important question is difficult to answer

definitively. Book or Market values?

– In general, financial economists prefer market values. Debt levels have fallen recently.

– However, many corporate treasurers find book values more appealing due to the volatility of market values. These have slightly risen recently.

Whether we use book or market values, debt ratios for U.S. non-financial firms have remained below 60 percent of total financing.

Capital Structure:How should a firm structure the liability

side of the balance sheet? Debt vs. Equity We have seen how to do capital budgeting

when the firm has debt in its capital structure.

However, we have not figured out how much debt the firm should have.– Can the firm create value for shareholders

through its financing decisions? In particular, should the firm load up with

‘low cost’ debt?

One possible answer:It makes no difference.

Assume PCM, importantly, there are no taxes, and that the firm’s investment policy is unaffected by how it finances its operations.

Both Modigliani and Miller won the Nobel Prize for showing:

The value of a firm with debt is in this case equal to the value of the same firm without debt. MM Proposition I.

The important idea is that since the assets are the same regardless of how they are financed so are the expected cash flows and so are the asset risks (asset betas) of a “levered” and “unlevered” firm.

Irrelevance Proposition II

What this means is that the expected return on equity rises with leverage according to: (B/S = leverage ratio -- market value of debt over market value of equity, r denotes expected return).

)( DebtAssetsAssetsEquity rrS

Brr

WACC under Irrelevance

Cost of B/S M = B/(B+S) Equity WACC

0.00 0.00 9.00 9.000.50 0.33 10.50 9.001.00 0.50 12.00 9.001.50 0.60 13.50 9.002.00 0.67 15.00 9.003.00 0.75 18.00 9.00

Let the expected return on the underlying assets be 9% and the cost of debt be 6%.

MM Proposition II with No Corporate Taxes: Another View

Debt-to-equity Ratio

Cos

t of

capi

tal:

r (%

)

r0

rB

SBWACC rSB

Sr

SB

Br

)( 00 BL

S rrS

Brr

rB

S

B

What About The Tax Deductibility of Interest?

Interest is tax deductible (dividends are not). A valuable “debt tax shield” is created by substituting

payments of interest for payments of dividends, i.e. debt financing for equity financing.

Modigliani and Miller also showed that if the only change in their analysis is an acknowledgement of the US corporate tax structure, then:

The value of a levered firm is: VL = VU + TcB– the value of an equivalent unlevered firm PLUS– the value of the tax shields from debt.

Firm Value always rises with additional borrowing!

Proposition II with Taxes

When we take the tax deductibility of interest payments into account the equations we presented must change:

and

)1( cBSWACC TrBS

Br

BS

Sr

))(1( BAcAS rrTS

Brr

Proposition II

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr

SL

LCB

LWACC r

SB

STr

SB

Br

)1(

Limits to The Use of Debt

Given the treatment the U. S. corporate tax code gives to interest payments versus dividend payments, firms have a big incentive to use debt financing.

Under the MM assumptions with corporate taxes the argument goes to extremes and the message becomes: firms should use 100% debt financing.

What other costs are associated with the use of debt? – Bankruptcy costs and/or financial distress

costs!

Bankruptcy Costs Direct costs:

– Legal fees– Accounting fees– Costs associated with a trial (expert witnesses)

Indirect costs:– Reduced effectiveness in the market.– Lower value of service contracts, warranties.

Decreased willingness of suppliers to provide trade credit.

– Loss of value of intangible assets--e.g., patents.

Agency costs of debt When bankruptcy is possible incentives may be affected.

Example (Risk Shifting):

– Big Trouble Corp. (BTC) owes its creditors $5 million, due in six months.

– BTC has liquidated its assets because it could not operate profitably. Its remaining asset is $1 million cash.

– Big Bill, the lone shareholder and general manager is considering two possible investments.

(1) Buy six month T-bills to earn 3% interest. (2) Go to Vegas and wager the entire $1 million on a single

spin of the roulette wheel.– Why might Bill consider the second “investment”?– Would he have considered it in the absence of leverage?

Under-investment Problem

Example:– Slight Trouble Corp. (STC) has a small but significant

chance of bankruptcy in the next few years. Its debt is trading far below par.

– Managers are evaluating an investment project that will cost $1 million to undertake. The alternative is to pay $1 million out as dividends.

– While the NPV of the project is positive it may be that the shareholders are better off with the dividend than if the project is taken.

– The reason is that while shareholders pay all the costs of the project, they will have to share the value with bondholders, the added value will raise bond prices as well as stock prices.

Disciplinary Power of Debt “On the other hand” as economists are fond of

saying, debt can be a disciplinary device.– It has long been realized that an owner works harder

and makes better decisions than does an employee.– This was an often cited justification for the LBO wave

of the mid 80’s and early 90’s. Idea is that one of the most contentious issues

between managers and shareholders is the payout of excess cash.– Debt allows manager to commit to the payout in a

way that cannot be accomplished with a dividend policy.

A Theory of Capital Structure

The value of a levered firm can be thought of as: the value of an equivalent but unlevered

firm + present value of tax shields (net)

– present value of expected bankruptcy costs and agency costs.

The Value of the Firm with Costs of Financial Distress

Present value of financial distress costs

Value of firm (V)

VL = VU +TC B = Value of firm under

MM with corporate

Maximum taxes and debt

firm value

V= Actual value of firm

VU= Value of firm with no debt

Debt (B) B *

Optimal amount of debtThe tax shield increases the value of the levered firm. Financial distresscosts lower the value of the levered firm. The two offsetting factors producean optimal amount of debt.

Present value of tax shield on debt

Financing Decisions

Pecking Order Theory says that there is no optimal capital structure, just the culmination of all your financing decisions.– Internally generated funds.– External Debt.– External Equity as a last resort.

Data shows that preferences such as these are there but a subject of debate is whether they are necessarily inconsistent with there being an optimal capital structure.

Choosing an Amount of Debt

The theory provides no clear formula (unlike NPV) but the tradeoffs are clear; the benefits versus the costs of debt.

Use more debt if:– effective tax rates (without debt) are higher,– operating cash flows are more predictable,– agency costs can be controlled by contracts.

A safe strategy might be to emulate the industry average. After all these are the firms who have survived. From there you make alterations as your own situation dictates.

Example Ralph’s firm has been in the food processing

business for the last 10 years. It has maintained a conservative capital structure financing 60% of its value with equity.

Ralph has recently considered investing in the IPO of a start-up company that will develop and manufacture internet infrastructure. In discussions with the start-up’s manager, Ralph’s nephew, it is revealed that the start-up will use either no or 20% debt financing. You have been called in to help identify an appropriate cost of capital for evaluating this investment.

Ralph’s Dilemma

Currently Ralph’s equity beta is estimated at 0.95. There is no beta we can estimate for this private company (the start-up) but we know that Cisco has an equity beta of 1.92.

The risk free rate is 6% and the market risk premium is 7%. The tax rate for all corporations is 35%.

How can we approach determining the appropriate discount rate?

Ralph’s Dilemma cont…

Start with the following:

We can reasonably assume that the asset beta for Cisco will be a close estimate for the asset beta for the start-up.

We know that the equity beta for Cisco is 1.92. What is Cisco’s asset beta?

Equityc

Assets BTS

S

)1(

Ralph’s Dilemma cont…

Now we know that the asset beta for the start-up can be estimated at 1.92. What is the equity beta?

We have two scenarios to consider, a debt to value ratio of either 0% or 20%.

If it is zero, the equity beta equals the asset beta or 1.92.

If it is 20%, we need to use:23.2

8.

)35.1(2.192.1

)1(1

S

TB CAssetsEquity

Ralph’s Dilemma cont…

Now we need a weighted average cost of capital.

For the case of no debt rE = rA = rWACC:– rE = 6% + 1.92(7%) = 19.44%.

With 20% debt:– rE = 6% + 2.23(7%) = 21.61.– rD = 6% (since we assumed the debt was riskless).– rWACC = 21.61%(.8) + 6%(1-.35)(.2) = 18.07%.– Why was I sure that I did something wrong when I

calculated the rWACC as 22.50% on my first try?

Example: BK Industries

($ Millions) Year 0 2000

Year 1 2001

Year 2 2002

Year 3 2003

Year 4 2004

Year 5 2005

(A) Cash Flow From Investment

-26.0 0.0 -0.632 -0.865 0.375 19.298

(B) Cash Flow From Operations

0.0 3.98 6.051 7.550 5.615 3.167

Project Cash Flow [(A) + (B)]

-26.00 3.98 5.42 6.69 5.99 22.46

If you recall, BK was evaluating a project in a very different industry from its own with the following incremental cash flows (FCF). At 10% we found an NPV of $5.2 million.

Example: BK Industries Revisited

BK Industries is a conglomerate company with operations in marine power, pleasure boating, defense, and fishing tackle. BK’s equity beta is 1.0. BK has and will maintain a debt/equity ratio of 1.0.– Can we use the company cost of capital

to value the text editing project? Latec Inc. is a firm that makes only text

editing systems. Latec’s equity beta is 1.35. Latec has a debt to equity ratio of 0.75, and a marginal tax rate of 45%.

Delevered Betas with debt/equity ratios

The formulas for obtaining asset betas from equity betas and vice versa provided earlier required dollars values for debt (B) and equity (S). What if you are only given the leverage ratio, L = B/S? The formulas are restated as:

EquityC

Assets TL

)1(1

1

))1(1( CAssetsEquity TL

Unlever Latec’s Beta to obtain the Beta of Text-Editing Assets:

Latec has L =0.75, TC = .45, and an equity beta of 1.35.

955.035.1)45.01(75.01

1

Assets

Relever the asset Beta to reflect BK’s capital structure:

48.1)45.1(11955.0 Equity

Recalling that BK will keep its debt/equity ratio equal to one, we can get:

•This is the beta for a BK equity position in a text editing asset.•Why is this equity beta greater than Latec’s?

BK Industries, Cont. Assume that the risk free rate is 8% and

that BK’s cost of debt is also 8%. The market risk premium is 7%. Then the required return on BK’s equity is:

The weighted average cost of capital for the text editing venture (using the fact that B/S = 1) is:

%38.11)45.01%(8B+S

B%36.18

B+S

S=

)1(

CBS TrBS

Br

BS

SWACC

%36.18%7*48.1%8)][( FMFequity RRERr

Finally, we can evaluate the NPV of the text editing venture using the WACC that reflects the risk associated with this particular business. Using the cash flow estimates obtained earlier:

Million

NPV

78.3$

)1138.1(

465.22

)1138.1(

990.5

)1138.1(

685.6

)1138.1(

419.5

)1138.1(

980.30.26

5432

• The NPV is positive, so proceed with the text editing business.

• Note also that the market value of the project will be $28.78 M.

• Notice that the selected discount rate of 11.38% reflects: The risk (beta) of text editing businesses, not BK’s existing The risk (beta) of text editing businesses, not BK’s existing

businesses.businesses. BK’s capital structure, BK’s capital structure, notnot that of the comparable firm. that of the comparable firm.

Questions BK Industries’ debt to equity ratio is 1.0

as it is for the project. BK’s equity beta prior to starting the text editing business was 1.0 (levered beta).– What will happen to the beta of BK Industries after

starting the text editing business?– Suppose that BK uses its firm cost of capital to

evaluate the text business? Would this favor the investment?

– Does BK diversifying into the text editor business help shareholders by providing them a more diversified portfolio?

An Alternative Approach

The Adjusted Present Value (APV):– Follows from the MM equation

VL = VU + TCB.– Take the value of the project, if it were

unlevered, then add the debt tax shields (more completely the additional effects of debt).

– Let’s just do the exercise. We have cash flows for the unlevered firm but remember that the formulas are derived using a perpetuity (a simplification).

– If BK’s project generates $3.39124 million each year forever its NPV is the same using the WACC.

An Alternative Approach The unlevered NPV is now, using the perpetual

equivalent cash flow derived as follows:– rA = 8% + .955(7%) = 14.69%– NPVU = $3.39124/.1469 – $26 = - $2.9 m– APV = NPVU + TCB = -$2.9 + .45($14.9m)

= +$3.79 m. This approach is most useful when you know

the dollar amount of debt that will be used each year rather than the debt ratio over the life of the project (perhaps an LBO or other highly levered transactions).