Cartwright Health Finance1 Capital Structure and the Cost of Capital Chapter 13.

Cartwright Health Finance 1

Capital Structure and the Cost of Capital

Chapter 13


Introduction

• Choose between debt and equity– Risk and return implications– Introduce capital structure theory

• Cost of Capital– Estimation– Use as Hurdle Rate for projects– Interpretation


Does Debt Policy Matter?

• Value comes from the cash stream generated by the assets in the business

• Two streams debt and equity securities

• Is it worthwhile to establish a target value for the debt ratio?


Modigliani and Miller I

• In perfect capital market, cannot alter firm value by debt policy

• One should treat the investment decision and the financing decision separately

• Investors can also borrow and lend and undo any capital structure picked by the firm.


Modgiliani and Miller II

• The expected return on the common stock of a levered firm increases in proportion to the debt-equity ratio D/E.

• Any increase in expected return is exactly offset by an increase in risk, and in shareholders required rate of return


Debt Policy Matters

• Taxes (value for the tax shield)• Costs of bankruptcy

– 20 percent of the market value equity

• Financial distress- conflict among management, board, shareholders, creditors

• Well functioning capital markets respond to these factors.

• Resuscitation for Trade-off Theory


Pecking Order• Firms prefer internal finance• Target dividend payout ratios to investment

opportunities, while trying to avoid any sudden changes in dividends

• If cash flow is more than opportunities, will payoff debt or purchase its stock

• If external finance required, first start with debt than equity as last resort.

• S. C. Meyers’ idea


Capital Components

• Right-hand side of balance sheet– liabilities and equity (or fund capital)

• Focus on long term assets; long term debt and equity– might use short-term debt as bridge, e.g.

construction loan until converted to L.T.

• Should short-term, non-interest bearing liabilities such as payables and accruals be included?


Risk and Return impacted by Capital Structure

• Consider Super Health a new for-profit walk in clinic

• Operating income is expected to be $50,000– EBIT: Earnings Before Interest and Taxes

• We consider only two capital structures, NO debt or 50/50 mix, but EXCEL spreadsheet can handle any structure from 0 to 100% L.T. debt.


Pro Forma Balance SheetsAll Equity 50% Debt

Current assets $100,000 $100,000Fixed assets 100,000 100,000

Total assets $200,000 $200,000

Debt (10% cost) 0.1 $0 $100,000Common stock 200,000 100,000

Total claims $200,000 $200,000


Pro Forma Income StatementsAll Equity 50% Debt

Net revenue $150,000 $150,000Operating costs 100,000 100,000 operating income $50,000 $50,000Interest expense $0 $10,000Taxable income $50,000 $40,000Taxes (40%) $20,000 $16,000

Net income $30,000 $24,000

ROE 15.00% 24.00%

Total $ return to investors $30,000 $34,000


Table 13.2 Super Health, IncPartial Income Statements for an Uncertain World

All Equity 50% DebtProbability 0.25 0.5 0.25 0.25 0.5 0.25

Operating income 0 50,000 100,000 0 50,000 100,000Interest expense 0 0 0 $10,000 $10,000 $10,000

Taxable income 0 50,000 100,000 -10000 40,000 90,000Taxes (40%) 0 20000 40000 -4000 16000 36000

Net income 0 30,000 60,000 -6,000 24,000 54,000

ROE 0.00% 15% 30.00% -6.00% 24% 54.00%

Expected ROE 15% 24%

Standard Deviationof ROE 10.6% 21.2%


Pro Forma Income Statements

• Based on net income should the clinic use debt financing?

• What is the total dollar return to investors, including both owners and creditors

• Where did this extra $4,000 come?


Conclusions

• Use of debt financing lowers net income, but it increases the ROE

• Debt financing permits more business operating income to flow to investors

• Debt financing is called

Financial Leverage

Levers up returns.


When uncertainty is not ignored

• Use of debt increases the equity holders risk

• The greater the amount of financial leverage, the greater the risk– Just examine the standard deviation as debt is

added.

• Managers must tradeoff risk and return.


Business Risk

• Uncertainty about the business’s operating income (EBIT)

• Business risk is not influenced by the amount of debt financing use, Why?


Sources of Business Risk

• Volume

• Reimbursement rates

• Costs of providing services

• Liability insurance

• Claims costs

• The degree of operating leverage?– Higher DOL, higher business risk


Financial Risk

• When debt financing is used, additional risk is placed on equity owners.

• Or stakeholders of Not-for-Profit Business

• The greater the percentage of debt financing, the greater the financial risk.


Capital Structure Theory

• Strikes the optimal balance between risk and return and maximizes a stock’s price.

• NonProfit-optimizes ability to perform mission.

• Trade-off Theory is the most widely accepted.– Cost savings of using debt (tax shelter)– Costs of financial distress.


C o s t o f Eq uity

A verage C o s t o f C ap ital

C o s t o f D eb t

O p tim al C ap ital S truc ture

100P ro p o rtio n o f D eb t F inanc ing (5)

0

C o s t

T rad e-o ff T heo ry o f C ap ital S truc ture


Valu e o fBu s in es s

V

0 D eb t (% )D *

M ax im iz in g V alu e o f th e B u s in ess


Trade-off Theory

• There is a Target Capital Structure

• Equal to the optimal structure

• In practice, there are many factors that influence the capital structure.


Factors in Capital Structure

• Inherent business risk

• Lender attitudes

• Rating Agency attitudes

• Reserve borrowing capacity

• Industry averages

• Current Asset structure


Not-for-Profits

• Use analogy– Debt financing has a benefit (lower cost)– But there is still financial distress

• Not for Profits do not have access to the equity markets which reduces there financial flexibility.


Cost of Capital

• Weighted average of a business long-term financing resources

• Very important benchmark rate of return to evaluate proposed projects (strategic)


Key Consideration

• What capital components to include?

• Handling of tax benefits

• Historical versus marginal costs


Debt Tax Benefits

• Not-for-profit -- direct incorporation• For-profit firms -- after tax

– Metro clinic has a 40% tax rate and a new bank loan would be at 10% interest rate.

– Cost of debt would be 10% x (1-T) = 10% x .06 = 6.0%– Build this into the cost of capital formula.

• Issuance cost small and are ignored• Component cost of debt is return required by debt

suppliers


Cost of Debt

• Banker– Investment banker if bonds– Commercial banker if loan

• YTM on outstanding bond issues where actively traded

• Debt markets– Similar companies– Prime rate


Historical Versus Marginal Costs

• Past cost of funds– Reimbursement on cost bases

• New funds– Future acquisitions and capital financing

• Focus on marginal cost of new funds– Economic concept: opportunity cost


Cost of Debt

• Nonprofit– tax exempt bonds (15,20,30 year maturity)– Ask a bond department in bank– New issue - 30 year tax exempt, semiannual

interest payment $30; par value $1,000. – ROR = 60/1,000 = 6.0%– Ignore flotation costs


Component Cost of Equity

• For profit: Cost of equity is ROR required by investor. Sell new common stock and retain earnings. – Do retained earnings have a cost? Reinvest in

alternative investments of similar risk.

• Not for profit: contributions, government grants, earnings


Methods to estimate Equity Component

• Capital Asset Pricing Model CAPM

• Discounted Cash Flow

• Debt Cost Plus Risk Premium Method


CAPM

• Security Market Line

• R(Re) = Risk Free + Risk premium

RF + (Rm - RF) x b

• Note (Rm - RF) is market risk premium

• Note (Rm - RF) x b is stock risk premium


Capital Asset Pricing Model CAPM Approach

• Investors compare the risk of the volatility of their stock returns to a well diversified market portfolio

• Beta is the measure of risk

• Market has a beta of 1. (e.g. S&P 500)

• A beta of .5 indicates stock is half as volatile

• A beta of 2 indicates stock is twice as volatile


Estimating Risk Free Rate

• Why is it impossible to find a risk free measure in the long term capital market?

• Use a rate that incorporates inflation expectations.

• T-bond is used the most (20 year maturity)


Estimating the Required Rate of Return on the market, R(Rm)

• Historical returns - expected future results = past results– average over a long series, starting point

problems– RPm = Rm - RF = 7.4% in Ibbotson Associates

• Forecasted Market Returns– variety of forecasts– use current forecast– ask your investment bank or advisors what to

use


Estimating Beta

• Look up Betas in S&P

• Calculate your own regression

• Use similar companies– Drug– Hospital Corporations– Equipment


BETA estimates2004 2006

Baxter Medical Supplies 0.5 1.29Beverly Nursing Homes 1.8 1.8Healthsouth Rehabilitative care 1.8 naHumana Managed Care 0.35 1.26Manor Care Nursing homes 0.8 0.97Merck Pharmaceuticals 0.4 0.5Tenet Healthcare Acute care hospitals -0.3 0.81St Jude Medical Medical Equipment 0.2 0.77


Illustration of the CAPM Approach

• Assumptions

beta is found by looking up current

RF is 20 year bond rate

Rm is RROR in market


Using SML Equation

• If RF = 6.0%, RPm = 7%, and market beta for Valley Clinic is 1.14, what is cost if equity?

• R(Re) = RF + [R(Rm) – RF] x b– 6.0% + (7.0% x 1.14) = 14.0%

• Note RPm stands for market risk premium


Discounted Cash Flow (DCF) Approach

• The intrinsic value of a stock is the present value of its own discounted dividend stream. Of course assumes a dividend is paid.

• Using constant growth assumption– Nonconstant is available with more

complications.


DCF Method

• E(P0) = E(D1)/[Ks-E(g)] rewrite

• P0 = E(D1)/[R(Re) - E(g)] invoked equilibrium

• E(Re) = R(Re) = E(D1)/ P0 + E(g)

• Under constant growth assumptions


Estimating the Current Price P0

• Look up current market price in the paper or the internet.

• Wall Street Journal for example


Estimating the Next Dividend Payment

• Insiders look at financial plans.• Outsiders talk to brokerage houses and

investment advisory services (Value line, S&P). Analysts’ estimates.

• The current dividend D0 can be used to estimate the next period dividend by multiplying by [1+E(g)].

• Weakest link?


Estimating the Dividend Growth Rate

• Historical growth rate– pick time period– point to point– average to average– compare Earnings Per Share and Dividend per

share growth rate

• Always problems of starting point and lack of relevance to the future.


DCF Method Estimation

• Assume that P0 = $40, E(D1) = $3.60, and E(g) = a constant 5.0% for Valley Clinic. What is the required rate of return?

• R(Re) = E(D1)/ P0 + E(g)

• = $3.60/$40 + 5.0%

• = 9.0% +5.0% = 14.0%


Debt Cost Plus Risk Premium Method

• Cost of equity – pre-tax cost if debt is a risk premium for bearing equity risk over creditor’s debt risk.

• This premium has been estimated in the range of 3 to 6 percent for large businesses

• Current estimate can be based on the premium for an average firm (A-rated, and b=1.0)


Dealing with Equity Issuance Costs

• Equity sales larger than debt.

• Adjust project costs

• Adjust cost of equity, which produces two costs: one for retained earnings and one for new stock sales.

• Ignore equity issuance costs here.


Final Judgment for Cost of Equity

• CAPM = 14.0%

• DCF = 14.0%

• Debt cost plus risk premium = 14.0%

• Let’s take 14.0%

• If different must select one or average over estimates with the most confidence.


What is Valley Clinic’s Corporate Cost of Capital (CCC)?

Target weights of 35% for debt and 65% for equity

• CCC = wd x R(Rd) x (1 – T) + we x R(Re)

• = (0.35 x 10% x 0.6) + (0.65 x 14.0%)

• = (0.35 x 6.0%) + (0.65 x 14.0%)

• = 2.1% + 9.1%

• = 11.2%


A business may be for profit, but has no publicly traded stock

• Equity estimate is the biggest problem

• Use similar business

• Use debt plus risk premium method


If Business is Not-for-Profit

• CCC = wd x R(Rd) + we x R(Re)

• Use cost of equity for similar traded business

• Use long run growth rate

• Use the R(Re) specified by rating agencies to maintain creditworthiness


Business’s Corporate Cost of Capital

• Market conditions– Interest rate levels– Risk Aversion

• The firm’s risk:– Business Risk – line of business and operating

leverage– Financial risk – financial leverage (debt)


R isk an d th e C o s t o f C ap ita l

P ro je c t c o s t o fC a p ita l (% )

Lo w A verage H igh P ro je c t R is k


Cost of Fund Capital

• Not for profits receive equity from contributions and government grants and by retained earnings.

• Retained earnings cannot be distributed to the board or managers.


What is the Cost of Fund Capital?• Zero cost: Contributors do not expect a return.

Community stakeholders and patients have no requirements.

• Opportunity cost is marketable securities such as a portfolio of low risk T-bills, use low rate.

• Should have a rate of return equal to its growth rate so that the firm may replenish capital and meet growing demand, and inflation.

• Same cost as equity funds since these represent the society’s alternative investments.

• Use investor owned healthcare provider as alternative. Use stock values of similar activities.


Measuring the Cost of Fund Capital

• Use Hamada’s equation to make adjustments

• bstock = bstock with no debt[1+(1-T)D/S)]

• Adjusts for capital structure and tax rate differentials

• Then use the CAPM with the b just calculated• This is only approximate. Hard to compare such

firms.


The Overall Cost of Capital

• General formula is a weighted average.

• Cost of Capital = wdKd(1-T) + ws(ks or Kf)

– .6(10%)(1-.4) + .4(12.8%)– = 8.7%

• This is of course the average, new projects may of course require higher cost of capital at incremental or marginal cost.


Cost of Depreciation-Generated Funds

• Use overall cost of capital.

• Depreciation belongs to original capital suppliers.

• Would you invest depreciation charges in a business that could not return the going market rate?


Economic Interpretation of the Cost of Capital

• Opportunity costs of investors

• Business risk and capital structure

• Hurdle rate for investment decisions

• Cost of capital is an average rate based on average risk. Other projects may be risky and require higher rate


Divisional Cost of Capital (DCC)

• Subsidiaries of large corporations in different business lines

• Each division may have unique risk and capital structure

• Differential project risk measured on a divisional basis.

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Cartwright Health Finance1 Capital Structure and the Cost of Capital Chapter 13.

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