WACC Capital Structure

8/4/2019 WACC Capital Structure

1/68

1

Capital

StructureMGMT-6030


2/68

2

Outline

Modigliani-Miller and Optimal capitalstructure

No Taxes

With Taxes

WACC, APV and FTE methods

Agency costs


3/68

3

What we know

Investment decisions should follow thepositive NPV rule:

Invest into projects that have non-negative

NPV for a given cost of capitalNormally, the higher the cost of capital, the

lower the NPV

Ergo, company would like to have the costof capital as low as possible


4/68

4

?

BIG QUESTION

Shareholders and debt-holders requiredifferent return on their investment,because of the different risk involved

Is there some optimal combination of debt

and equity (we call it capital structure),that would minimized the weighted-averagecost of capital (WACC) and thus maximizethe value of the firm?

Related question: why should shareholderscare about the value of the firm, rather thanthe equity value?


5/68

5

Main results of MM

In the perfect world (no taxes, noasymmetric information, no transactioncosts) the capital structure does not matter.

Level of debt is irrelevantOnce we introduce taxes, high leverage

increases firm value to its shareholders

Therefore, there exists an optimal leverage,which would maximize the firm value


6/68

6

Modigliani-Miller Assumptions

No asymmetric information

No frictions (no transaction costs)

Individuals and companies can borrow andlend at the same rate


7/68

7

Proof of MM1 by no arbitrage. Example

Ulevered firm:

Average EBIT10,000

kRF=4%;Dkm=6%;

bU=1

1,000 shares

Value of the firm?

Share price?

Levered firm:

Average EBIT 10,000

1,000 shares

Risk-free debt D=40,000

Value of equity?

Share price? Value of the firm?


8/68

8

Example (2)

Unlevered firm:

Net Income = EBIT x (1-T) = 10,000

kU= kRF+bUDkm= 4% + 6%= 10%

Value of the firm, VU= 10,000 / 10% = 100,000

PU= 100


9/68

9

Example (3)

Levered firm Interest = D x kRF= 40,000 x 4% = 1,600

Net Income = (EBIT - Interest) x (1-T) = 8,400

Since the cash flow from the levered firm is exactly thesame, its total value should be the same. VL=VU, valueof equity EL = VL - D

Value of the firm VL = VU= 100,000

Value of equity EL = VL - D = 100,000 - 40,000 = 60,000

PL = 60,000/1,000 = 60

Return to shareholders kEU= 8.4 / 60 = 14 %


10/68

10

Example (4)

Proof: by arbitrage. For simplicity assume that all netincome is paid as dividendsSuppose that VL>VU(PL > 60)

You can sell short 1 share of the levered company,borrow 40 and buy 1 share of the unlevered company

Your Cash Flow:Item Now Every year in the future

Sell short PL +PL -8.4

Borrow @ 4% +40 -1.6

Buy PU -100 10

_______________________________________________

Total PL - 60 > 0 0

Arbitrage!!!


11/68

11

(No) Arbitrage Principle

What is an arbitrage?

Making a guaranteed (non-speculative) profit by takingadvantage of some mispricing, e.g., differences in interestrates, exchange rates, commodities pricing etc.

Thelaw of one price: Two securities with the same cashflows should have the same price

The same cash flow means the same in everystate of theworld

The same expected payoff is not enough!

To price a security, we can create a replicating portfolio of

other securities, which prices are known The price of this security should be equal to the price of this

replicating portfolio

Commonly used in to price bonds and derivatives


12/68

12

Note on arbitrage pricing

To price security using the arbitrage argument:1. Correctly identify all the cash flow until maturity

2. Choose the replicating portfolio

2.1. With derivative securities, the mostly likely candidates

are the underlying security and a riskless bond2.2. With bond pricing the candidates are other bonds of

the same risk, but with different maturities and couponrates

3. Check that the cash flow for the replicating portfolio is

exactly the same as for the security of interest (no dividendsat intermediate dates, no extra costs)

4. Find the current value of the replicating portfolio. This is theprice of our security of interest


13/68

13

Example

What is the price of financial asset ABM, if it will pay toits holder $ 1,000 in one year under all circumstancesand $ 2,000 in two years if the Dow Jones index willbe below 9,000 at that time?

Asset ABM: $ 1,000 In 1 year

$ 2,000 In 2 years, iff DJ < 9,000

Two assets are traded on the market

CL (current price = $ 98) $ 100 In one Year

Asset BND ( current price = $ 600) $ 1,000 In 2 years, iff DJ < 9,000


14/68

14

D

U

E

U

E

L

E

ED

kkE

Dkk

constk

V

Ek

V

DWACC

Modigliani-Miller without taxes

In a tax-free world the capital structuredoes not matter (it does not matter how youslice the pizza)

MM1: Value of the firm remains the same

VL=VU

MM2:


15/68

15

Self-made replication of the capitalstructure

What about higher return to the shareholders ofthe levered firm?

First, high risk - high return

Second, shareholders of the unlevered firm can

enjoy the same return! Instead of buying 1 share of the unlevered firm byusing $ 100 of personal wealth, the shareholder canpersonally borrow $ 40 @ 4% interest and invest only$ 60 of his own money

Investment: 60 $

Payoff: 10 - 1.6 = 8.4 Return: 14%


16/68

16

Example:

Firms U and L without taxes

EBIT= $ 10 M; VU= $ 100 M, E= $ 100 M

EBIT= $ 10 M; VL= $ 100 M, D = $ 40 M;E = $ 60 M

WACC=10%, kD = 8%

kEU = ?kEU = 10%


17/68

17

Example:

Firms U and L without taxes

EBIT= $ 10 M; VU= $ 100 M, E= $ 100 M

EBIT= $ 10 M; VL= $ 100 M, D = $ 40 M;E = $ 60 M

WACC=10%, kD = 8%

kEL =

DkV

D

WACCE

V

%33.11%8100

40

%1060

100

DkV

D

WACCE

V


18/68

18

Introducing taxes. Example

Once we introduce taxes, the cash flows to twofirms become different

Suppose that T= 40%

Unlevered firm: Net Income = EBIT x (1-T) = 10,000 x 0.6 = 6,000

kU= kRF+bUDkm= 4% + 6%= 10%

VU= 6,000 / 10% = 60,000

PU= 60


19/68

19

Example (2)

Levered firm

Interest = D x kRF= 40,000 x 4% = 1,600

Net Income = (EBIT - Interest) x (1-T) = 8,400 x .6= 5,040

Total Cash Flow to stakeholders (shareholders +debtholders):

1,600 + 5,040 =6,640

Every year the levered firm enjoys increased cash

flow of 640 This is due to theinterest rate tax shield:

Interest x T = 1,600 x 0.4 =640

How much value does the tax shield add?


20/68

20

Example (3)

How much value does the tax shield add?

Let us assume that the company will keep

this debt forever, repaying only the interestThen we have (TCdenotes corporatetax

rate):

000,16000,404.0)(

)(

DTTaxShieldPV

TDk

DkT

k

InterestTTaxShieldPV

C

D

D

D


21/68

21

Modigliani-Miller with taxes

In the world with tax the capital structure doesmatter, because interest is tax deducted

The value of a levered firm is (MM1)

VL=VU+TcD

And its WACC and kEL are, respectively (MM2)

D

U

EC

U

E

L

E

L

EcD

kkTE

Dkk

constkVETk

VDWACC

1

)1(


22/68

22

Example

An all finance equity firm has EBIT=20 M $ andE=100 M $. The tax rate is TC = 35%. It has 10 Mshares outstanding

What is the value of this firm, if it issues D = 40 M $to buy back some equity? Assume kD= 8%? What

is the new WACC? Solution:

FCF=20x0.65 = 13

kU= 13/100 = 13%

VL = VU + TCD = 100 + .35 x 40 = 114; D/E = 40 / 74 = .54; D/V = 40/114 = .35

kL = 13% + .54 x 0.65 x (.13 - .08) = 14.76%

WACC = 11.4%


23/68

23

Debt issuedPrice per shareShares bought =

Changing Capital Structure (example)

Company ABC announces therecapitalization

New debt is issued

Proceeds are used to repurchase stock


24/68

24

Calculating share price after share repurchase

A Company raises debt D buy back shares. Oldequity value is Eold. New equity value after thebuyback is Enew. What is the new share pricePnew? How many shares D are bought?

old

new

new

new

old

new

new

newoldnewnewnewnew

oldnewnew

NDE

EN

N

DEP

PNPNPE

NNPD

D

DD

;

;


25/68

25

51.349.610

49.610114

74)1(

4.1110

14100

7440)35.01(100)1(

D

old

cold

cold

new

old

cold

new

coldnew

NDTE

DTE

N

N

DTEP

DTEE

Example (contd.)

D=$ 40 M, Vnew=$ 114 M; Tc=35%, Nold=10 M

C f ff


26/68

26

D/V D/E Bondratio ratio rating k

d

0 0 -- --

0.125 0.1429 AA 8%

0.250 0.3333 A 9%0.375 0.6000 BBB 11.5%

0.500 1.0000 BB 14%

Example: ABCs cost of debt at different

debt levels after recapitalization


27/68

27

Why does the bond rating and cost of debtdepend upon the amount borrowed?

As the firm borrows more money, the firm increasesits risk causing the firms bond rating to decrease,and its cost of debt to increase

Since V

L

=V

U

+TcD, why would the credit ratingmatter?

Because of the cost of financial distress!

Financial distress occurs when promises to creditors

are broken or honored with difficulty (often leads tobankruptcy). Therefore

VL=VU+PV(tax shield) - PV(cost of financial distress)


28/68

28

Recap: Benefits of debt

Tax advantage

According to MM, the company should have asmuch debt as possible

Disciplining device

If a company has a lot of cash, its managersbecome complacent. They might start makingwrong investment decisions and divert cash flowsto their own benefits

Should companies have near 100% of debt? Of course NO!

Debt has its own costs! These costs depend on theamount of debt


29/68

29

Costs of debt

Direct Costs

Legal and administrative costs (tend to be asmall percentage of firm value)

Indirect Costs

Impaired ability to conduct business (e.g., lostsales)

Agency Costs

Selfish strategy 1: Incentive to take large risks

Selfish strategy 2: Incentive towardunderinvestment

Selfish Strategy 3: Milking the property


30/68

30

Agency theory

An agency relationship exists whenever aprincipal hires an agent to act on theirbehalf

Within a corporation, agency relationshipsexist between:

Shareholders and managers

Shareholders and creditors


31/68

31

Shareholders versus managers

Managers are naturally inclined to act intheir own best interests

But the following factors affect managerialbehavior:

Managerial compensation plans

Direct intervention by shareholders

The threat of firing The threat of takeover

As a managers disciplining device debt is

good!


32/68

32

Shareholders versus creditors

Shareholders (through managers) couldtake actions to maximize stock price that

are detrimental to creditorsCreditors take this into account, when

lending money

Therefore, In the long run, such actions willraise the cost of debt and ultimately lowerstock price


33/68

33

Capital structure and agency costs

Distortions in investment strategies due toshareholders/debtholders conflict

Debt overhang problem:

Pre-existing debt distorts the payoff from a newproject to shareholders

Results in underinvestment, because existing debtprecludes from undertaking a good project)

Example

Asset substitution problem

Results in investment into too risky projects Example

Shortsighted investment

Reluctance to liquidate when liquidation is optimal

E l F i d j t


34/68

34

Example: Foregoing a good project(debt overhang)

Company ongoing operations generate 50 M at T=1 and T=2 (after taxes and interest)

Outstanding debt D = 100 (payable at T=2)

Investment project I=50 at T=1, payoff V=70at T=2

WACC=20% (kd = 8 % ). Cost of equity is notknown, but we know that it is higher than

WACCShould the company undertake the project?

Will it undertake the project?


35/68

35

Debt overhang example (2)

NPV

70/1.2 - 50 = 58.33 - 50 = 8.33 > 0

Distribution to the Stakeholders

With the project: Debtholders get 100. PV(100) = 92.59

Shareholders get 50+70-100 = 20. PV(20) 0

Project 2. Expected payoff is

2001/4 + 03/4 = 50

Project 2 NPV is

50/1.2 - 50 = -8.33 < 0


39/68

39

Asset substitution example (3)

With project 1: Debtholders get 100, PV(100) = 92.59

Shareholders get 20, PV(20) < 16.67

With project 2:

Debtholders get 100 with probability 1/4 and50 with probability 3/4. PV(72.5)=67.13

Shareholders get 150 with probability 1/4.PV(37.5) > PV(20)


40/68

40

Agency cost of debt

Debtholders know about shareholdersopportunistic behavior

They require higher interest rate

Positive NPV projects are not undertaken -this is called the agency cost of debt

Possible remedy - convertible debt

Convertible debt gives creditors the right toconvert debt into shares to reap the benefitsfrom a good outcome


41/68

41

Recap: Mitigating incentive problems

Covenants

Issuing more short-term than long-termdebt

Potential problem - higher exposure tointerest rate risk

Use of convertible bonds

Giving right incentives to the managers


42/68

42

Value of Stock

0 D1 D2D/V

MM result

Actual

No leverage


43/68

43

%

15

0 .25 .75.50 D/V

ksWACCkd(1 T)

$

D/V.25 .50

P0

EPS

Cost of capital and EPS


44/68

44

Possible levels of debt

Which capital structure is better? Is it ideal?

time

Value

Debt,

Face value

time

Value

Debt,

Face value

VLVL


45/68

45

Signaling

Signal is a message credibly conveyinginformation from informed to uninformed

players It is credible

if it is in the players interest to tell the truth

it is too costly to mimic (to lie) by others


46/68

46

Capital structure and signaling

Assumptions: Managers have better information about a

firms long-run value than outside investors

Managers act in the best interests of current

stockholders

Managers can be expected to:

Issue stock if they think stock is overvalued

Issue debt if they think stock is undervalued

As a result, investors view a common stockoffering as a negative signal -- managers

think stock is overvalued


47/68

47

Capital structure and signaling (2)

Signaling theory, suggests firms shoulduse less debt than MM suggest

This unused debt capacity helps avoidstock sales, which depress P0 because of

signaling effects


48/68

48

The Pecking-Order Theory

Theory stating that firms prefer to issue

debt rather than equity if internal finance isinsufficient

Rule 1: Use internal financing first

Rule 2: Issue debt next, equity last

According to the pecking-order theory:

There isno targetD/E ratio

Profitable firms use less debt (they use self-financing instead)

Companies like financial slack


49/68

49

How Firms Establish Capital Structure?

Most corporations have low D/V Ratios

Changes in leverage affect firm Value

Stock price increases with increases in leverageand vice-versa; this is consistent with M&M with

taxes

Another interpretation is that firms signal goodnews when they lever up

Capital structure varies across Industries

There is some evidence that firms behave as ifthey had a target D/E ratio


50/68

50

Factors in Target D/E Ratio

Taxes

If corporate tax rates are higher than bondholdertax rates, there is an advantage to debt

Types of assets

The costs of financial distress depend on the types

of assets the firm has Uncertainty of operating Income

Even without debt, firms with uncertain operatingincome have high probability of experiencing

financial distress Pecking order and financial slack

Theory stating that firms prefer to issue debt ratherthan equity if internal finance is insufficient

Long-term debt ratios (D/V) for


51/68

51

Industry Book MarketPharmaceuticals 27.4% 7.34%Computers 24.75% 7.46%Steel 32.88% 14.61%

Aerospace 46.32% 23.25%Airlines 71.88% 32.86%Electr. Utilities 61.74% 47.71%Auto & Truck 81.52% 65.51%

Internet 18.57% 2.18%Educational services 12.97% 2.24%

Source: Bloomberg, January 2005 (collectedby Aswath Damodaran (NYU))

Long term debt ratios (D/V) forselected industries


52/68

52

Summary and Conclusions

Costs of financial distress cause firms to restrain their issuance

of debt Direct costs

Lawyers and accountants fees

Indirect Costs

Impaired ability to conduct business Incentives to take on risky projects

Incentives to underinvest

Incentive to milk the property

Three techniques to reduce these costs are: Protective covenants

Repurchase of debt prior to bankruptcy

Consolidation of debt


53/68

53


Because costs of financial distress can be

reduced but not eliminated, firms will notfinance entirely with debt

Debt (B)

Value of firm (V)

0

Present value of taxshield on debt

Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

VL

= VU

+ TCB

V= Actual value of firm

VU

= Value of firm with no debt

B*

Maximumfirm value

Optimal amount of debt


54/68

54


If distributions to equity holders are taxed at a lower

effective personal tax rate than interest, the taxadvantage to debt at the corporate level is partiallyoffset. In fact, the corporate advantage to debt iseliminated if (1-TC) (1-TS) = (1-TB)

Debt (B)

Value of firm (V)

0

Present value of taxshield on debt

Present value offinancial distress costs Value of firm under

MM with corporatetaxes and debtVL

= VU

+ TCB

V= Actual value of firm

VU

= Value of firm with no debt

B*

Maximumfirm value

Optimal amount of debt

VL

< VU

+ TCB when T

S< T

B

but (1-TB

) > (1-TC)(1-T

S)

Agency Cost of Equity Agency Cost of Debt

Calculating NPV of a Project in a Levered


55/68

55

Calculating NPV of a Project in a LeveredFirm

WACC approach

Adjusted present value (APV) approach

Flow-to-equity (FTE) approach


56/68

56

WACC approach

Estimate FCF ignoring financing effects

Calculate cost of equity for each type ofcapital used

Calculate WACC Make sure that you are using the correct

D/E ratios for each year!

Find NPV


57/68

57

Adjusted present value (APV) approach

Calculate NPV for an all-equity financedproject

Adjust for the debt effects such as the

value of the tax shield and bankruptcycosts

If the absolute amount of debt remains thesame over time, then the value of the taxshield is TcD

Fl i (FTE) h


58/68

58

Flow-to-equity (FTE) approach

Calculate the levered cash flow

Make sure that you calculate the interestpayment correctly

Calculate the levered cost of equity

Make sure that you use the right D/E ratio

Calculate the NPV

Whi h h ?


59/68

59

Which approach to use?

If D/E ratio is constant over time, WACC issimpler to use

If the absolute value of debt is constant,APV is simpler to use

E l


60/68

60

Example

An all-equity company (the current value $

2 M, cost of capital kU

=12%, kRF=6%) isplanning to undertake a new project, whichrequires investment of $ 500 K and willgenerate free cash flow with CF=100

growing in perpetuity at g=2%. Thecompany wants to finance the project byissuing $ 500 K of console bonds at therate 8%. The tax rate is 40%.

What is the new value of the company(total value and equity value)?

E l (2)


61/68

61

Example (2)

Solution: since the D = const, we use the APV

approach The PV of the project is 100/(.12-.02)=1,000 K

Therefore, if all equity financed, the new value

of the firm would be $ 3 M The PV of the tax shield is 500 x .4 = 200

The value of the levered firm is $ 3.2 M. The

value of debt is $ 500 K and the value ofequity is $ 2.7 M

Why is using WACC approach more difficult?


62/68

62

Appendix: Capital structure and option

theory

St k d B d O ti


63/68

63

Stocks and Bonds as Options

Levered Equity is a Call OptionThe underlying asset comprise the assets of thefirm

The strike price is the payoff of the bond

If at the maturity of debt, the value of the firmassets is greater than the face value of debt,the shareholders will pay the bondholders and

call in the assets of the firm Otherwise, the shareholders will declare

bankruptcy and let the call expire

St k d B d O ti


64/68

64

Stocks and Bonds as Options

Levered Equity is a Put Option The underlying asset comprise the assets of the firm

The strike price is the payoff of the bond

If at maturity, the assets of the firm are

less in value than the debt Shareholders have an in-the-money put

They will put the firm to the bondholders

If at maturity the assets are more valuablethan the face value of debt The shareholders will not exercise the option

(i.e. NOT declare bankruptcy) and let the putexpire

C i l S P li d O i


65/68

65

Capital-Structure Policy and Options

Recall some of the agency costs of

debt: they can all be seen in termsof options

For example, recall the incentiveshareholders in a levered firm haveto take large risks

They do that because high riskprojects increase the value of theoption

V l f d bt d it ti


66/68

66

Value of debt and equity as options

Example Biotech start-up develops a new drug. They finance

their investment with debt maturing in 3 years(repayment of 600 M). By that time either the drug issuccessful (with different degrees of success) and

company sells itself to a big pharmaceutical company,or it fails. 4 possible states with equal probability

State: Success Moderate Mediocre Failure

Payoff: 1000 700 500 100Debt: 600 600 500 100

Equity: 400 100 0 0

Val e of debt and eq it as options (2)


67/68

67

Value of debt and equity as options (2)

600 CF to firm

Equity

0

600

CF to firm

Debt

0

600



68/68


In option valuation language:

Underlying asset: the firm itself

Maturity - 3 years (maturity of debt)

Exercise price X = 600 M

Two similar interpretations: Equity holders buy a call option from the debt-

holders (a right to buy the firm from thebondholders at maturity). Debt-holders(Bondholders) effectively own the firm and sell the

call option Alternatively: Equity-holders own the firm, they

borrow 600 M and they buy a put option to sell thefirm to the bondholders at X=600 M

Date post:	07-Apr-2018
Category:	Documents
Upload:	mileticmarko
View:	238 times
Download:	3 times

WACC Capital Structure

Documents