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					CPO West Conference
Capital Structure Session

January 4th, 2005April 27, 2007
San Diego, CA

January 4th, 2005
 January 4th, 2005

      –   Program Overview
      –   Cost of Capital – Big Picture
      –   Cost of Equity for Public Firms
      –   Cost of Equity for Private Firms
      –   Discount for lack of marketability
      –   Cost of debt
      –   Cost of capital calculation
      –   Optimal structure discussion

      Spectrum of Financing Alternatives
                                 Senior Secured                                                   Subordinated / Equity-Linked                           Equity

                        Traditional       Institutional        Private          2nd Lien               High         Mezzanine          Convertible
      Products          Bank Debt          Term Loan         Placement         Term Loan               Yield          Debt                Debt

                                                                                             •Debt incurrence covenant (Mezz
                      • Maintenance covenants required           • Maintenance covenants     debt includes maintenance
                                                                   (outside of bank debt)    covenants)
                      • Always pre-payable (usually at                                                                              • Dilutive to EPS
      Flexibility       par)                                     • Pre-payment premiums      •Provides more flexibility than all    • May not be attractive at current
                                                                                             senior structure                         stock price
                      • Allows for frequent modifications        • Less flexibility than
                        (covenants, acquisitions, etc.)            subordinated debt         •No call period
                                                                                             •Pre-payment premiums

                                                                                                     • Highest Issuance and Borrowing Costs (can include a PIK
                                                                           Increased Issuance          component)
        Cost                  Lowest Issuance and Borrowing Costs
                                                                          and Borrowing Costs        • Convertible Debt will carry a lower interest cost in exchange for

                      Lenders look for
                                                               Fixed rate                         Requires
                     ancillary businessTypically requires a                                                            High fixed
        Other                                                              Need to understanda rating; typically
                                                          placement requires
                       opportunities;      rating and                                                                  borrowing                 Potentially dilutive
    Considerations                                            make-whole    investor rationale unsecured or
                       security based is always secured                                                                  costs
                                                               premium                         second priority
                        credit quality

                          Balancing the Competing Factors of Flexibility & Costs

    Fundamentals on Capital Structure

    Capital Structure Pyramid
                                          Lower Cost
    To Lender/Investor:                                To Company:

       Lower Risk                                        Higher Financial Risk

                                Debt, High Yield,

       Higher Risk                                         Lower Financial Risk

                                                       Higher Cost
     Fundamentals on Capital Structure
    Cost & Flexibility Chart
                         Lowest Cost                                                                          Highest Cost

                         Least Flexible                                                                       Most Flexible

    •No external           •Lowest cost   •Could be lowest    •Relatively low    •Minimal        •Future flexibility   •Story deal OK
    reliance or limits                    cost depending on   cost               amortization    •Liquidity            •Future flexibility
                           •No dilution   tax situation
                                                              •No covenants                      •Potential higher
                                          •No/few covenants                                      valuation
                                                              •No Amortization
                                                              •Complex stories
Some                                                          OK

                                           •Limited by        •Size required     •Covenants         •Highest cost          •Highest cost
    •Leverage              •Restrictive
    increases ROE          covenants       amount of                             •Maybe equity      •Size required
                                           leasable assets                       kicker

    Capital Sourcing Alternatives

                                   Financing Alternatives at Various Stages of the
                                               Corporate Life Cycle
                                   30                                                                                         Rejuvenation

              Sales ($ Millions)
                                    R&D           Start-Up                         Growth               Maturity Uncertain
                                          Individual Investors

                                                                 Venture Capital
                                                                             Private Equity Funds
                                                                                            Strategic Alliances

                                                                                    Asset-Based Working Capital Lines

                                                                                            Internally Generated Cash Flow

                                                                                                    Mezz./Subord. Debt

                                                                                                Long -Term Debt (Cash Flow)

                                                                                                         Public Equity

    Capital Sourcing Alternatives

         Line of Credit
           / Revolver

    Short term financing

        • Trade gap
        • Least expensive financing
        • Discretionary

    Capital Sourcing Alternatives

          Senior Secured
        Asset Based
        • Least expensive form of financing
          after revolver and possibly lease
              - Interest rate typically based
                upon “spread” plus “prime,
                LIBOR, CP…” but can have a
                fixed rate option
        • Benefit of tax deductibility of
          interest payments
        • Principal repayments are a drain on
          cash flow and earnings
        • Claims take priority over all other
          debt financings

    Capital Sourcing Alternatives

        Senior Unsecured

       Cash Flow Based

        • Manage by very specific
          performance standards/covenants
        • Place strong emphasis on
          historical cash flow
        • Less ideal for a company planning
          rapid growth or for a company
          that cannot predict future with
          great certainty.

     Capital Sourcing Alternatives

         Senior Unsecured - Cash Flow Based


         Borrower Profile            When Appropriate
         • Strong cash flows         • Available capacity
         • Long Operating History    • Long term needs
         • Low risk profile          • Attractive fixed rates

        Capital Sourcing Alternatives

     Senior Lender Underwriting Considerations
           (Line of Credit, Revolver, Senior Secured, Senior Unsecured)

                   Financial performance (historical)
                      Cash flow analysis and coverage
                      Ratio analysis
                   Future cash flow sustainability
                   Projections; level of growth; improvements rationale
                   Industry characteristics/fundamentals
                   Management resumes/background
                   Company/competitive standing

     Capital Sourcing Alternatives

        Mezzanine/Subordinated Debt

         • Lower creditor priority to senior
           debt, but higher than equity
         • Higher risk debt, therefore more
             - Fixed or variable rate
             - Equity kicker, usually warrants
         • Various forms:
             - subordinated debt
             - subordinate debt with kicker
             - convertible debenture

     Capital Sourcing Alternatives

         Mezzanine/Subordinated Debt


         Borrower Profile              When Appropriate
         • Stable cash flow            •Limited senior debt capacity
         • Growth prospects            •Medium term needs (5-10 years)
         • Operating History           •Reluctance to give up much equity
         • Strong management
         • Non-cyclical, low/medium-

     Capital Sourcing Alternatives

        Preferred Equity

          • Hybrid of pure equity and debt
                - Fixed dividend to investor
                     (Cash or Paid-in-kind)
                - Capital appreciation
          • Senior priority to common stock
          • Often convertible to common
          • Dividend payment not tax
            deductible to issuing company
          • Unless convertible, preferred
            holders don’t participate in equity

     Capital Sourcing Alternatives

        Common Equity

         • Most expensive form of financing
         • Drawbacks include:
              - Non-tax deductibility of
                dividend payments
              - Loss of corporate control
              - Dilution of ownership in
                further issuance
              - High issuance costs (public)

     Capital Sourcing Alternatives

        Common Equity - Majority Interest


        Borrower Profile                     When appropriate
        • Strong management                  • Flexibility needed and/or can’t
        • Strong growth potential            support
        • Little operating history             current debt payments
        • Clear exit strategy (for private   • Willing to share ownership / control
          placements)                        • Benefit of partner
              - IPO                          • High growth - all cash flow needs to
              - Private Sale                    be reinvested
              - Recapitalization             • High R&D requirements
                                             • Acquisition funding

     Capital Sourcing Alternatives

         Common Equity - Minority Interest
           Terms and Description

         • Take out 2-5 year investment horizon
         • Required return of approximately low 20s%
         • Defined exit
         • Usually preferred stock or separate class of common stock
         • New investors have voice, not control

         Borrower Profile                  When appropriate
         • Strong management              • Don’t want change in control
         • Strong growth potential        • Growth / Recapitalization / Deleverage
         • Some operating history         • Flexibility needed or lack of senior or
                                            mezzanine debt available
                                          • Pre-IPO or shareholder liquidity vehicle
     Capital Sourcing Alternatives

      Equity & Equity-Like Investor Underwriting Considerations
      (Subordinated Debt, Preferred Equity, Common Equity - Majority/Minority)

        Valuation comparables
        Industry characteristics
        Management resumes/background
        Company/competitive standing/advantages
        Historical & projected growth rate
        Financial performance (projected)
           EBITDA, Free Cash Flow and Net Income growth
           Exit strategy: IPO or Private Sale
        Refinance with new sub-debt or preferred
        Current and Potential size of the company’s market
     Capital Sourcing Alternatives

        Other Instruments
          Off Balance Sheet Financing: Equipment Leases
              Potential tax advantages
              Makes balance sheet “cleaner” if not capitalized
              Requires security collateral

          Sale Leaseback of Real Estate; Land and/or Building
              Type of property (office, industrial, commercial, etc.)

          Securitization of Receivables
              Available to large companies with strong customer base

     Prudent Capital Structure with Financial Flexibility

     • Value of a Firm = Present Value of Cash Flows to the Firm,
       discounted back at the cost of capital.
     • You need to optimize the value of the firm by minimizing capital costs
       while maintaining both ample free cash flow and financial flexibility.

           •   A survey of Chief Financial Officers of large U.S. companies provided the
               following ranking (from most important to least important) for the factors that
               they considered important in the financing decisions
           Factor                                                               Ranking (0-5)
           1. Maintain financial flexibility                                       4.55
           2. Ensure long-term survival                                            4.55
           3. Maintain Predictable Source of Funds                                 4.05
           4. Maximize Stock Price                                                 3.99
           5. Maintain financial independence                                      3.88
           6. Maintain high debt rating                                            3.56
           7. Maintain comparability with peer group                               2.47

     Measuring Cost of Capital

     • It will depend upon:
         – (a) the components of financing: Various tranches of debt, Equity or
           Preferred stock
         – (b) the cost of each component
     • In summary, the cost of capital is the cost of each component
       weighted by its relative market value.

                       WACC = ke (E/(D+E)) + kd (D/(D+E))

     WACC    = weighted average cost of capital
      ke     = cost of equity (obtained with CAPM)
      kd     = cost of debt (or weighted average cost of debt)
      E      = market value of equity (market cap)
      D      = market value of debt (theoretically), book debt (practically)

     Cost of Equity for Public Firms

          Dividend yields are lower than interest
           rates…so equity is cheaper…right?

     Cost of Equity for Public Firms
     • The cost of equity should be higher for riskier investments and lower
       for safer investments
     • While risk is usually defined in terms of the variance of actual returns
       around an expected return, risk and return models in finance assume
       that the risk that should be rewarded (and thus built into the discount
       rate) in valuation should be the risk perceived by the marginal
       investor in the investment
     • Most risk and return models in finance also assume that the marginal
       investor is well diversified, and that the only risk that he or she
       perceives in an investment is risk that cannot be diversified away (i.e,
       market or non-diversifiable risk)

     The Cost of Equity: Capital Asset Pricing Model

     Model      Expected Return
     CAPM       E(R) = Rf + b (Rm- Rf)

     CAPM       = capital asset pricing model
     E(R)       = expected, or required, rate of return for the equity
     Rf         = risk-free rate (10-year Treasury)
     b          = beta relative to market portfolio
     R m- R f   = expected return on the market – risk-free or market risk

     The CAPM: Cost of Equity

     • Feedback that I’ve heard regarding CAPM:

     • Come on…how can this stuff be relevant for my clients?
     • If I show this to my clients, their eyes will glaze over.

     • Does your client care about the value of his/her firm?

                $10 million FCFE, 4% growth assumption
     Key Factors that Influence Betas

                                                   Higher beta
                            High Proportion of
      Highly Leveraged
                               Fixed Costs                                       •Discretionary products and services

                                                         Nature of company and
                                                                                 •Small firms/growth firms
       Financial Leverage

                              Operating Leverage

                                                           product or service
                                                                                 •High priced goods

                                                                                 •Stable products or services
                                                                                 •Large firms

             Zero or Low    Low Proportion of                                    •Low priced goods
              Amount of       Fixed Costs

                                                    Lower beta
     Cost of Equity for Private Firms

     • My clients don’t trade publicly. All of their firm’s capital comes from
       their own pocket. So this stuff doesn’t apply to my clients, does it?

     • If your clients’ money wasn’t working in their businesses, what could
       they do with it?

     • Even if the firm is solely capitalized by owners’ capital, there is a cost
       of capital. At the least we would expect to see some form of
       opportunity cost applies to this capital. A better approach is to
       calculate the firm’s cost of equity as if it were a publicly traded entity
       and then make adjustments for lack of marketability (illiquidity

     Cost of Equity for Private Firm - Motivations
     • You will need to determine enterprise value for a private company for
         –   Legal purposes: Estate tax and divorce court
         –   Sale or prospective sale to another individual or private entity.
         –   Sale of one partner’s interest to another
         –   Sale to a publicly traded firm
         –   As prelude to setting offering price in an initial public offering
     • You can also use this approach to value a division or divisions of a
       publicly traded firm
         – As prelude to a spin off
         – For sale to another entity
         – To do a sum-of-the-parts valuation to determine whether a firm will be
           worth more broken up or if it is being efficiently run.

     A private firm’s true cost of equity……?
     • The beta of a firm measures only market risk, and is based upon the
       assumption that the investor in the business is well diversified. Given
       that private firm owners often have all or the bulk of their wealth
       invested in the private business, would you expect their perceived
       costs of equity to be higher or lower than the costs of equity from
       using betas?

     ￿…is higher than that calculated using beta.
     ￿…is lower than that calculated using beta.

     Valuation Motives and the Next Step in Private Company
     Valuation: Control and Illiquidity
     • If valuing a private business for sale (in whole or part) to another
       individual (to stay private), it is necessary that we estimate
         – a illiquidity discount associated with the fact that private businesses
           cannot be easily bought and sold
         – a control premium (if more than 50% of the business is being sold)
     • If valuing a business for taking public, it is necessary to estimate
         – the effects of creating different classes of shares in the initial public offer
         – the effects of options or warrants on the issuance price per share
     • If valuing a business for sale (in whole or part) to a publicly traded
       firm, there should be no illiquidity discount, because stock in the
       parent firm will trade but there may, however, be a premium
       associated with the publicly traded firm being able to take better
       advantage of the private firm’s strengths

     Conventional Practice on Illiquidity
     • In private company valuation, illiquidity is a constant theme that
       analysts talk about.
     • All the talk, though, seems to lead to a rule of thumb. The illiquidity
       discount for a private firm is between 20-30% and does not vary
       across private firms.

     Key Factors that Influence the Amount of the Illiquidity Discount

                                              Higher illiquidity discount

                  Less Liquid                      Small                               Troubled                      Not large

                                                                                                  Cash flow generating
                                                                  Health of the firm
     Type of assets

                                Size of the firm
     owned by firm

                More liquid                        Large                               Healthy                           Large

                                                   Lower illiquidity discount
     Empirical Evidence on Illiquidity Discounts

     • Illiquidity discounts are typically in the 25%-35% range for
       most transactions.

     (See appendix for more information on studies of restricted securities)

     Illiquidity Discount and Revenues

     Estimating the Cost of Debt
     • The cost of debt is the rate at which you can borrow at currently.
     • It will reflect not only your default risk but also the level of interest
       rates in the market.

     • The most widely used approach to estimating cost of debt is:
         – Take the weighted average coupon on book value of debt for existing
           cost of debt and to look to current market factors to determine
           appropriate spread for new debt.

     Hypothetical Illustration of WACC and Debt Ratios

                   Optimal Level Evolves with the Market
     Estimating the Optimal Capital Structure

     Hypothetical Illustration of a Capital Structure’s Impact on
     Enterprise Value
     •   The illustration below shows four capital structures for a firm with $20 million EBITDA
     •   Capital structure A = equity capital with cost of 20%.
     •   Capital structure B = same as 1, + $20mm revolver at L+200 + $40mm TL A at L+250
     •   Capital structure C = same as 2, +$20mm TL B at L+300
     •   Capital structure D = reduce TL B by $10mm + $25mm mezz at 12% cash, 2% PIK

     Hypothetical Illustration of Enterprise Value with Varying
     Capital Structure: Note Sub-Optimal Opportunity Costs

     Recapping the Cost of Capital

     In summary, the cost of capital is the cost of each component weighted by its relative market value.

                                      WACC = ke [E/(D+E)] + kd [D/(D+E)]

     where: WACC            = weighted average cost of capital
                ke          = cost of equity (capital asset pricing model)
                kd          = cost of debt
                D           = weight of debt
                E           = weight of equity

       • Equity Betas and Leverage
       • Empirical Experience on Illiquidity Discount: Restricted Shares
       • Estimating a Beta for the NY Yankees
       • Estimating a Beta for InfoSoft – A Private Firm
       • Links to articles on Cost of Capital and Excel calculators

     Equity Betas and Leverage

     • Conventional approach: If we assume that debt carries no market risk
       (has a beta of zero), the beta of equity alone can be written as a
       function of the unlevered beta and the debt-equity ratio
                               bL = bu [1+ [(1-t)D/E]]
        In some versions, the tax effect is ignored and there is no (1-t) in the

     Empirical Evidence on Illiquidity Discounts: Restricted
     • Restricted securities are securities issued by a company, but not
       registered with the SEC, that can be sold through private placements
       to investors, but cannot be resold in the open market for a two-year
       holding period, and limited amounts can be sold after that. Restricted
       securities trade at significant discounts on publicly traded shares in
       the same company.
         – Maher examined restricted stock purchases made by four mutual funds
           in the period 1969-73 and concluded that they traded an average
           discount of 35.43% on publicly traded stock in the same companies.
         – Moroney reported a mean discount of 35% for acquisitions of 146
           restricted stock issues by 10 investment companies, using data from
         – In a recent study of this phenomenon, Silber finds that the median
           discount for restricted stock is 33.75%.

     Estimating a Beta for the NY Yankees
     • You have three choices for comparable firms:
         – Firms that derive a significant portion of their revenues from baseball
           (Traded baseball teams, baseball cards & memorabilia…)
         – Firms that derive a significant portion of their revenues from sports
         – Firms that derive a significant portion of their revenues from
     Comparable firms        Levered Beta         Unlevered Beta
     Baseball firms (2)             0.70                 0.64
     Sports firms (22)              0.98                 0.90
     Entertainment firms (91)0.87                 0.79   Management target

     • Levered Beta for Yankees = 0.90 ( 1 + (1-.4) (.25)) = 1.04
     • Cost of Equity = 6% + 1.04 (4%) = 10.16%

     Estimating a beta for InfoSoft: A private software firm
     • Comparable firms include all software firms, with market
       capitalization of less than $ 500 million.
     • The average beta for these firms is 1.29 and the average debt to
       equity ratio for these firms is 7.09%. With a 35% tax rate, this yields
       an unlevered beta of:

             Unlevered Beta = 1.29/ (1 + (1-.35) (.0709)) = 1.24

     • We will assume that InfoSoft will have a debt to equity ratio
       comparable to the average for the comparable firms and a similar tax
       rate, which results in a levered beta of 1.29.

     • Cost of Equity = 6.00% + 1.29 (4%) = 11.16%


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