Capital Structure and Cost of Capital

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• Part 9
• Capital Structure and Cost of Capital
• Topics Covered
• Sources of Financing Capital Structure
• Impact of Leverage
• The Costs of Equity, Debt and Preferred Stock
• The After-tax Weighted Average Cost of Capital
• Capital Structure, Agency Costs, and Project
  Selection

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9.1 Sources of Financing Capital Structure

• Companies can finance its operations and
  expansions by
• Issuing stocks (including preferred stocks)
• Issuing bonds
• Borrowing from banks
• Using retained earnings (internal equity)
• The mix of sources of funds used by a firm is
  called its capital structure.

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9.2 Business Risk vs. Financial Risk

• Capital structure can change shareholders risk
  exposure
• All companies are subjected to business risk.
• The term financial leverage refers to the use of
  debt finance to increase the expected rate of
  return to shareholders.
• Financial leverage exposes shareholders to
  financial risk.

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9.3 Impact of Leverage

• Financial leverage is measured by debt ratio (the
  ratio of debt to debt plus equity).
• Leverage also increases the variability of
  returns to shareholders.
• Leverage therefore increases the beta of the
  firms equity.

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9.4 Unlevered Firm

• An unlevered firm with 1000 shares outstanding at
  a price of 10 per share and a market value of
  10000.
• With equal probabilities across states, expected
  return is 1.50/10 .15. Risk is that the return
  will be .10, .15, or .20.
• Suppose now the firm borrows 5000 at .12 to buy
  back 500 shares at 10 a share.

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9.5 Levered Firm

• The firm is 50 percent debt financed. Equity is
  valued at 5000 and stock price is 10 per share.
• Expected return of equity is 1.8/10 .18. Risk
  is that the return will now be .08, .18, or .28.
  

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9.6 Weighted Average Cost of Capital (WACC) No
Taxes

• re is the cost of equity rd is the cost of
  debt ra is the weighted-average cost of capital
  to the firm.

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9.7 Modigniani and Miller (MM)

• MM Proposition on the cost of capital The cost
  of capital for a company is independent of its
  capital structure.
• You will learn the reasoning of MM in Corporate
  Finance subject.
• Under competitive and perfect market conditions
  and with no taxes, the cost of capital is
  determined by the firms business risk alone.
• Implication of MM proposition is The required
  return of a firms equity (i.e., cost of equity)
  is increasing in the firms debt-equity ratio
  (expressed in market values).

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9.8 Illustration of MM Proposition

• With risk-free debt.

r
Equity
Firm
Debt
D/E
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9.9 Illustration of MM (concluded)

• With risky debt, the required returns of debt and
  equity are not linear, but they are still upward
  slopping.

r
Equity
Firm
Debt
D/E
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9.10 Leverage Effects on Beta

• Leverage will not change the firms beta on
  assets (business risk). But leverage will
  increase the firms beta on equity (financial
  risk). This is a straight forward application of
  the formula for a portfolios beta.

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9.11 In-Class Exercise 1

• The market value of the firms common stock is
  16 million, and the market value of its
  (risk-free) debt is 4 million. The beta of the
  companys common stock is 1.5, and the expected
  risk premium on the market is 8.
• If the Treasury bill rate is 5, what is the
  companys cost of capital? Ignoring the tax
  effect.

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9.12 In class exercise 2

• The Vulcan Forge Company is financed entirely by
  common stock, which has a beta of 0.7, a required
  rate of return at 10, and a total market value
  of 80 million.
• Suppose the firm repurchases 30 million of stock
  and replaces it with risk-free debt. The
  risk-free rate is 5.
• What is the required rate of return and the beta
  of the stock after the refinancing?

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9.13 Classical Tax System and the After-tax WACC

• Under the classical tax system, the dividend
  income is taxed twice at both the corporate
  level and the personal income level. This is
  called Double Taxation.
• Because interest payments are tax deductible, the
  tax shield (corporate tax rate x expected
  interest payment) is higher when the firm takes
  on debt, therefore reduces the cost of debt.
• The after-tax WACC

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9.14 Australian Imputation Tax System

• In Australia, shareholders receive a credit for
  the full amount of corporate tax that has been
  paid on their behalf. This is known as an
  imputation tax system.
• However, foreign investors have difficulty to use
  the tax credits
• Intention of the imputation system to avoid
  double taxation of dividends which is inherent in
  the classical system.

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9.15 Elimination of Debt Advantage

• Suppose a firm earns pretax profits of 100 per
  share. Assume the corporate tax rate is 30, then
  the after-tax profit is 70/share.
• If the company does not retain any earnings, then
  it sends shareholders a check for 70 and a tax
  credit of 30. If at the end of the financial
  year, the shareholders tax rate is 30, then he
  does not have to pay any more taxes on the
  dividend income.
• For those on the 48.5 marginal tax rate, they
  still have to pay the gap in income tax.

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9.16 Imputation Tax System and the Cost of Debt

• If the firm reduces dividends paid to
  shareholders by 1 and increases interest
  payments by 1, then the firm pays 0.30 less in
  corporate taxes. But it also reduces the tax
  credit taken by the Australian resident
  shareholders by 0.30.
• The imputation tax system eliminates the tax
  benefit of debt, since the overall tax burden is
  the same for both debt and equity.
• Oversea investors are not covered by the
  imputation tax system. Therefore, they may still
  enjoy the tax benefit of debt financing.

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9.17 Cost of Capital under Imputation tax

• We typically use the after-tax WACC in Australia
• Some research suggested that l 0.6, reflecting
  the Australian imputation tax system.

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9.18 Estimating Cost of Equity The Dividend
Growth Model Approach

• Estimating the cost of equity the dividend
  growth model approach (Gordons formula)
• According to the constant growth model,
• RE D1 / P0 g
• That is the cost of equity is equal to the
  dividend yield plus the dividend growth rate.

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9.19 Estimating the Cost of Equity The SML
Approach

• According to the CAPM RE Rf E ? (RM -
  Rf)
• 1. Get the risk-free rate (Rf ) from financial
  pressmany use the Treasury bill rate, say 5.
• 2. Get estimates of market risk premium and
  security beta.
• a. Historical risk premium RM - Rf
  7b. Beta historical
• 3. Suppose the beta is 1.40, then, using the
  approach
• RE Rf E ? (RM - Rf) 5 1.40 ?
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• 14.8

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9.20 The Cost of Debt

• 1. The cost of debt, RD, is the interest rate
  on new borrowing.
• 2. The cost of debt is observable Yield on
  currently outstanding debt and/or yields on
  newly-issued similarly-rated bonds.
• 3. The historic debt cost is irrelevant -- why?
• Example We sold a 20-year, 12 bond 10 years
  ago at par. It is currently priced at 86. What is
  our cost of debt? The yield to maturity is 14.8,
  so this is what we use as the cost of debt, not
  12.

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9.21 Costs of Preferred Stock (Preference
Shares)

• 1. Preferred stock has a fixed dividend paid
  every period forever, thus it is a perpetuity.
  The cost is RP D/P0.
• Most of the preferred issues are cumulative
  the firm must pay all past preferred dividends
  before common stock holders get a cent. If the
  company misses a preferred dividend, the
  preferred shareholders get some voting rights.
• 2. Notice that cost is simply the dividend
  yield.
• Example We sold an 0.8 annual dividend
  preferred issue 10 years ago. It sells for
  12/share today.
• The dividend yield today is .80/12 6.67,
  so this is what we use as the cost of preferred
  stock.

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9.22 Example EM Chemicals WACC

• EM Chemical has 78.26 million shares of common
  stock outstanding. The book value per share is
  22.40 but the stock sells for 58. The market
  value of equity is 4.54 billion. EMs stock beta
  is .90. T-bills yield 4.5, and the market risk
  premium is 9.2.
• The firm has four debt issues outstanding.
• Coupon Book Value Market Value Yield-to-Maturity
• 6.375 499m 501m 6.32
• 7.250 495m 463m 7.83
• 7.635 200m 221m 6.76
• 7.600 296m 289m 7.82
• Total 1,490m 1,474m

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9.23 Example EM Chemicals ATWACC No
Imputation

• Cost of equity (SML approach) RE .045 .90 ?
  (.092) .045 .0828 .1278 ? 12.8
• Cost of debt Multiply the proportion of total
  debt represented by each issue by its yield to
  maturity the weighted average cost of debt
  7.15
• Capital structure weights
• Market value of equity 78.26 million ? 58
  4.539 billionMarket value of debt 501m
  463m 221m 289m 1.474 billion
• V 4.539 billion 1.474 billion 6.013
  billion
• D/V 1.474b/6.013b .2451 ? 25 E/V
  4.539b/6.013b .7549 ? 75
• WACC .75 (.128) .25 ? .0715(1 - .35) .1076

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9.24 Divisional and Project Costs of Capital

• When is the WACC the appropriate discount rate?
• When the project is about the same risk as the
  firm.
• Other approaches to estimating a discount rate
• Divisional cost of capital
• Pure play approach
• Subjective approach

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9.25 Capital Structure Agency Problem

• Agency costs costs that arise due to a conflict
  of interest between different parties.
  (shareholders, bondholders, and managers).
• Managers tend to favor shareholders over
  bondholders.
• Conflicts between shareholders and lenders.
  Limited liability for shareholders lead to
  managers taking excessive risk, which may affect
  capital budgeting and project selections.

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9.26 House Rehab Example

• You will buy a house for 500,000 and spend
  100,000 up front to make repairs. A buyer is
  willing to commit credibly to buy the house one
  year from now for 715,000. r10. Ignoring
  taxes.
• NPV -600,000 715,000/1.1 50,000.
• If you borrow at 10, then the NPV (500,000 -
  600,000) (715,000 - 550,000)/1.1 50,000 as
  well.
• It is the same because the NPV of the financing
  is 0.
• In either case, if 50,000 is enough compensation
  for the amount of time you spend on the rehab,
  you will want to undertake the project.

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9.27 Example Continues

• After the money has been borrowed but before the
  house has been purchased, you come across another
  rehab possibility.
• There is another building nearby you could buy
  for 500,000. This would take the same amount of
  your time and expenses as the other rehab, and
  other commitments leave you too little time to do
  both.
• At the end of one year, you would sell for either
  990,000 (if you find a dentist to buy the
  building) or 330,000 (if not), and each outcome
  is equally likely. With an expected payoff of
  660,000 instead of 715,000, this is clearly an
  inferior project.

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9.28 Example Continues

• Compute your cash flows from switching to the
  dentist office rehab after the 500,000 loan is
  in place. Assuming you are indifferent about
  risk, just how much does the change benefit you?
• If you were the lender and you anticipated the
  possibility of some sort of switch, what would
  you do?

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9.29 Lessons

• The tendency that managers (shareholders) take on
  riskier projects is one type of agency problem.
• A negative NPV project may be attractive to
  shareholders, if the debt level is high!
• Lessons drawn from this example
• Shareholders prefer riskier projects due to
  limited liability.
• Loans and debt contracts have to specific about
  what kinds of opportunistic behavior are not
  acceptable. That is, a bond covenant must be
  enforced.

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9.30 Free Cash Flows and Agency Problem

• Free cash flows (definition recap) cash
  generated by past investments and retained in the
  firm which exceeds the amount needed to invest in
  positive NPV projects.
• There is also a conflict of interest between
  managers and shareholders. Managers may use free
  cash flow unwisely. Here debt can act as a
  discipline tool to control over-investment.
• If a firm is largely equity financed, then
  managers may invest in negative NPV projects --
  empire building.
• Implications for using DFCF approach.

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9.31 Interaction of Financing Valuation

• In competitive markets and with no taxes,
  financing has zero NPV, as shown in the
  house-rehab example.
• However, with taxes under the classical tax
  system, after-tax WACC will be reduced if debt
  ratio increases. This account for the value of
  interest tax shields.
• This is the most common approach of adjustment.

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9.32 Adjusted NPV Method (APV)

• Alternatively, we can start by estimating the
  projects base-case value as an all-equity
  financed mini-firm, and then adjust this base
  case NPV to account for the projects impact on
  the firms capital structure.
• Adjusted NPV base case NPV PV (tax shield)
  issue cost

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9.33 APV Example

• Project B has a based-case NPV of -20,000. We
  can issue debt at 8 to finance the project. The
  new debt has a PV Tax Shield of 60,000.The
  issuance cost is 20,000.
• Project NPV - 20,000
• PV (Tax Shield) 60,000
• Debt issue cost - 20,000
• Adjusted NPV 20,000
• Do the project!