Transcript OPTIMAL CAPITAL STRUCTURE & COST OF CAPITAL
FINANCE 7311
Optimal Capital Structure & Cost of Capital
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OUTLINE
Introduction
Cost of Capital - General
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Required return v. cost of capital
– –
Risk WACC
Capital Structure
Costs of Capital
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CAPITAL STRUCTURE
NO TAXES
TAXES
BANKRUPTCY & OTHER COSTS
TRADE-OFF THEORY
PECKING ORDER HYPOTHESIS
OTHER CONSIDERATIONS
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COMPONENT COSTS
DEBT
PREFERRED
EQUITY
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DISCOUNTED DIVIDENDS
–
CAPM
WACC Again
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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
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Investors’ Required v. Cost of Capital
Investors: R = r + π + RP
–
1st two same for most securities
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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 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?)
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Unlevered: Assets = Equity = 100
GOOD: SALES 100.00
COSTS 70.00
EBIT INT 30.00
0.00
EBT TAX NI ROE 30.00
12.00
18.00
18%
BAD: SALES 82.50
COSTS 80.00
EBIT INT 2.50
0.00
EBT TAX NI ROE 2.50
1.00
1.50
1.5%
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Levered: A = 100: D = E = 50
GOOD: SALES 100.00
COSTS 70.00
EBIT INT 30.00
5.00
EBT TAX NI ROE 25.00
10.00
15.00
30%
BAD: SALES 82.50
COSTS 80.00
EBIT INT 2.50
5.00
EBT TAX NI ROE (2.50) (1.00) (1.50) (3%)
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Example:
Cash Flows to Assets same (EBIT)
Cash Flows to Equity Differ
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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
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BATHTUB EXAMPLE
WACC = Re*[E/(D+E)] + Rd(1-t)[D/D+E]
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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
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Business Risk
Sales/Input Price Variability
High operating leverage
Technology
Regulation
Management depth/breadth
Competition
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FINANCIAL RISK
The additional risk imposed on S/H from the use of debt financing.
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Debt has a prior claim
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S/H must stand in line behind B/H
Higher Risk ==> Higher Required Return
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Optimal Capital Structure Benchmark Case
No Taxes
No Transaction Costs
Information is symmetric
No other market imperfections
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Optimal Capital Structure No 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 Structure No 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 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 - 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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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
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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
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TAXES, cont.
Now, WACC < Re (all equity) = Ra ==> Logical Conclusion: ==> Use ‘all’ debt
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Why Not Use All Debt?
Other Tax Shields
COSTS OF FINANCIAL DISTRESS
DIRECT BANKRUPTCY COSTS Accountants Attorneys Others Who Pays?
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Costs of Financial Distress, cont.
INDIRECT COSTS: DISRUPTION IN MANAGEMENT Is B/R Management Specialty?
EMPLOYEE COSTS Morale Low Turnover increases
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Indirect Costs, cont.
CUSTOMERS Quality concerns (airlines; insurance) Service concerns (autos; computers)
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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
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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
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Handout #2
Vl = Vu (No Taxes) (M&M I)
Vl = Vu + Tc*D (Taxes)
Re = Ru + (Ru - Rd)*D/E*(1 - Tc)
Pictures (M&M II)
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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
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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
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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
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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
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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
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Pecking Order Summary
Firms use INTERNAL FUNDS first
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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 FACTORS
CASH FLOW STABILITY
ASSET STRUCTURE
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TANGIBLE V. INTANGIBLE
PROFITABILITY
AGENCY PROBLEMS
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OVER & UNDER INVESTMENT PROBLEM
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REMOVES CASH FROM MGMT
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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 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 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 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
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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)
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PREFERRED STOCK
Preferred is like a ‘perpetuity’
Pp = D / Rp ==> Rp = D / Pp Cost of preferred = Dividend Yield
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COMMON STOCK
Three Methods
Capital Asset Pricing Model (CAPM)
Dividend Discount Model
Risk Premium Method
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Capital 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, 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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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
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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)]
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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.
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Cost of Equity: Discount Dividends
Recall: P 0 = D 1 / (R - g)
Expected returns = required in equilibrium We can solve above for ‘expected’ return: R = D 1 /P 0 + g The trick is to estimate g (Forecasts; history; SGR)
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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 = D 1 / [P 0 *(1-c)] + g
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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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WACC 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.
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