Financing Decisions and The Cost of Capital

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					Financing Decisions and
   The Cost of Capital
     Where do Firms Get Their
   Self Financing (using internal cash flow)
    – Accounts for 80% (avg.) of financing
    – Difficult for start-up companies

   External Financing
    – Borrowing from banks or issuing bonds
    – Sharing the business with investors by issuing
The Long-Term Financial Deficit
          (in 1999)
 Uses of Cash Flow               Sources of Cash Flow
      (100%)                           (100%)

      Capital                        Internal cash
     spending                       flow (retained
       80%                           earnings plus       Internal
                                     depreciation)      cash flow
    capital plus                     Long-term           External
     other uses                       debt and          cash flow
        20%                          equity 30%
    Where Do Small Businesses
           Get Money?
  Other Businesses



Financial Companies


                      0   10        20          30           40          50          60
                               Fraction of Funds Raised (%)

                           Source: 1987 SBA survey of firms with less than $500,000 in assets.
           What Happens As Firms Get
             Firm Size
        Very small, no track record   Small with growth potential   Medium-sized       Large with Track record

               Inside seed money
Short Debt                               Short-term commercial loans                   Commercial paper

                                               Intermediate-term commercial loans             Medium-term
   Inter-                                                                                     Notes
    Debt                                 Mezzanine Finance               Private Placements
   Debt                                                                                            Bonds

Outside Equity                        Venture Capital                  Public Equity

                                             Source: FRB Report on Private Placements, Rea et. al., 1993
      What is the Difference
    Between Debt and Equity?
      Debt                      Equity
 Fixed Promised            Uncertain residual
  payments                   cash flows
 Senior to equity          Subordinated
 Interest is deductible    Dividends are not
 Only get control           deductible
  rights in default         Comes with control
                             rights (can vote)
    Recent Trends in Financing
 This important question is difficult to answer
 Book or Market values?
    – In general, financial economists prefer market
      values. Debt levels have fallen recently.
    – However, many corporate treasurers find book
      values more appealing due to the volatility of
      market values. These have slightly risen recently.
   Whether we use book or market values, debt
    ratios for U.S. non-financial firms have
    remained below 60 percent of total financing.
              Capital Structure:
     How should a firm structure the
   liability side of the balance sheet?
 Debt vs. Equity
 We have seen how to do capital budgeting
  when the firm has debt in its capital structure.
 However, we have not figured out how much
  debt the firm should have.
   – Can the firm create value for shareholders
     through its financing decisions?
 In particular, should the firm load up with „low
  cost‟ debt?
          One possible answer:
         It makes no difference.
   Assume PCM, importantly, there are no taxes, and that the
    firm‟s investment policy is unaffected by how it finances its
   Both Modigliani and Miller won the Nobel Prize for showing:
   The value of a firm with debt is in this case equal to the
    value of the same firm without debt. MM Proposition I.
   The important idea is that since the assets are the same
    regardless of how they are financed so are the expected
    cash flows and so are the asset risks (asset betas) of a
    “levered” and “unlevered” firm.
     Irrelevance Proposition II

   What this means is that the expected return
    on equity rises with leverage according to:
    (B/S = leverage ratio -- market value of debt
    over market value of equity, r denotes
    expected return).

     rEquity  rAssets    (rAssets  rDebt )
     WACC under Irrelevance
Let the expected return on the underlying assets be 9% and the
cost of debt be 6%.

                                  Cost of
     B/S          M = B/(B+S)     Equity         WACC
           0.00           0.00          9.00       9.00
           0.50           0.33        10.50        9.00
           1.00           0.50        12.00        9.00
           1.50           0.60        13.50        9.00
           2.00           0.67        15.00        9.00
           3.00           0.75        18.00        9.00
MM Proposition II with No Corporate
      Taxes: Another View
 Cost of capital: r (%)

                                    rS  r0        (r0  rB )

                                            B          S
                          r0    rW ACC         rB       rS
                                           BS        BS

                      rB                                          rB

                               Debt-to-equity Ratio B
        What About The Tax
      Deductibility of Interest?
   Interest is tax deductible (dividends are not).
   A valuable “debt tax shield” is created by substituting
    payments of interest for payments of dividends, i.e.
    debt financing for equity financing.
   Modigliani and Miller also showed that if the only
    change in their analysis is an acknowledgement of
    the US corporate tax structure, then:
   The value of a levered firm is: VL = VU + TcB
    – the value of an equivalent unlevered firm PLUS
    – the value of the tax shields from debt.
   Firm Value always rises with additional borrowing!
   Proposition II with Taxes

 When  we take the tax deductibility of
 interest payments into account the
 equations we presented must change:
                    S        B
         rWACC        rS      rB (1  Tc )
                   SB      SB
 and
             rS  rA  (1  Tc )(rA  rB )
                     Proposition II
Cost of capital: r

                                      rS  r0        (1  TC )  (r0  rB )

                                     B                        SL
                         rW ACC          rB  (1  TC )          rS
                                    BSL                    B  SL

                                                                       ratio (B/S)
    Limits to The Use of Debt
 Given the treatment the U. S. corporate tax code
  gives to interest payments versus dividend
  payments, firms have a big incentive to use debt
 Under the MM assumptions with corporate taxes
  the argument goes to extremes and the message
  becomes: firms should use 100% debt financing.
 What other costs are associated with the use of
   – Bankruptcy costs and/or financial distress
           Bankruptcy Costs
 Direct costs:
  – Legal fees
  – Accounting fees
  – Costs associated with a trial (expert witnesses)
 Indirect costs:
   – Reduced effectiveness in the market.
   – Lower value of service contracts, warranties.
     Decreased willingness of suppliers to provide
     trade credit.
   – Loss of value of intangible assets--e.g., patents.
          Agency costs of debt
   When bankruptcy is possible incentives may be
   Example (Risk Shifting):
    – Big Trouble Corp. (BTC) owes its creditors $5 million, due in
      six months.
    – BTC has liquidated its assets because it could not operate
      profitably. Its remaining asset is $1 million cash.
    – Big Bill, the lone shareholder and general manager is
      considering two possible investments.
         (1) Buy six month T-bills to earn 3% interest.

         (2) Go to Vegas and wager the entire $1 million on a
          single spin of the roulette wheel.
    – Why might Bill consider the second “investment”?
    – Would he have considered it in the absence of leverage?
    Under-investment Problem
   Example:
    – Slight Trouble Corp. (STC) has a small but significant
      chance of bankruptcy in the next few years. Its debt is
      trading far below par.
    – Managers are evaluating an investment project that will cost
      $1 million to undertake. The alternative is to pay $1 million
      out as dividends.
    – While the NPV of the project is positive it may be that the
      shareholders are better off with the dividend than if the
      project is taken.
    – The reason is that while shareholders pay all the costs of the
      project, they will have to share the value with bondholders,
      the added value will raise bond prices as well as stock
    Disciplinary Power of Debt
   “On the other hand” as economists are fond
    of saying, debt can be a disciplinary device.
    – It has long been realized that an owner works
      harder and makes better decisions than does an
    – This was an often cited justification for the LBO
      wave of the mid 80‟s and early 90‟s.
   Idea is that one of the most contentious
    issues between managers and shareholders
    is the payout of excess cash.
    – Debt allows manager to commit to the payout in a
      way that cannot be accomplished with a dividend
  A Theory of Capital Structure

 Thevalue of a levered firm can be thought of as:
     the value of an equivalent but unlevered firm
    + present value of tax shields (net)
    – present value of expected bankruptcy costs and
      agency costs.
          The Value of the Firm with Costs
               of Financial Distress
Value of firm (V)

                                      VL = VU +TC B = Value of firm under
             Present value of tax
                shield on debt                             MM with corporate
Maximum                                                    taxes and debt
firm value                               Present value of financial distress costs
                                      V= Actual value of firm
                                      VU= Value of firm with no debt

                                                   Debt (B)
               Optimal amount of debt
The tax shield increases the value of the levered firm. Financial distress
costs lower the value of the levered firm. The two offsetting factors produce
an optimal amount of debt.
          Financing Decisions

   Pecking Order Theory says that there is no
    optimal capital structure, just the culmination
    of all your financing decisions.
    – Internally generated funds.
    – External Debt.
    – External Equity as a last resort.
   Data shows that preferences such as these
    are there but a subject of debate is whether
    they are necessarily inconsistent with there
    being an optimal capital structure.
    Choosing an Amount of Debt
   The theory provides no clear formula (unlike NPV)
    but the tradeoffs are clear; the benefits versus the
    costs of debt.
   Use more debt if:
     – effective tax rates (without debt) are higher,
     – operating cash flows are more predictable,
     – agency costs can be controlled by contracts.
   A safe strategy might be to emulate the industry average.
    After all these are the firms who have survived. From there
    you make alterations as your own situation dictates.
 Ralph‟s  firm has been in the food processing
  business for the last 10 years. It has
  maintained a conservative capital structure
  financing 60% of its value with equity.
 Ralph has recently considered investing in
  the IPO of a start-up company that will
  develop and manufacture internet
  infrastructure. In discussions with the start-
  up‟s manager, Ralph‟s nephew, it is revealed
  that the start-up will use either no or 20%
  debt financing. You have been called in to
  help identify an appropriate cost of capital for
  evaluating this investment.
           Ralph’s Dilemma

 Currently Ralph‟s equity beta is estimated at
  0.95. There is no beta we can estimate for
  this private company (the start-up) but we
  know that Cisco has an equity beta of 1.92.
 The risk free rate is 6% and the market risk
  premium is 7%. The tax rate for all
  corporations is 35%.
 How can we approach determining the
  appropriate discount rate?
     Ralph’s Dilemma cont…

 Start with the following:
                         S        
                   S  (1  T ) B   Equity
        Assets                  
                             c    
 We can reasonably assume that the asset
  beta for Cisco will be a close estimate for the
  asset beta for the start-up.
 We know that the equity beta for Cisco is
  1.92. What is Cisco‟s asset beta?
           Ralph’s Dilemma cont…
   Now we know that the asset beta for the start-up can
    be estimated at 1.92. What is the equity beta?
   We have two scenarios to consider, a debt to value
    ratio of either 0% or 20%.
   If it is zero, the equity beta equals the asset beta or
   If it is 20%, we need to use:

                       B(1  TC )          .2(1  .35 ) 
 Equity     Assets 1            1.92 1              2.23
                           S                   .8       
        Ralph’s Dilemma cont…

 Now we need a weighted average cost of
 For the case of no debt rE = rA = rWACC:
    – rE = 6% + 1.92(7%) = 19.44%.
 With    20% debt:
    –   rE = 6% + 2.23(7%) = 21.61.
    –   rD = 6% (since we assumed the debt was riskless).
    –   rWACC = 21.61%(.8) + 6%(1-.35)(.2) = 18.07%.
    –   Why was I sure that I did something wrong when I
        calculated the rWACC as 22.50% on my first try?
        Example: BK Industries
If you recall, BK was evaluating a project in a very different
industry from its own with the following incremental cash
flows (FCF). At 10% we found an NPV of $5.2 million.
($ Millions)       Year 0 Year 1 Year 2   Year 3   Year 4 Year 5
                   2000   2001   2002     2003     2004   2005
(A) Cash Flow      -26.0   0.0    -0.632 -0.865 0.375      19.298
From Investment
(B) Cash Flow      0.0     3.98   6.051   7.550    5.615   3.167
From Operations
Project Cash       -26.00 3.98    5.42    6.69     5.99    22.46
Flow [(A) + (B)]
Example: BK Industries Revisited
 BK  Industries is a conglomerate company
  with operations in marine power, pleasure
  boating, defense, and fishing tackle. BK‟s
  equity beta is 1.0. BK has and will maintain a
  debt/equity ratio of 1.0.
   – Can we use the company cost of capital to
     value the text editing project?
 Latec Inc. is a firm that makes only text
  editing systems. Latec‟s equity beta is 1.35.
  Latec has a debt to equity ratio of 0.75, and a
  marginal tax rate of 45%.
     Delevered Betas with debt/equity

   The formulas for obtaining asset betas from
    equity betas and vice versa provided earlier
    required dollars values for debt (B) and equity
    (S). What if you are only given the leverage
    ratio, L = B/S? The formulas are restated as:
                              1        
            Assets                     Equity
                        1  L(1  TC ) 
            Equity   Assets (1  L(1  TC ))
       Unlever Latec’s Beta to
       obtain the Beta of Text-
           Editing Assets:
   Latec has L =0.75, TC = .45, and an equity
    beta of 1.35.

                           1          
       Assets                       1.35  0.955
                   1  0.75(1  0.45) 
  Relever the asset Beta to
reflect BK’s capital structure:

 Recalling that BK will keep its debt/equity
 ratio equal to one, we can get:

      Equity  0.9551  1(1  .45)   1.48

 •This is the beta for a BK equity position in a text
  editing asset.
 •Why is this equity beta greater than Latec’s?
           BK Industries, Cont.
     Assume that the risk free rate is 8% and that
      BK‟s cost of debt is also 8%. The market risk
      premium is 7%. Then the required return on
      BK‟s equity is:
requity  RF   ( E[ RM ]  RF )  8%  1.48 * 7%  18.36%
  The weighted average cost of capital for the text
  editing venture (using the fact that B/S = 1) is:
               S           B
  WACC             rS         rB (1  TC )
            SB          SB
       S                 B
  =       18.36%            8%(1  0.45)  11.38%
    S+B                S+B
 Finally,we can evaluate the NPV of the text
  editing venture using the WACC that reflects the
  risk associated with this particular business.
  Using the cash flow estimates obtained earlier:
                 3.980    5.419      6.685     5.990      22.465
  NPV  26.0                                      
               (1.1138) (1.1138) 2 (1.1138)3 (1.1138) 4 (1.1138)5
       $3.78 Million
• The NPV is positive, so proceed with the text editing business.
• Note also that the market value of the project will be $28.78 M.
• Notice that the selected discount rate of 11.38% reflects:
    The risk (beta) of text editing businesses, not BK’s existing
    BK’s capital structure, not that of the comparable firm.
 BK Industries‟ debt to equity ratio is 1.0
 as it is for the project. BK‟s equity beta
 prior to starting the text editing business
 was 1.0 (levered beta).
  – What will happen to the beta of BK Industries after
    starting the text editing business?
  – Suppose that BK uses its firm cost of capital to
    evaluate the text business? Would this favor the
  – Does BK diversifying into the text editor business
    help shareholders by providing them a more
    diversified portfolio?
      An Alternative Approach

   The Adjusted Present Value (APV):
    – Follows from the MM equation
                      VL = VU + TCB.
    – Take the value of the project, if it were unlevered,
      then add the debt tax shields (more completely the
      additional effects of debt).
    – Let‟s just do the exercise. We have cash flows for
      the unlevered firm but remember that the formulas
      are derived using a perpetuity (a simplification).
    – If BK‟s project generates $3.39124 million each
      year forever its NPV is the same using the WACC.
       An Alternative Approach
   The unlevered NPV is now, using the perpetual
    equivalent cash flow derived as follows:
    – rA = 8% + .955(7%) = 14.69%
    – NPVU = $3.39124/.1469 – $26 = - $2.9 m
    – APV = NPVU + TCB = -$2.9 + .45($14.9m)
                         = +$3.79 m.
   This approach is most useful when you know the
    dollar amount of debt that will be used each year
    rather than the debt ratio over the life of the project
    (perhaps an LBO or other highly levered