Capital Structure Optimal Financing Mi by alicejenny

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									The Borrowing Mix


      02/21/08
       Ch. 8
What is the Borrowing Mix?
 The Borrowing Mix
     The funds used to finance the operations and
      the sources of the funds
     Debt
          Bank Loans
          Bonds
     Hybrid Stock – Preferred Stock
     Equity
          Shares
          Owner’s Money
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Objective of the Firm
 The objective of the firm
    Maximize Shareholder/Owner Wealth
    Wealth is the future cash flow of the firm
     discounted back to today at the appropriate
     weight
    Debt holders paid first
    Debt is leverage and can increase the wealth
     of the owner
 Objective is to find the borrowing mix that
  maximizes the value of the firm

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Value of the Firm
 Value of the company “claimed” by owners
     Think of company as a project
     Value is NPV = -Inv + Σ Cash Flowi / (1+ r)I
     And r is the cost of capital, hurdle rate, or
      WACC


Cost of Capital   RE   RD  1  TC 
                 E      D
                 V      V

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If Cash Flow is fixed…
 Lowest cost of capital maximizes the value of
  the firm
 Find borrowing mix that results in the lowest
  cost of capital
 This is the optimal capital structure of the firm
 Ways to find optimal capital structure
      Operating Income Approach
      Cost of Capital Approach
      Adjusted Present Value Approach
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Operating Income Approach
 What operating income is the firm capable of
  producing (distribution)
 What different levels of debt will the firm be able to
  make payments on debt (probability of default)
 Select an acceptable probability of default
 Compare probability of default at different borrowing
  amounts…
      If you can handle more debt, add debt
      If you can not handle more debt, reduce debt
 Difficult part of the task…distribution of operating
  income
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Operating Income Approach
 Personal Example…How big a house can
  you buy?
     You estimate your annual income
     Cash you have on hand (down payment)
     Percent of your income you want to commit to
      the house payment (P&I, Insurance, PMI,
      Taxes)
     Rule of thumb is 35% of income
 Same concept for a corporation, how much
  debt can it handle?

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Operating Income Approach
 Average Income and standard deviation of
  income (normal distribution assumption)
 Estimate the cash outflow per year for the
  debt (principal (sinking fund) and interest)
      Adjust cost of debt as you borrow more
 Find probability of default (find the t-statistic
  and look up the probability)
 Compare probability of default to Company’s
  acceptable level
 Borrow until you hit the acceptable level…
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Example from the book…
 Disney’s average income $2,713
 Disney’s standard deviation on income
  19.54%
 Disney’s acceptable level of default, 5%
 Break-even debt level
    ($2,713 – X) / (0.1954 x $2,713) = 1.645
   1.645 is the t-statistic where you have 5%
               probability of default
               X = $1,841 million
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Cost of Capital Approach
 Want to find the lowest WACC
     Lowest WACC is the combination of borrowing
      that produces the highest firm value
 As you add debt
     Cost of equity rises


Cost of Capital   RE   RD  1  TC 
                 E      D
                 V      V

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Calculating WACC
 Cost of Equity
     Security Market Line
 Cost of Debt
     YTM on an outstanding bond
     Multiply by 1 minus the tax rate
 Market value of Equity and Debt
     Equity + Debt = Value of the Firm
 Adjusting from current D/E to Optimal D/E


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Increasing Leverage – Impact on WACC

 Beta increases as more debt is added and
  thus equity holders require higher return
     BetaLEV = BetaUNLEV / (1+ [1-tax rate] x [D/e])
 Cost of debt (Yield) increases with more
  debt…
     Bond ratings fall as you increase debt
     Bond ratings correlated with yields
 How to estimate bond rating from interest
  coverage ration
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Interest Coverage Ratio
 Measure of how many times over the current
  (or projected) EBIT can cover the interest
  expense of the debt
     Interest Coverage Ratio = EBIT / Interest
      Expense
     Table 8.3 for Bond Rating (page 351)
     Table 8.4 for yield by Bond Rating (page 352)
     Market interest rate is a function of current risk
      free rate and the default spread
 This is RD

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Table of Cost of Capital
 With the levered beta and the current risk free
  rate and market premium…
     Find the cost of equity at different D/E
     Your increasing beta as you increase D/E
 Calculate Interest Coverage Ratio as you add
  more debt (Interest Expense increases and
  EBIT is constant)
     Find bond rating at the Interest Coverage
      Ratio
     Find the yield based on spread and risk free
      rate
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Table Cost of Capital
 Find the Market Value of Equity
 Find the Market Value of debt
 Find WACC at the different D/E ratios…
 Look for the lowest WACC
 This is the optimal D/E ratio
      Adjustment to tax rate at higher levels of debt
      The (1 – tax rate) in WACC assumes you can
       use all of the tax shield from debt
      Benefit only up to the EBIT of the company
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 Application of Lowest WACC
  Once you find the optimal debt structure of
   the firm
       You can estimate the value of the firm
       Dividend growth model


FirmValue  (Cash flow to Firm) 1  g  / WACC  g 




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What is Cash Flow to the Firm
  EBIT (Earnings before interest and taxes)
+ Depreciation (non cash flow expense)
- Taxes
- Capital Spending (funds used to buy PPE)
- Change in Net Working Capital
= Free Cash Flow to Owners
With Market Value of Equity (outstanding shares x
   price) and Market Value of Debt (bonds outstanding x
   price of bonds)
Find the growth rate in the company…

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Moving to Optimal D/E
 Once we know the WACC at the optimal D/E
 Once we find the Cash Flow to Firm
 Once we find growth rate
 We can use the “Dividend Growth Model” to
  find the new firm value at the optimal D/E
 Increase in firm value goes to the owners
     Recall debt is a fixed claim
     Calculate new stock price


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Disney Example – page 357
 Cash Flow to Firm = $1,722
 Market Value of Equity = $55,101
 Market Value of Debt = $14,668
 Growth Rate = 5.98%
 Lowest WACC = 8.50%
 Firm Value = $72,420 at optimal D/E
 Increase in Firm Value = $2,651
 Increase in price of stock = $1.29 per share

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Adjustments to Cost of Capital
Approach
 Growth rate...what is a sustainable growth
  rate? Is 5.98% too high…should it match risk
  free rate?
 Is the firm willing to accept low bond ratings?
  If not the highest D/E may not be the optimal
  D/E
 Is Cash Flow to the Firm at the appropriate
  level…was this a good year or a bad year
 Was capital spending high or low for the
  year?

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Adjusted Present Value Approach
 Start with an all equity firm…
      Find its value
 Find the marginal benefit of the tax shield
 Find the marginal cost of bankruptcy
  (distress)
 Add debt to the firm as long as the marginal
  benefit of the tax shield is greater than the
  marginal cost of bankruptcy (distress)


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Marginal Benefits of Debt
 The interest payment on debt is an expense
  and reduces the taxes of the firm as long as
  the interest expense is equal to or less than
  the EBIT (there are carry forwards…but skip
  that for now)
 Value of Tax Shield
     Marginal Tax Rate times Amount of Debt
     This is the present value of the Tax Shield


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Marginal Cost of Bankruptcy
 This is very difficult to estimate but it is the
  cost if you fall into default and those indirect
  costs that you incur to stay out of default
 Assess the probability of default (again, not
  easy to do…book suggests a probit
  regression of past sinners)
 Cost to firm is probability of default times the
  present value of the cost of bankruptcy


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Value of the Firm APV
 Find Current Value
     Discounted Cash Flows, “Dividend growth
      model” etc.
     Starting point for value then start adding debt
 Add in the present value of the tax shield
 Subtract the present value of bankruptcy
 Does Firm Value Increase?
     Yes, add more debt
     No, subtract debt
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Tuesday Homework
 Problem #1
 Problem #2 a and b only
 Problem #3 a, b, c and d only
 Problem #7
 Problem #10
 Problem #13
 Problem #21 a and b only



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