Transcript Introduction to Financial Management

12-1
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
• Know how to determine:
– A firm’s cost of equity capital
– A firm’s cost of debt
– A firm’s overall cost of capital
• Understand pitfalls of overall cost of
capital and how to manage them
12-2
Cost of Capital Basics
• The cost to a firm for capital funding =
the return to the providers of those funds
– The return earned on assets depends on
the risk of those assets
– A firm’s cost of capital indicates how the
market views the risk of the firm’s assets
– A firm must earn at least the required return
to compensate investors for the financing
they have provided
– The required return is the same as the
appropriate discount rate
12-3
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the
cash flows from the firm
• Two major methods for determining the
cost of equity
- Dividend growth model
- SML or CAPM
12-4
The Dividend Growth Model
Approach
Start with the dividend growth model
formula and rearrange to solve for RE
P0 
RE 
D1
RE  g
D1
P0
 g
12-5
Advantages and Disadvantages of
Dividend Growth Model
• Advantage – easy to understand and use
• Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth
rate
– Does not explicitly consider risk
12-6
Risk and Return
• Risk:
– Uncertanity
– Stand alone risk
– Systematic Reisk
• Return:
– Expected Return, based on expected
outcomes and probabilities
– Required Return, based on the level of risk
11-7
Expected Returns
• Expected returns are based on the
probabilities of possible outcomes
n
E(R ) 
p
i
Ri
i 1
Where:
pi = the probability of state “i” occurring
Ri = the expected return on an asset in state i
11-8
Variance and Standard Deviation
• Variance and standard deviation measure
the volatility of returns
• Variance = Weighted average of squared
deviations
• Standard Deviation = Square root of variance
n
σ 
2
p
i
( R i  E ( R ))
2
i 1
11-9
Portfolios
• Portfolio = collection of assets
• An asset’s risk and return impact how the
stock affects the risk and return of the
portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected
return and standard deviation, just as
with individual assets
11-10
Portfolio Expected Returns
• The expected return of a portfolio is the
weighted average of the expected
returns for each asset in the portfolio
• Weights (wj) = % of portfolio invested in
each asset
n
E (RP ) 
w
j
E (R j )
j 1
11-11
Portfolio Risk
Variance & Standard Deviation
• Portfolio standard deviation is NOT
a weighted average of the standard
deviation of the component
securities’ risk
– If it were, there would be no benefit to
diversification.
11-12
s of n-Stock Portfolio
n
n
s    w i w js is j  ij
2
p
i 1 j 1
n
n
s    w i w js ij
2
p
s ab
 ab 
s as b
i 1 j 1
 Subscripts denote stocks i and j
 i,j = Correlation between stocks i and j
 σi and σj =Standard deviations of stocks i and j
 σij = Covariance of stocks i and j
11-13
Correlation Coefficient
• Correlation Coefficient = ρ (rho)
• Scales covariance to [-1,+1]
– -1 = Perfectly negatively correlated
– 0 = Uncorrelated; not related
– +1 = Perfectly positively correlated
s ab
 ab 
s as b
11-14
Systematic Risk
• Factors that affect a large number of
assets
• “Non-diversifiable risk”
• “Market risk”
• Examples: changes in GDP, inflation,
interest rates, etc.
11-15
Unsystematic Risk
• = Diversifiable risk
• Risk factors that affect a limited number of
assets
• Risk that can be eliminated by combining
assets into portfolios
• “Unique risk”
• “Asset-specific risk”
• Examples: labor strikes, part shortages,
etc.
11-16
The Principle of Diversification
• Diversification can substantially reduce
risk without an equivalent reduction in
expected returns
– Reduces the variability of returns
– Caused by the offset of worse-thanexpected returns from one asset by betterthan-expected returns from another
• Minimum level of risk that cannot be
diversified away = systematic portion
11-17
Total Risk = Stand-alone Risk
Total risk = Systematic risk + Unsystematic risk
– The standard deviation of returns is a measure
of total risk
• For well-diversified portfolios, unsystematic
risk is very small
Total risk for a diversified portfolio is
essentially equivalent to the systematic risk
11-18
Systematic Risk Principle
• There is a reward for bearing risk
• There is no reward for bearing risk
unnecessarily
• The expected return (market required
return) on an asset depends only on that
asset’s systematic or market risk.
11-19
Market Risk for Individual Securities
• The contribution of a security to the
overall riskiness of a portfolio
• Relevant for stocks held in well-diversified
portfolios
• Measured by a stock’s beta coefficient
• Measures the stock’s volatility relative to
the market
11-20
The Beta Coefficient
i = (i,M si) / sM
= siM / sM2
Where:
ρi,M = Correlation coefficient of this asset’s returns with
the market
σi = Standard deviation of the asset’s returns
σM = Standard deviation of the market’s returns
σM2 = Variance of the market’s returns
σiM = Covariance of the asset’s returns and the market
11-21
Interpretation of beta
If  = 1.0, stock has average risk
If  > 1.0, stock is riskier than average
If  < 1.0, stock is less risky than average
Most stocks have betas in the range of 0.5
to 1.5
• Beta of the market = 1.0
• Beta of a T-Bill = 0
•
•
•
•
11-22
Beta and the Risk Premium
• Risk premium = E(R ) – Rf
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between
the risk premium and beta so that we can
estimate the expected return?
– YES!
11-23
SML and Equilibrium
Figure 11.4
11-24
Reward-to-Risk Ratio
• Reward-to-Risk Ratio:
E ( Ri )  R f
i
• = Slope of line on graph
• In equilibrium, ratio should be the same for all
assets
• When E(R) is plotted against β for all assets, the
result should be a straight line
11-25
Market Equilibrium
• In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio
• Each ratio must equal the reward-to-risk
ratio for the market
E(RA )  Rf
A

E(RM  Rf )
M
11-26
Security Market Line
• The security market line (SML) is the
representation of market equilibrium
• The slope of the SML = reward-to-risk
ratio:
(E(RM) – Rf) / M
• Slope = E(RM) – Rf = market risk premium
– Since  of the market is always 1.0
11-27
The SML and Required Return
• The Security Market Line (SML) is part of
the Capital Asset Pricing Model (CAPM)
E ( Ri )  Rf  E ( RM )  Rf  i
E ( Ri )  Rf  RPM  i
Rf = Risk-free rate (T-Bill or T-Bond)
RM = Market return ≈ S&P 500
RPM = Market risk premium = E(RM) – Rf
E(Ri) = “Required Return”
11-28
Capital Asset Pricing Model
• The capital asset pricing model (CAPM)
defines the relationship between risk and
return
E(RA) = Rf + (E(RM) – Rf)βA
• If an asset’s systematic risk () is known,
CAPM can be used to determine its
expected return
11-29
Factors Affecting Required Return
E( Ri )  Rf  E( RM )  Rf  i
• Rf measures the pure time value of
money
• RPM = (E(RM)-Rf) measures the
reward for bearing systematic risk
• i measures the amount of systematic
risk
11-30
Portfolio Beta
βp = Weighted average of the Betas of the
assets in the portfolio
Weights (wi) = % of portfolio invested in
asset i
n
 p  wi i
i 1
11-31
The SML Approach
• Use the following information to compute
the cost of equity
– Risk-free rate, Rf
– Market risk premium, E(RM) – Rf
– Systematic risk of asset, 
RE  Rf   E (E(RM )  Rf )
12-32
Advantages and Disadvantages
of SML
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as beta is
available
• Disadvantages
– Must estimate the expected market risk premium,
which does vary over time
– Must estimate beta, which also varies over time
– Relies on the past to predict the future, which is not
always reliable
12-33
Example: Cost of Equity
• Data:
– Beta = 1.5
– Market risk premium = 9%
– Current risk-free rate = 6%.
– Analysts’ estimates of growth = 6% per year
– Last dividend = $2.
– Currently stock price =$15.65
– Using SML: RE = 6% + 1.5(9%) = 19.5%
– Using DGM: RE = [2(1.06) / 15.65] + .06
= 19.55%
12-34
Cost of Debt
• The cost of debt = the required return on
a company’s debt
• Method 1 = Compute the yield to
maturity on existing debt
• Method 2 = Use estimates of current
rates based on the bond rating
expected on new debt
• The cost of debt is NOT the coupon rate
12-35
Component Cost of Debt
• Use the YTM on the firm’s debt
• Interest is tax deductible, so the after-tax
(AT) cost of debt is:
R D , AT  R D , BT ( 1  T C )
• If the corporate tax rate = 40%:
R D , AT  8 . 9 %( 1  . 40 )  5 . 34 %
12-36
Weighted Average Cost of Capital
• Use the individual costs of capital to
compute a weighted “average” cost of
capital for the firm
• This “average” = the required return on
the firm’s assets, based on the
market’s perception of the risk of
those assets
• The weights are determined by how
much of each type of financing is
used
12-37
Determining the Weights for the
WACC
• Weights = percentages of the firm
that will be financed by each
component
• Always use the target weights, if
possible
– If not available, use market values
12-38
Capital Structure Weights
• Notation
E = market value of equity
= # outstanding shares times price per share
D = market value of debt
= # outstanding bonds times bond price
V = market value of the firm = D + E
• Weights
E/V = percent financed with equity
D/V = percent financed with debt
12-39
WACC
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)
Where:
(E/V) = % of common equity in capital structure
Weights
(P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure
Component
costs
RE = firm’s cost of equity
RP = firm’s cost of preferred stock
RD = firm’s cost of debt
TC = firm’s corporate tax rate
12-40
Estimating Weights
Component Values:
• VE = $50 x (3 m) = $150m
Stock price = $50
3m shares common stock • VP = $25m
• VD = $75m
$25m preferred stock
• VF = $150+$25+$75=$250m
$75m debt
Given:
•
•
•
•
• 40% Tax rate
Weights:
E/V = $150/$250
P/V = $25/$250
D/V = $75/$250
= 0.6 (60%)
= 0.1 (10%)
= 0.3 (30%)
12-41
WACC
Component
Debt (before tax)
Preferred Stock
Common equity
W
0.30
0.10
0.60
R
10%
9%
14%
WACC = E/V x RE + P/V x RP + D/V x RD (1- TC)
WACC = 0.6(14%)+0.1(9%) +0.3(10%)(1-.40)
WACC = 8.4% + 0.9% + 1.8% = 11.1%
12-42
Table 12.1
12-43
Factors that Influence a
Company’s WACC
• Market conditions, especially interest
rates, tax rates and the market risk
premium
• The firm’s capital structure and dividend
policy
• The firm’s investment policy
– Firms with riskier projects generally have a
higher WACC
12-44
Risk-Adjusted WACC
• A firm’s WACC reflects the risk of an
average project undertaken by the firm
– “Average”  risk = the firm’s current operations
• Different divisions/projects may have
different risks
– The division’s or project’s WACC should be
adjusted to reflect the appropriate risk and
capital structure
12-45
Subjective Approach
• Consider the project’s risk relative
to the firm overall
– If the project is riskier than the firm,
use a discount rate greater than the
WACC
– If the project is less risky than the firm,
use a discount rate less than the
WACC
12-46
Key Concepts and Skills (Session 8)
• Understand:
– The effect of financial leverage on cash
flows and cost of equity
– The impact of taxes and bankruptcy on
capital structure choice
– The basic components of the
bankruptcy process
13-47
Capital Structure
• Capital structure = percent of debt and
equity used to fund the firm’s assets
– “Leverage” = use of debt in capital structure
• Capital restructuring = changing the
amount of leverage without changing the
firm’s assets
– Increase leverage by issuing debt and
repurchasing outstanding shares
– Decrease leverage by issuing new shares
and retiring outstanding debt
13-48
Capital Structure & Shareholder Wealth
• The primary goal of financial managers:
– Maximize stockholder wealth
• Maximizing shareholder wealth =
– Maximizing firm value
– Minimizing WACC
• Objective: Choose the capital structure
that will minimize WACC and maximize
stockholder wealth
13-49
The Effect of Financial Leverage
• “Financial leverage” = the use of debt
• Leverage amplifies the variation in both
EPS and ROE
• We will ignore the effect of taxes at this
stage
• What happens to EPS and ROE when we
issue debt and buy back shares of stock?
13-50
Trans Am Corporation Example
Table 13.1
Assets
Debt
Equity
Debt/Equity Ratio
Share Price
Shares Outstanding
Interest rate
Current
$8,000,000
$0
$8,000,000
0.0
$20
400,000
10%
Proposed
$8,000,000
$4,000,000
$4,000,000
1.0
$20
200,000
10%
13-51
Trans Am Corp
With and Without Debt
Table 13.2
EBIT
Interest
Net Income
ROE
EPS
Current Capital Structure: No Debt
Recession
Expected
Expansion
$500,000
$1,000,000
$1,500,000
0
0
0
$500,000
$1,000,000
$1,500,000
6.25%
12.50%
18.75%
$1.25
$2.50
$3.75
Proposed Capital Structure: Debt = $4 million
Recession
Expected
Expansion
EBIT
$500,000
$1,000,000
$1,500,000
Interest
400,000
400,000
400,000
Net Income
$100,000
$600,000
$1,100,000
ROE
2.50%
15.00%
27.50%
EPS
$0.50
$3.00
$5.50
13-52
Leverage Effects
Variability in ROE
– Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS
– Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS
increases when financial leverage is
increased
13-53
Trans Am Corp Conclusions
1. The effect of leverage depends on EBIT
When EBIT is higher, leverage is beneficial
2. Under the “Expected” scenario, leverage
increases ROE and EPS
3. Shareholders are exposed to more risk
with more leverage
ROE and EPS more sensitive to changes in
EBIT
13-54
Capital Structure Theory
• Modigliani and Miller
– M&M Proposition I – The Pie Model
– M&M Proposition II – WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
firm’s assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows
13-55
Capital Structure Theory
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
13-56
Case I – Propositions I and II
• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not change;
therefore, value doesn’t change
• Proposition II
– The WACC of the firm is NOT affected by
capital structure
13-57
Case I - Equations
• WACC = RA = (E/V) x RE + (D/V) x RD
• RE = RA + (RA – RD) x (D/E)
RA = the “cost” of the firm’s business risk
(i.e., the risk of the firm’s assets)
(RA – RD)(D/E) = the “cost” of the firm’s
financial risk (i.e., the additional return
required by stockholders to
compensate for the risk of leverage)
13-58
M&M Propositions I & II
Figure 13.3
The change in the capital structure weights (E/V and D/V) is exactly
offset by the change in the cost of equity (RE), so the WACC stays
the same.
13-59
Business and Financial Risk
RE = RA + (RA – RD) x (D/E)
Business Risk
Financial Risk
• Proposition II: the systematic risk of the
stock depends on:
– Systematic risk of the assets, RA, (business
risk)
– Level of leverage, D/E, (financial risk)
13-60
Case II – Corporate Taxes
• Interest on debt is tax deductible
• When a firm adds debt, it reduces taxes,
all else equal
• The reduction in taxes increases the
cash flow of the firm
• The reduction in taxes reduces net
income
13-61
Case II - Example
EBIT
Interest
Taxable Income
Taxes (30%)
Net Income
CFFA
Unlevered
U
1,000
0
1,000
300
700
700
Levered
L
1,000
80
920
276
644
724
Interest Tax Shield = $24 per year
13-62
Interest Tax Shield
• Annual interest tax shield
 Tax rate times interest payment
 $1,000 in 8% debt = $80 in interest expense
 Annual tax shield = .30($80) = $24
• Present value of annual interest tax
shield
 Assume perpetual debt
 PV = $24 / .08 = $300
 PV = D(RD)(TC) / RD = D*TC = $1,000(.30) =
$300
13-63
M&M Proposition I with Taxes
Figure 13.4
13-64
Case II – Graph of Proposition II
13-65
M&M Summary
Table 13.4
13-66
Bankruptcy Costs
• Direct costs
– Legal and administrative costs
• Enron = $1 billion; WorldCom = $600 million
– Bondholders incur additional losses
– Disincentive to debt financing
• Financial distress
– Significant problems meeting debt obligations
– Most firms that experience financial distress
do not ultimately file for bankruptcy
13-67
Indirect Bankruptcy Costs
• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to
measure and estimate
– Stockholders wish to avoid a formal bankruptcy
– Bondholders want to keep existing assets
intact so they can at least receive that money
– Assets lose value as management spends time
worrying about avoiding bankruptcy instead of
running the business
– Lost sales, interrupted operations, and loss of
valuable employees, low morale, inability to
purchase goods on credit
13-68
Case III
With Bankruptcy Costs
•  D/E ratio → probability of bankruptcy
•  probability → expected bankruptcy costs
• At some point, the additional value of the
interest tax shield will be offset by the
expected bankruptcy costs
• At this point, the value of the firm will start to
decrease and the WACC will start to increase
as more debt is added
13-69
Optimal Capital Structure
Figure 13.5
13-70
Conclusions
• Case I – no taxes or bankruptcy costs
– No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
– Optimal capital structure = 100% debt
– Each additional dollar of debt increases the cash
flow of the firm
• Case III – corporate taxes and bankruptcy costs
– Optimal capital structure is part debt and part
equity
– Occurs where the benefit from an additional dollar
of debt is just offset by the increase in expected
bankruptcy costs
13-71
The Capital Structure Question
Figure 13.6
13-72
Additional Managerial
Recommendations
• Taxes
– The tax benefit is only important if the firm has
a large tax liability
– Higher tax rate → greater incentive to use debt
• Risk of financial distress
– The greater the risk of financial distress, the
less debt will be optimal for the firm
– The cost of financial distress varies across
firms and industries
13-73
Observed Capital Structures
• Capital structure differs by industries
• Differences according to Cost of Capital
2008 Yearbook by Ibbotson Associates,
Inc.
– Lowest levels of debt
• Computers
• Drugs
= 5.31%
= 6.76% debt
– Highest levels of debt
• Cable television
• Airlines
= 61.84%
= 56.30% debt
13-74
Financial Distress Defined
• Business failure – business terminated
with a loss to creditors
• Legal bankruptcy – petition filed in federal
court for bankruptcy
• Technical insolvency – firm unable to
meet debt obligations
• Accounting insolvency – book value of
equity is negative
13-75
Financial Management &
Bankruptcy
• The right to file bankruptcy has strategic value
–
–
–
–
Immediate “stay” on creditors
Ability to terminate labor agreements
Ability to lay off large numbers of workers
Ability to reduce wages
• “Workouts” and “Cram-downs”
– Pre-packaged filings
– Negotiated filings and extensions
– Court-ordered plan acceptance
13-76