Module I Investment Banking Capital Structure and Valuation - PowerPoint by giv23807

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									           Module I: Investment Banking:
           Capital Structure and Valuation
                             Week 2 – January 19, 2006




J. K. Dietrich - FBE 532 – Spring 2006
   Introduction
             Cash  flows to investors and their risk determine
              the value of claims on the firm
             When a firm issues both debt and equity, it agrees
              to split the cash flows produced by its real assets
              between shareholders and bondholders. The firm’s
              mix of securities is known as its capital structure.
             Firm value depends on capital structure in a
              fundamental way. This lecture reviews the theory
              of capital structure and its links to valuation.

                                                               2
J. K. Dietrich - FBE 532 – Spring 2006
   Distribution of Corporate Income

                                         EAC (Div + Retained Earnings)
                EBIT




                                         I (Fixed Claims)


                                         T (No Value to Investors)


J. K. Dietrich - FBE 532 – Spring 2006
   Cash Flow Determination

           Items From the Income Statement
              –   Revenues (R)
              –   Cash Expenses (W)
              –   Non-Cash Expenses (Dep)
              –   Capital Expenditures (Capex)
              –   Cost of Goods Sold (CGS):
                    » Excludes depreciation
              – Interest Expense (Int)
              – Taxes (T)


J. K. Dietrich - FBE 532 – Spring 2006
   Cash Flow Determination
             Other           Items
                  –   Tax Rate (t)
                  –   Repayment of Principal (P)
                  –   Changes in Net Working Capital (DNWC)
                  –   Permanent Debt (D)




J. K. Dietrich - FBE 532 – Spring 2006
   Definition of Earnings Components
             Earnings               Before Interest & Taxes [EBIT]
                  R-(W+Dep+CGS)
             Earnings  Before Interest, Taxes,
              Depreciation (and Amortization) =
                  EBITD(A) = EBIT+Dep+(Amort)
             Amortization is associated with allocation
              of past financial investments over book
              value (e.g. good will)


J. K. Dietrich - FBE 532 – Spring 2006
   Definitions of Earnings Components
             Pre-Tax               Income
                  – [EBIT-Int]
             Tax         Bill [T]
                  – t(EBIT-Int)
             Net         Income
                  – NI =Pre-Tax Income - T




J. K. Dietrich - FBE 532 – Spring 2006
   Cash Flow Definitions
             Levered            Cash Flow [to equity] {LCF or FTE}
                  Money that goes to stockholders account
                  [R-(W+Dep+CGS+Int)](1-t)+Dep-Capex-P-DNWC
             Unlevered                  Cash Flow {UCF}
                  Cash flow that would occur if there was no debt
                  (1-t)EBIT+Dep-Capex -DNWC




J. K. Dietrich - FBE 532 – Spring 2006
   Value and Leverage Strategy
  Conservative Strategy                  Aggressive Strategy

                        Debt


                                                 Debt

                      Equity

                                                Equity



J. K. Dietrich - FBE 532 – Spring 2006
   Empirical Facts

            Most  corporations set a target debt ratio.
            There are many similarities in capital
             structure
                 – Across firms in the same industry
                 – Across industries in different countries
                 – These regularities suggest that there are some
                   fundamental determinants of capital structure


                                                                10
J. K. Dietrich - FBE 532 – Spring 2006
   Summary M-M Theory & Issues
                     M-M                   ISSUES           STATE
                                                          OF DEBATE
              CAPITAL    (1) TAXES                     TRADEOFFS
              STRUCTURE
              IRRELEVANT (2) BANKRUPTCY

                                     (3) AGENCY

                                     (4) EQUILIBRIUM
              DIVIDENDS              (1) INFORMATION   EVIDENCE
              IRRELEVANT
                                     (2) TAXES

                                     (3) MILLER-
                                     SCHOLES




J. K. Dietrich - FBE 532 – Spring 2006
   An Example
             Consider   the following data for a company
                reviewing its capital structure.
                  –   Number of Shares         100
                  –   Price Per Share          $20
                  –   Market Value of Shares   $2,000
                  –   Market Value of Debt     $0
                  –   Interest Rate            10%
                  –   Tax Rate                 0


                                                        12
J. K. Dietrich - FBE 532 – Spring 2006
   Possible Outcomes:
             Depending   on the state of the economy,
              EBIT may be as predicted, below average
              or above average.
             If EBIT is $250, as predicted, earnings per
              share are $250/100 = $2.50 and the return
              on equity is $2.50/$20 = 0.125 or 12.5
              percent.


J. K. Dietrich - FBE 532 – Spring 2006
   EBIT-EPS Table

                                         Recession   Predicted   Boom
                  EBIT ($)                 100         250       300
                   EPS ($)                 1.00        2.50      3.00
            Return on Equity (%)            5          12.5       15




         Based on the hypothetical EBITs, we can compute the
         associated EPS. This gives rise to the EBIT-EPS table or
         chart.


                                                                        14
J. K. Dietrich - FBE 532 – Spring 2006
   EBIT-EPS Chart
             3.5
              3
             2.5
              2
       EPS




             1.5
              1
             0.5
              0
                   0        50           100   150          200   250   300   350
                                                     EBIT



J. K. Dietrich - FBE 532 – Spring 2006
   Desirability of Leverage
             Suppose  the company repurchases $1,000
              of equity at $20 each
             The purchase is financed by issuing consol
              bonds.
             The new capital structure consists of 50
              shares of stock and $1,000 of debt.



J. K. Dietrich - FBE 532 – Spring 2006
   Hypothetical Outcomes:
   Levered Firm

                                           Recession   Predicted   Boom
                          EBIT ($)           100         250       300
                         Interest ($)        100         100       100
                     Equity Earnings ($)      0          150       200
                          EPS ($)             0           3         4
                    Return on Equity (%)      0           15        20




                                                                          17
J. K. Dietrich - FBE 532 – Spring 2006
      EBIT-EPS Chart
      4.5
                                                                   Levered Firm
      4.0


      3.5
                                                                      Unlevered Firm
      3.0


      2.5
EPS




      2.0


      1.5


      1.0


      0.5


      0.0
            0         50            100   150          200   250          300          350
                                                EBIT
J. K. Dietrich - FBE 532 – Spring 2006
   The Home-made Leverage
             Consider  an alternative scenario now
             Suppose an investor were to borrow $20
              and invest $40 in two (unlevered) shares of
              the original all equity company.
             The net cost to the investor is $20.




J. K. Dietrich - FBE 532 – Spring 2006
   Home Made Leverage


                                         Recession   Predicted   Boom
           Share Earnings ($)               2           5         6
           Interest on $20 ($)              2           2         2
            Net Earnings ($)                0           3         4
         Return on $20 inv (%)              0           15        20




                                                                        20
J. K. Dietrich - FBE 532 – Spring 2006
   Home Made Leverage
             The  returns from this strategy are exactly the same
              as buying 1 share of the levered firm. Therefore a
              share in the levered firm must sell for $20 (= 2 x
              20 - 20).
             Investors on their own can accomplish what the
              company can do by adding debt, so leverage will
              not create value. This leads to the famous
              irrelevance proposition of Merton Miller and
              Franco Modigliani.

                                                              21
J. K. Dietrich - FBE 532 – Spring 2006
   Miller-Modigliani Theory
             The         Miller-Modigliani Proposition I:

                With no taxes and perfect financial
                markets, the value of any firm is
                independent of its capital structure.




                                                             22
J. K. Dietrich - FBE 532 – Spring 2006
   Miller-Modigliani Theory:
   Value of the Firm
         Firm Value

                               Leverage has no effect on firm value when
                               there are no taxes and markets are perfect


                                                                All Equity
                                                                Firm Value



                                                         Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
   Miller-Modigliani Theory: WACC
                                   With no taxes and perfect markets, the
                                   weighted average cost of capital is constant

          %
                                                                   Cost of Equity



                                                                    WACC

                                                                    Cost of Debt


                                                            Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
   Implications
             The  Miller-Modigliani theorem is a starting
              point to examining capital structure effects
              in the real world.
             If capital structure matters, it is because one
              of the MM assumptions is violated.
             The first assumption to relax is the
              assumption that there are no corporate
              taxes.

                                                          25
J. K. Dietrich - FBE 532 – Spring 2006
   Miller-Modigliani Theory and Taxes
             As  a simple example, consider two firms, U
              and L.
             Firm U has no debt and firm L has issued
              consol bonds worth $200 at the current
              interest rate of 10 percent; otherwise the
              firms are the same.



                                                      26
J. K. Dietrich - FBE 532 – Spring 2006
   Levered and Unlevered Firms

                                            Firm U   Firm L
               Operating Income ($)          100      100
            - Interest to Bondholders ($)     0       -20
                = Pretax Income ($)          100      80
                  - Tax at 34% ($)           -34     -27.2
        = Net Income to Stockholders ($)     66       52.8

                Value of Equity ($)          660      528
                 Value of Debt ($)            0       200
        Value of the Firm (Debt + Equity)    660      728
                        ($)



                                                              27
J. K. Dietrich - FBE 532 – Spring 2006
   Implications
             This  simple example shows that interest tax
              deductibility increases the value of the firm
              that is levered.
             The tax bill of L is $6.80 less than that of U
             In effect, the government is paying 34
              percent of the interest expense of L. This
              perpetual reduction in taxes is worth
              $6.80/0.10 = $68.


J. K. Dietrich - FBE 532 – Spring 2006
   Value of the Interest Tax Shield
             The   present value of the tax shield accounts
              for the difference in firm value.
             If tC is the corporate tax rate and rD the debt
              rate, then interest payments = rD.D and the
              tax shield is tC.rD.D.
                  – How do we value the tax shields with risk?
                    The most common approach is that the risk of
                    the tax shields is the same as the interest
                    payments generating them.

                                                              29
J. K. Dietrich - FBE 532 – Spring 2006
   A Convenient Formula
             Forperpetual debt, we have:
                 PV tax shield = (tC.rD.D)/rD = tC.D
              which is independent of rD.
             The MM Theorem with corporate taxes
              implies: VL = VU + tCD.
                  – The PV of tax shields is lowered if the firm
                    does not borrow permanently or if it may not be
                    able to use the tax shields in the future.


                                                               30
J. K. Dietrich - FBE 532 – Spring 2006
   A Paradox
             The   Miller-Modigliani theorem implies
                capital structure is irrelevant if there are no
                taxes and capital markets are perfect.
                  – Relaxing the assumption of no corporate taxes
                    leads to the result that the company should take
                    on as much debt as it can.
                  – But an all debt company is owned by its
                    creditors. What stops a company from being
                    entirely debt financed?


J. K. Dietrich - FBE 532 – Spring 2006
   Miller-Modigliani Theory with
   Corporate Taxes
         Firm Value                      Value of a Levered Firm



                                                                   Present value of
                                                                   the tax shield

All Equity
Firm Value




                                                              Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
   MM With Taxes: WACC
                                   With taxes, the weighted average cost of
                                   capital declines with higher leverage

          %                                                       Cost of Equity




                                                                  WACC

                                                                   Cost of Debt


                                                           Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
   A Reconciliation
             What    offsets the tax advantages of debt
                financing?
                  – Bankruptcy costs
                        » But empirical evidence seems to suggest these direct
                          costs are quite small
                  – Costs of financial distress
                        » These costs may be sufficiently large as debt
                          increases that there it offsets the tax shield.



                                                                            34
J. K. Dietrich - FBE 532 – Spring 2006
   MM with Taxes and COFD
                                         Optimal Leverage Zone Balances Tax
         Firm Value                      Advantages of Debt Against the Costs of
                                         Financial Distress




                                                                     All Equity
                                                                     Firm Value



                                                              Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
 MM with Taxes and COFD: WACC
                                   The weighted average cost of capital declines
                                   with higher leverage and then rises
                                                                Cost of Equity
          %

                                                                   WACC


                                                                   Cost of Debt



                                                            Leverage Ratio
J. K. Dietrich - FBE 532 – Spring 2006
   Real-World Capital Structure
             Some            stylized facts fit well with the theory
                  – Firms with high taxes rely more on debt
                  – Firms with a high percentage of intangible
                    assets rely on equity
                  – Firms with uncertain operating income avoid
                    debt




J. K. Dietrich - FBE 532 – Spring 2006
   Cost of Capital for All Equity Firm?
             Many      - including some executives - believe
                it is zero because
                  – there is no direct cost to internal funds or from
                    equity capital issued some time ago
                  – no obligation to pay a dividend.
             This          reasoning is wrong.




J. K. Dietrich - FBE 532 – Spring 2006
   Cost of Capital for All Equity Firm?
             Itis the opportunity cost of the equity that
              matters.
             The cost of capital is simply the rate that
              investors use discount the cash flows from
              the firm. Investors will price the stock to
              offer this expected return. If CAPM holds
              we have :

                          k e  E  Re   RF   e  E  R M   RF 
                                    ~                     ~

J. K. Dietrich - FBE 532 – Spring 2006
   Cost of Capital for All-Debt
   Financed Projects
             Many    firms issue either debt or equity to
              finance purchases of new assets and
              projects. What is the cost of capital for a
              project financed 100% with debt?
             It is not the after-tax debt rate. Why?
                  – You cannot 100% debt-finance all projects
                  – Debt capacity comes from existing assets - not
                    all the tax shield is attributable to the project


J. K. Dietrich - FBE 532 – Spring 2006
   Review
             The  capital structure decision is a crucial
              one for the firm and is fundamentally linked
              to questions of valuation
             Firms trade-off the tax benefits of debt
              financing against the costs of financial
              distress
             Finding the right capital structure is difficult
              in practice

                                                          41
J. K. Dietrich - FBE 532 – Spring 2006
   Next Week – January 26
              Review  background readings on valuation
               implications of mergers and acquisitions
              Read, analyze and prepare individual write-
               up for Continental Carriers Inc. case
              Form group and sign-up members and
               schedule meetings needed for group do
               necessary work and write-up for next case
              Hand in case write-ups (group and
               individual) at the beginning of classes
J. K. Dietrich - FBE 532 – Spring 2006

								
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