VIEWS: 170 PAGES: 48 CATEGORY: Corporate Finance POSTED ON: 1/29/2011
Advanced Project Evaluation Global Financial Management 1 Overview l “Capital Structure does not matter!” » Modigliani Miller propositions – Implications for corporate debt policy » Capital structure with taxes and bankruptcy costs l Capital structure and required returns » The weighted average cost of capital (WACC) » Ungearing betas l Optimal debt policy 2 What is “Capital Structure”? l Definition The Capital Structure of a firm is the mix of different securities issued by the firm to finance its operations. » Bonds, Bank loans » Equity, Preferences shares » Warrants l What is the optimal capital structure? » Debt/equity mix » Maturity structure of debt » Option features » Currency-mix 3 Capital Structure Does not Matter! The Modigliani-Miller Propositions l Under the assumption that: » There are no taxes. » There are no costs of financial distress » There are no asymmetries of information » The investment and operating policies of the firm are given. * the value of a firm is independent of its capital structure (MM Proposition I). l However, » Assumptions are not realistic. » Focus on cases where one of the assumptions are violated. 4 Why is This True? An Example Two ways of buying the same cash flow: 1. Buy 1% of an unlevered firm Outlay: 0.01 VU (Value of unlevered firm) Payoff: 0.01 OP (Operating Profit) Can we replicate this for a levered firm? 5 Buying a Stake in an Unlevered Firm YES! 2. Buy 1% of a levered firm: Outlay: 0.01 E (Equity of unlevered firm) + 0.01 D (Debt of unlevered firm) = 0.01 VL (Value of levered firm) Payoff: 0.01 I (interest) + 0.01 Div (Dividends, OP-I) = 0.01 I + 0.01 (OP - I) = 0.01 OP Conclusion: Investors who buy 1% of all liabilities of a levered firm have the same payoffs as investors who buy 1% of the shares in an unlevered firm. VU = VL 6 Who should Borrow? Firms or Investors? Assume: Private investors can borrow and lend on the same terms as the corporation. Example 1. Buy 1% of the equity of a levered firm: Outlay: 0.01 E = 0.01 (VL - D) Payoff: 0.01 Div = 0.01 (OP - I) 2. Buy 1% of the shares in an unlevered firm and borrow 1% of the debt level of the levered firm: Outlay 0.01 VU - 0.01 D Payoff 0.01 OP - 0.01 I * If investors can borrow on the same terms, then it does not matter who borrows. VU = VL. 7 Perfect Capital Markets: Leverage and the Cost of Capital Firm Value VU VL DL/EL 8 Why Capital Structure is (Ir)relevant Investor Preferences: Investors are willing to pay a premium for wider choice of securities if: » they prefer certain types of payoffs; (e. g. highly geared securities, securities offering hedges against certain risks) – and can’t create the securities themselves (e. g. cannot borrow) – and no other firm can offer these securities. Is this realistic? » Recall NPV-rule: – are you protected from competition/imitation? – can your security be replicated? (Cf. options) – where could demand come from? 9 Leverage and the Cost of Capital l Consider an unlevered firm with earnings before interest and taxes of 100 in perpetuity and cost of capital of 10%. » Firm value is 1000 » How is this affected by leverage? l Suppose the firm issues debt of 400 with interest of 7%. » Then dividends become: 100-0.07*400=72 » The value of equity becomes: 1000-400=600 » Hence, equity holders return is: 72/600=12% l Hence, the return on the levered firm is unchanged! 0.6*12%+0.4*7%=10% l How does this work generally? 10 Leverage and the Cost of Capital: The General Result l Modigliani-Miller Proposition II: In a perfect capital market, the firm’s weighted average cost of capital is invariant to its capital structure. Hence, r*L = r*U. l This implies the following relationship between the firm’s cost of equity and its leverage: DL reL r*L r*L rd L E l In a perfect capital market, r*L = r*U =reU. This represents a return to compensate investors for the inherent business risk of the assets of the firm. 11 Leverage and the Cost of Capital A Graphical Illustration Required rLe Return rUe= rU* =rL* rLd DL/EL 12 What Determines Risk? Market value balance sheet Assets Liabilities Market value of assets Debt Equity Total value of company Total value of company Market value of assets = PV(Cash flow from operations) = PV(Cash flows - interest/principal) + PV(interest/principal) = Value of equity + value of debt The cost of capital does not depend on gearing. It depends only on the risk and return of operations. 13 The Weighted Average Cost of Capital WACC l In a perfect capital market, the firm’s weighted average cost of capital (WACC)is calculated as follows: EL DL Cost of r*L reL L rd L V V Capital l However, the WACC does not depend on leverage. r* U r*L DL/EL 14 Perfect Capital Markets: Leverage and the Cost of Capital l In addition to this business risk, there is a leverage effect. » The equityholders in the levered firm demand a higher return: » compensate them for higher risk of equity in a levered firm. l As leverage increases two things happen: » the equityholders demand higher returns. » we finance more projects by (relatively cheaper) debt. l In a perfect capital market, these two effects cancel exactly! 15 Perfect Capital Markets: Leverage and the Cost of Capital l The CAPM can be used to compute all of these discount rates: » Use the equity beta to compute the return on equity: E[reL] = rf + beL (E[rm]- rf). » Use the debt beta to compute the return on debt: E[rd] = rf + bd (E[rm]- rf). » Use the asset beta to compute a return commensurate with the business risk of the assets: E[reU] = rf + beU (E[rm]- rf). l Note that the beta of equity in an unlevered firm (beU) is also known as the beta of the assets (ba) since the unlevered firm has no leverage effect. l The only source of risk in the unlevered firm is the inherent business risk of the assets themselves. 16 Perfect Capital Markets: Leverage and the Cost of Capital l The firm’s asset beta is a weighted average of the debt and equity betas: DL EL ba bd L be L L L V V l This implies the following relationship between the firm’s equity beta and its leverage: DL b e b a b a b d L L L E 17 Capital Structure and Returns Macbeth Spot Removers is 100% equity financed and considers a debt/equity-swap. Currently: $12m equity $2m operating income (perpetuity) Plan: Retire equity worth $6m Expected return on debt: 10% » What is the required return on equity after the recapitalization? » What is the debt placed in the recapitalization worth? » What is the perpetual stream of dividends and interest? 18 MacBeth Spot Removers l Issue $6m debt, retire $6m equity » Cash flows to firm remain unaffected l Uses of funds (in perpetuity): » Interest = 0.1*$6m=$600,000 » Dividends = Operating Income - Interest = $1.4m » Return on equity = $1.4m/$6m=23.3% l Then cost of capital calculations give us: » WACC = 0.5*23.3%+0.5*10%=16.7% » Cost of capital=$2m/$12m=16.7% 19 Leverage and Beta l Assume a riskfree interest rate of rf = 10.0% and a market risk premium of [E(rM)-rf] = 8.0%. » Debt beta = 0 » Asset beta =0.833 l After the recapitalization we have: » Equity beta = 1.667 » Debt beta = 0 » Asset beta = 0.5*0+0.5*1.667=0.833 l How does shareholder wealth changed? 20 The impact of leverage: Another Example: East Western Airlines l East Western Airlines has 10 million shares out-standing, » Share price = $20 and a » equity beta = 1.0. » Plan issuing $50 million of 10% debt and using the proceeds to pay a dividend to shareholders; keep debt constant. l What effect will this capital structure change have on » the value of the firm » the WACC » the equity beta » the required return on equity » the wealth of the firm’s shareholders? l Assume a riskfree interest rate of rf = 6.0% and a market risk premium of [E(rM)-rf] = 8.0%. 21 East Western Airlines (cont.) l Value of the Unlevered Firm: VU = 10(20) = 200 million. l Cost of Capital for the Unlevered Firm: E[reU] = rf + beU (E[rm]- rf). E[reU] = 0.06 + 1.0 (0.08) = 0.14. l Since the firm is unlevered, the value of equity and cost of equity are the same as for the firm as a whole. l In perfect capital markets, VL = VU and r*L = r*U. VL = VU = $200 million r*L = r*U = 14.0% l Since the cost of debt is 10.0%, the cost of equity is determined as follows: reL = reU + [reU -rd ](D/E) reL = 0.14 + [0.14 - 0.10 ](50/150) = 0.1533. 22 The impact of leverage - Example (cont.) l The equity beta can be determined from the CAPM as follows: E[reL] = rf + beL (E[rm]- rf). 0.1533 = 0.06 + beL (0.08). beL = 1.167. l The wealth of the firm’s shareholders has not changed. Shareholder Wealth = Share Value + Dividend = $150 + $50 = $200 million 23 Corporate Taxes and Leverage Capital Structure matters if some securities enjoy favourable tax treatments. Suppose firm pays out $1 from operating income: $1 EBIT Debt Equity $1 $1(1-TC) Hence, on debt value D, pay interest rDD and receive tax shield: rDDT. What is the tax shield worth? How does this affect the cost of capital? 24 Valuing the Corporate Tax Shield Assume capital structure and interest rate are constant. Then: rD DT r DT r DT Value of tax shield = D ... D DT 1 rD ( 1 rD )2 rD Value of levered company: VL = E + D + DT = VU + DT What is the optimal capital structure now? What is missing here? – Ignores personal taxes – Ignores other costs of debt (financial distress) 25 Valuing a Tax Shield Macbeth Spot Removers Reconsider Macbeth Spot Removers Suppose Macbeth pays 10% interest on debt and 34% corporation tax on income after interest expenses. What is the income statement before/after the recapitalization? Capital Structure (Debt) 0 6,000 EBIT Interest Pre-tax income Tax After tax income Total income 26 Valuing a Tax Shield Macbeth Spot Removers l Assume the debt level is constant at $6m. Then the value of the levered firm is: VL = VU +TD VL = $12m +(0.34)($6m) =$14.04m l The value of equity changes from $12m for the unlevered firm to: $14.04m - $6m = $8.04m Hence the price drop on the ex dividend day is: $12m-$8.04m=$3.96m Shareholders receive a special dividend of $6m. Then total shareholder value is: Share price + dividend = $8.04m + $6m = $14.04m which is an increase of $2.04m – where do they come from? 27 Who Benefits from the Interest Tax Shields? East Western Airlines Reconsidered l Reconsider the East Western Airlines case: » The firm’s tax rate is 34%. » How does this capital structure change affect the value of the firm and the wealth of the firm’s shareholders? l Since the debt is perpetual, the value of the firm will increase as follows: VL = VU +TD VL = 200 +(0.34)(50) = 217 million. l Since the debt is issued at fair market value, the value of equity after the capital structure change is: Equity Value = $217 - $50 = $167 million. l Since the proceeds from the debt issue are used to pay a dividend to shareholders, their wealth increases by $17 million. This is the value of the interest tax shields on debt. Shareholder Wealth = Share Value + Dividend = $167 + $50 = $217 million 28 The Effect of Corporate Taxes and Leverage on the Cost of Capital l With corporate taxes, the firm’s weighted average cost of capital Cost of is calculated as follows: Capital EL DL r *U r*L reL L rd 1 L V V r *L DL/EL 29 Problems of Debt The costs of financial distress A firm which is unable, or expects to be unable, to meet its debt obligations is in financial distress; this is costly: l Direct costs (legal fees, administrator); usually small (typically 3% of the market value of the firm) l Costs from losses on asset values in a “fire sale”. l Losses from business opportunities » customers and suppliers. l Losses from constraints on conducting business during corporate reorganizations. Indirect costs can be substantial (20% of the value of the firm). 30 Identify Firms with Value at Risk l What are the characteristics of firms with low / high costs of financial distress? » Growth opportunities » Tangible assets » Riskiness of cash flows 31 The “Trade-off Theory” Firm value with leverage is now: VL = VU + PV(Tax shield) - PV (Costs of financial distress) Costs of distress = costs of bankruptcy x probability of bankruptcy l The probability of bankruptcy increases with the debt ratio, hence higher debt ratios imply higher expected costs of financial distress. l The optimum debt ratio trades off increases in the costs of distress against increases in the tax shield: 32 The “Trade-off” A Graphical Presentation Firm Value PV(Cost of Distress) PV(Tax Shield) Debt Ratio Optimum 33 Problems of Debt Limited Liability and Risky Investments Problem: Managers have incentives to take negative NPV projects if indebtedness is too high. Example: Firm has following asset values: Debt Equity Prob = 1/5 100 50 50 Prob = 4/5 25 25 0 Debt has a face value of 50. What is the investment policy of the firm? 34 Investment in a Levered Company Do Managers Gamble? Then we have the following market value balance sheet: Assets 40 Equity 10 Debt 30 The firm has the following investment project: Prob = 1/5 40 - 10 Prob = 4/5 0 The NPV of this project is -10*4/5+30/5=-2. Will the firm take it? 35 Value Implications of Risky Projects Equity holders decide on the basis of the value implications for shareholders: Debt Equity Prob = 1/5 130 50 80 Prob = 4/5 15 15 0 36 Risky Projects: a Conflict of Interest The market value balance sheet now looks like: Assets 38 Equity 16 Debt 22 l Hence, taking the negative NPV project has: » reduced the value of the firm by 2 » increased the value of equity by 6 » reduced the value of debt by 8 (6+2). l Risky projects with negative NPV can induce a conflict of interest between bondholders and stock-holders. l If bondholders foresee this, they will either: » impose covenants, or » require higher interest; hence, higher cost of capital 37 The Debt-Overhang Problem Now, consider an alternative project the firm may take: Prob = 1/5 5 - 10 Prob = 4/5 15 The NPV of this project is -10 + 5*1/5 +15*4/5 = +3. Will equity holders take this project? 38 Value Implications The overborrowing-trap Debt Equity Prob = 1/5 95 50 45 Prob = 4/5 30 30 0 The value of equity has now been reduced to 45*1/5=9. 39 The Conflict of Interest - Reversed The market value balance sheet becomes: Assets 43 Equity 9 Debt 34 Hence, taking this project: » increases the value of the firm by 3 » reduces the value of equity by 1 » increases the value of debt by 4 (1+3) Equity-holders would loose; project cannot be financed through equity (or junior debt). Positive NPV is lost. Only solution: » lower gearing » renegotiate debt 40 Factors that Influence Debt Policy in Practice l Tax Position of the Corporation l Costs of Bankruptcy and Financial Distress l Variability of the Firm’s Earnings and Cash Flows l Asset Type: Tangible vs. Intangible Assets l Investment (or Growth) Opportunities l The Need for Financial and Operating Flexibility l Informational Asymmetries 41 Accounting for Leverage in Capital Budgeting l Each investment project has its own cost of capital that depends upon the risk of the investment. » NPV must be computed using a discount rate appropriate for the project, not the firm. l The risk of the investment project depends upon its unlevered (asset) beta. l The unlevered cost of capital can be estimated using the CAPM. l The project’s leverage ratio should depend upon its own debt capacity, not on the particular source of funds used to finance the project. 42 Accounting for Leverage in Capital Budgeting l How do we find this? » Step 1: Compute the beta of the assets by unlevering another firm’s equity beta. » Step 2: Use the CAPM to determine a required return to compensate investors for bearing this inherent business risk. » Step 3: Use this required return to find the NPV. 43 Capital Budgeting Example l Your firm is currently in the computer software business, but is considering investing in the development of a new airline. Information on your firm and the airline industry are given below: Your Airline Firm Industry Equity Beta 1.20 1.95 Debt-Equity Ratio 0 67% Ave. Cost of Debt - 10% 44 Capital Budgeting Example l Your airline project is expected to cost $20 million per year for the next 5 years and is expected to generate after-tax cash flows of $10 million per year indefinitely thereafter. l Because of your firm’s current debt position, you will finance the airline project with 50% debt, even though this is less than standard for airline projects. l The corporate tax rate is 34%, the riskfree interest rate is 9%, and the market risk premium is 8%. 45 Capital Budgeting Example l Step 1: Unlever Equity Beta for Airlines E b b a b Equity D V Debt V l The debt beta, bD comes from the CAPM: rd 0.10 0.09 b d 0.08 b d 0.125 b a 1.95 * 0.6 0.125 * 0.4 1.22 46 Capital Budgeting Example l Step 2: Calculate the Unlevered Cost of Capital r*U 0.09 1.220.08 0.1876 l Step 3: Calculate the NPV of the Project 5 $10 $20 NPV 37.61million t 6 (11738) t t 1 (11738) t . . 47 Summary l Capital structure is irrelevant » unless there are market imperfections to exploit l Leverage changes the required rates of return on debt and equity, » but not the required rate of return on a company » unless taxes are important l Take into account costs of debt » costs of financial distress » costs from overborrowing problem » induce managers to gamble 48