6 Capital Structure and Cost of Capital 30062012

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Capital Structure and Financial Distress

Wijantini

Prasetiya Mulya Business School

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Wijantini


3 Main Causes of Financial DistressHigh Leverage /DebtPoor Management

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Industry Effects

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Financing DecisionDebt (Utang) ?

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Equity (Modal Sendiri) ?

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Financial Risk

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Additional business risk concentrated on common stockholders when financial leverage is used. (Tambahan risiko jika pinjaman digunakan)

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Business RiskUncertainty in future Net Profit from Operations* (Ketidakpastian laba operasi di myad) * = EBIT (Earning Before Interest and Taxes) = Laba UsahaWijantini

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Financial RiskConsider Two Firms

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Firm U No debt 20 M in assets 40% tax rate

Firm L D =10 M @ 12% 20 M in assets 40% tax rate

Both firms have same EBIT of 3 M. They differ only with respect to use of debt.

Wijantini


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Impact of Leverage (Debt) on Returns Firm U EBIT Interest EBT Taxes (40%) NI ROEWijantini

Firm L 3M 1,20 1,80 0,72 1,08 10.8%Prasetiya Mulya Business School

3M 0 3M 1,2 1,8 M 9.0%

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Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?

ContinuedWijantiniPrasetiya Mulya Business School

Financial RiskFirm U: Unleveraged Bad Economy Avg. Good

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Prob. 0.25 EBIT 2,000 Interest 0 EBT 2,000 Taxes (40%) 800 NI 1,200Wijantini

0.50 3,000 0 3,000 1,200 1,800

0.25 4,000 0 4,000 1,600 2,400Prasetiya Mulya Business School

Financial RiskFirm L: Leveraged Economy Bad Avg. Prob.* 0.25 0.50 EBIT* 2,000 3,000 Interest 1,200 1,200 EBT 800 1,800 Taxes (40%) 320 720 NI 480 1,080 *Same as for Firm U.Wijantini

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Good 0.25 4,000 1,200 2,800 1,120 1,680


Financial RiskFirm U ROE Firm L ROE Bad 6.0% Bad 4.8% Avg. 9.0% Avg. 10.8% Good 12.0% Good

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16.8%

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Business RiskUncertainty about future pre-tax operating income (EBIT).ProbabilityLow risk High risk

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0

E(EBIT)

EBIT

Note that business risk focuses on operating income, so it ignores financing effects.WijantiniPrasetiya Mulya Business School

Business RiskFactors That Influence Business Risk

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Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs.

Wijantini


Business RiskWhat is DOL?

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Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firms overall cost structure, the greater the operating leverage.(More...)

Wijantini


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Probability

Low operating leverage

High operating leverage

EBITL

EBITH

In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.WijantiniPrasetiya Mulya Business School

Capital Structure Theory

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Miller Modigliani - MM theory Corporate taxesTrade-off theory

Signaling theory

Wijantini


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MM relationship between value and debt when corporate taxes are considered.Value of Firm, V VL TD VU Debt

0Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.WijantiniPrasetiya Mulya Business School

Trade-off Theory MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

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Signaling Theory

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MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.

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A second agency problem is the potential for underinvestment. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs.

Wijantini


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Choosing the Optimal Capital Structure: An ExampleCurrently is all-equity financed.

Expected EBIT = 500,000.Firm expects zero growth.

100,000 shares outstanding; rs = 12%;T = 40%; b = 1.0; rRF = 6%; RPM = 6%.WijantiniPrasetiya Mulya Business School

Estimates of Cost of Debt

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Percent financed with debt, wd rd 0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.WijantiniPrasetiya Mulya Business School

The Cost of Equity at Different Levels of Debt: Hamadas Equation

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MM theory implies that beta changes with leverage.bU is the beta of a firm when it has no debt (the unlevered beta) bL = bU [1 + (1 - T)(D/S)]

Wijantini


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The Cost of Equity for wd = 20% Use Hamadas equation to find beta: bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs = rRF + bL (RPM)

= 6% + 1.15 (6%) = 12.9%WijantiniPrasetiya Mulya Business School

Cost of Equity vs. Leveragewd 0% 20% 30% 40% 50%Wijantini

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D/S 0.00 0.25 0.43 0.67 1.00

bL 1.000 1.150 1.257 1.400 1.600

rs 12.00% 12.90% 13.54% 14.40% 15.60%Prasetiya Mulya Business School

The WACC for wd = 20%WACC = wd (1-T) rd + we rs

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WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%) WACC = 11.28%

Repeat this for all capital structures under consideration.WijantiniPrasetiya Mulya Business School

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WACC vs. Leveragewd 0% 20% 30% 40% 50%Wijantini

rd 0.0% 8.0% 8.5% 10.0% 12.0%

rs 12.00% 12.90% 13.54% 14.40% 15.60%

WACC 12.00% 11.28% 11.01% 11.04% 11.40%Prasetiya Mulya Business School

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What other factors would managers consider when setting the target capital structure?

Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender and rating agency attitudes (impact on bond ratings).WijantiniPrasetiya Mulya Business School

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Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible, and hence suitable as collateral?

Tax rates.

Wijantini


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Cost of Capital ( BIAYA MODAL)

Wijantini


COST OF CAPITALCost of capital is the minimum expected rate of return that the market requires in order to attract funds for a particular investment with a given level of risk

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Wijantini


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Cost of Capital Components

Debt Preferred Common Equity WACC (Weighted Cost of Capital)

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What capital components should be included?Evergreen interest-bearing Short-term debt (only in special case)Long-term debt Common equity

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Should we focus on ex-post (historical) costs or ex-ante (expected) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on ex-ante costs.

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Cost of DebtInterest is tax deductible, so

kd(1 - T)

= 12%(1 - 0.25) = 9%.kd= Cost of Debt =suku bunga pinjaman bank

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Cost of EquityWhat are the two ways that companies can raise common equity?

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Companies can issue new shares of common stock. Companies can reinvest earnings.

Wijantini


Cost of EquityThree ways to determine the cost of equity (ks)

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1. CAPM: ks 2. DCF: ks

= kRF + b(kM - kRF)

= kRF + b(RPM).= D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP

Wijantini


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1. Capital Asset Pricing Model (CAPM)Whats the cost of equity based on the CAPM?

For example: kRF = 6.0%; RPM = 12% ; b = 1.2

ks = kRF + b(kM - kRF ) = 6.0% + 1.2(12%) = 20.4%

Wijantini


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2. Discounted Cash Flow (DCF)

ke = D1/Po + gSuppose Charoen Pokphand Indonesia has been earning 20% on equity (ROE = 20%) and retaining 25% (dividend payout ratio or DPO = 75%), and this situation is expected to continue. Whats the expected future g?

Wijantini


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Retention growth rate: g = b(ROE) = 0.25(20%) = 5% b = Fraction retained = 1-Payout ratio g = 5% given earlier.

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ks = D1/Po + g

g = 5% given earlier. Do= 100 D1= 100(1+5%)= 105 Po= 650ks = 105/650 + 5% = 20.18%

Wijantini


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3. Bond-Yield-Plus-Risk-PremiumEstimating ks using the own-bond-yield-plus-riskpremium method

ks = kd + RP = 12.0% + 8.0% = 20.0%

This RP CAPM RPM.

Wijantini


Whats a reasonable final estimate of Cost of Equity (rs)?

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Method

Estimate

CAPMDCF

20.40%20.18%

kd + RPAverageWijantini

20.00%20.19%Prasetiya Mulya Business School

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Whats the WACC?Weighted Average Cost of Capital (WACC) is the weighted summation of: (i) cost of common equity capital (ks), and (ii) cost of debt capital (kd); WACC represents a firms overall capital cost WACC= wdkd(1 - T) + wsks

Wijantini


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Calculating WACCCap.Comp. Weight Debt 60% Common Eq. 40% 100% Comp.Cost Product 9.0%*) 5.4% 20.19% 8.01% WACC= 13.41%

*) After-tax cost of debt = Interest rate Tax savings = kd - kdT = kd (1-T) = 12% (1-25%) = 9%

Wijantini


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What factors influence a companys WACC? Market conditions, especially interest rates and tax rates Uncontrollable The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.

Wijantini


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4 Mistakes to Avoid Never base the cost of debt on the coupon rate on a firms existing debt. Never use the historical average Never use the current Book Value capital structure to estimate the weights Always remember that capital components are funds that come from investors

Wijantini


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6 Capital Structure and Cost of Capital 30062012

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