Finance Lecture8

MBAM 614 Finance The Weighted Average Cost Of Capital & Efficient Markets • MBAM614 Class 8 - 1 Summary of Last Class 1. Required return and cost of capital are the same thing from different perspectives 2. Cost of Equity is estimated - with the CGM: - with the CAPM: Re = D1/P0 + g Re = Rf + βe* [E(RM) - Rf] 3. Cost of Debt can be observed in the market as can the cost of preferred 4. Weights and values are ALWAYS based on market value 5. WACC is after-tax: WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) + (P/V) × Rp • MBAM614 Class 8 - 2 1 Agenda 1. 2. 3. 4. 5. Target Capital Structure The SML and WACC Project Cost of Capital Flotation Costs and WACC Efficient Capital Markets • MBAM614 Class 8 - 3 Target Capital Structure We are only interested in how the firm plans to raise capital in the long run, its Target Capital Structure We need E, D, P, and V that reflect the firm’s Target Structure In practice, firms seldom issue more than one security at a time. In order to maintain their target however, issuing debt (for example) now would mean they need to issue equity later. – If we knew the Target Capital Structure, we would use it – We cannot measure a firm’s Target Capital Structure, so we assume it is the same as the current market value capital structure • MBAM614 Class 8 - 4 2 Example: Macy’s Macy’s is considering opening two stores, one in Seattle ($60MM) this summer and one in Orlando ($40MM) next summer. Macy’s currently has a market value capital structure of 60% debt and 40% equity which is their target. Management believes that debt, at 9% before taxes of 40%, is inexpensive this year compared to what they expect next year and that the current cost of equity, at 15%, is too high. Consequently, management plans to finance the Seattle store by issuing debt. Next year, they plan to issue equity to build the Orlando store. What WACC should be used to evaluate the Seattle store? (The Marketing people think it should be 9% and HRM doesn’t care) • MBAM614 Class 8 - 5 Example: Macy’s First, although debt will be issued now, this will move Macy’s away from its target capital structure. To move back toward its target, future capital (Orlando) will be raised as equity Long term, both stores will be financed with 60% debt and 40% equity (the Target Capital Structure) Second, since these stores are typical of Macy’s, they have the same systematic risk as the overall company so WACCMacy is the appropriate discount rate After Tax WACCMacy = (E/V) × Re + (D/V) × Rd × (1 - TC) WACC WACCMacy = (0.40)(15%) + (0.60)(9%)(1 - 0.40) = 9.24% • MBAM614 Class 8 - 6 3 Risk and WACC When is a firm’s WACC the “appropriate” discount rate to use in making investment decisions? Consider a firm with βfirm = 1.0 and WACCfirm = 15% and two possible projects with βA = 0.8, RA = 14% and βB = 1.2, RB = 16% What is the effect of using WACC for all investment decisions? – Recall that WACC is the average cost of capital for the firm and reflects the firm’s average systematic risk • MBAM614 Class 8 - 7 The SML and WACC E(R) Incorrect Acceptance SML 16 15 14 WACC Accept but should reject since return too low for risk Incorrect Rejection Rf = 7% Reject but should accept since return greater than required for risk • MBAM614 βA βfirm βB Risk, β Class 8 - 8 4 WACC and Investment Decisions If the firm’s WACC is used to evaluate all investment projects, there will be a tendency to: – incorrectly accept risky projects often leads to bankruptcy since not earning enough to compensate for risk – incorrectly reject less risky projects leads to restricted growth Projects with different systematic risk must have different WACC • MBAM614 Class 8 - 9 Divisional Cost of Capital When a firm has different operating divisions with different risks, its WACC will be an average of the divisional required returns If the projects within each division have similar risk, can develop a Divisional WACC (divisional required return) for each division Projects for each division are then evaluated using the divisional WACC Process is similar to finding a firm’s WACC • MBAM614 Class 8 - 10 5 Example: Seagram’s Just before selling MCA Studios to Vivendi, Seagram’s had two principal lines of business: Liquor and Movies. Assume MCA was about a of Seagram’s market value and its Liquor business was about b. If Seagram’s had issued debt for its liquor business, it would have been rated AA but debt for its movie business would only have been rated A. The market at the time required 9% on A rated debt and 8.25% on AA debt. Movies, being risky, had a beta of 1.2 but the liquor business, which was stable and well developed, had low risk and a beta of 0.9. The risk-free rate was 6.5% and the market risk premium was 7%. Assuming a target capital structure of 45% equity and 55% debt for all divisions and a marginal tax rate of 35% on all earnings, what were the divisional WACCs for Seagram’s? What was Seagram’s overall WACC? • MBAM614 Class 8 - 11 Example: Seagram’s MCA Studios: ReMCA = Rf + βMCA* [E(RM) - Rf] = 6.5% + (1.2)(7%) = 14.9% RdMCA = cost of A rated debt = 9% E/V = 45% and D/V = 55% WACCMCA = (E/V) × ReMCA + (D/V) × RdMCA × (1 - TC) WACCMCA = (0.45)(14.9%) + (0.55)(9.0%)(1.0-0.35) WACCMCA = 9.9% • MBAM614 Class 8 - 12 6 Example: Seagram’s Liquor Business: ReL = Rf + βL* [E(RM) - Rf] = 6.5% + (0.9)(7%) = 12.8% RdL = cost of AA rated debt = 8.25% E/V = 45% and D/V = 55% WACCL = (E/V) × ReL + (D/V) × RdL × (1 - TC) WACCL = (0.45)(12.8%) + (0.55)(8.25%)(1.0-0.35) WACCL = 8.7% Seagram’s Overall WACC: Since a of Seagram’s capital costs WACCMCA and b costs WACCL: WACCSeagram’s = a WACCMCA + b WACCL = 9.1% • MBAM614 Class 8 - 13 Pure Play Approach Another approach is to find an investment or company that has very similar risk to the project A company with a single line of business is called a Pure Play Idea is to find the required return on a pure play that is a nearly perfect substitute for the project. Eg. Suppose Irving Oil wanted to build a methanol plant. Since Irving is not presently in the methanol business, WACCIrving would not be an appropriate discount rate to use. Methanex, one of the world’s leading methanol producers, is a pure play in methanol so WACCMethanex, adjusted for differences in capital structure, would be an appropriate discount rate. • MBAM614 Class 8 - 14 7 Subjective Risk Premium Approach Another approach is to assign each project to one of several “risk classes” where each class has a different risk premium Eg. Say your company has a WACC of 12%. They may define the following risk classes: Risk Class High Moderate Low Mandatory Example New Product Expansion Replacement Pollution control Premium +8% +2% -2% n/a Disc. Rate 20% 14% 10% n/a • MBAM614 Class 8 - 15 Example: Yogi Systems Yogi Systems is considering a new BEAR computer that will save $800,000 over the next year. Savings are expected to grow by 6% per year thereafter. Given a target debt/equity ratio of 2, a cost of equity of 22%, a tax rate of 30%, and a cost of debt of 13%, what is YS’s WACC? Since the computer is new and untested technology, the project is riskier than average. Yogi’s management uses the subjective approach and applies a +3% premium to the cost of capital for projects in the BEAR’s risk class. Under what circumstances should Yogi get a new BEAR? Target Capital Structure Weights: D/E = 2 so D = 2E and V = D + E = 3E D/V = 2E/3E = 2/3 and E/V = E/3E = 1/3 • MBAM614 Class 8 - 16 8 Example: Yogi Systems WACCYogi = (1/3)(22%) + (2/3)(13%)(1.0-0.3) = 13.4% Project Discount Rate = R = 13.4% + 3% = 16.4% PV of Savings: A growing perpetuity so use CGM PV = ($800,000)/(0.164 - 0.06) = $7,692,000 Only accept when NPV > 0 or When price greater than $7,692,000, Yogi is better with an average BEAR • MBAM614 Class 8 - 17 The SML and the Subjective Approach E(R) 20 15 11 Rf = 7% Low Risk -4%% Moderate Risk +0% High Risk +5% Determine Risk Classes and Premiums Discount Rate depends on Risk Class SML WACC βfirm • MBAM614 Risk, β Class 8 - 18 9 Flotation Costs and WACC When a firm issues securities to fund a project, they must pay flotation costs These costs are a cost of the project and must be included in NPV calculations Eg. If a project costs $8,000,000 and flotation costs are 10%, a firm must raise enough money to pay the $8,000,000 after paying the flotation costs. If they raise $X, flotation costs are $X(0.10) so they must raise $X(1.0-0.1) = $8,000,000 or $X = $8,889,000. The actual cost to the firm of the project is $8,889,000. • MBAM614 Class 8 - 19 Weighted Average Flotation Costs If a firm uses different types of securities to raise capital, the Weighted Average Flotation Cost, fA, is fA = (E/V) fE + (D/V) fD + (P/V) fP E/V, D/V, and P/V are the target capital structure weights as in WACC fA does not depend on how capital is actually raised as long as the target capital structure doesn’t change The multiplier 1/(1- fA) is used to determine the gross amount of funding needed to cover both the project investment and flotation costs. • MBAM614 Class 8 - 20 10 Example: H&R Block Expansion H&R Block is considering opening another tax office in the Topanga Mall. The expansion will cost $50,000 and is expected to generate after-tax cash flows of $10,000 per year in perpetuity. The firm has a target debt to equity ratio (D/E) of 0.5. New equity has a flotation cost of 10% and a required return of 15%, while new debt costs 5% to issue and has a required return of 10%. If H&R Block’s marginal tax rate is 40%, should they open the new office? Cost of Capital: WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) WACC = (2/3)(15%) + (1/3)(10%)(1.0-0.40) = 12.0% • MBAM614 Class 8 - 21 Example: H&R Block Expansion Flotation Costs: fA = (E/V) fE + (D/V) fD + (P/V) fP fA = (2/3)(10%) + (1/3)(5%) = 8.33% NPV: Investment = $50,000/(1 - 0.0833) = $54,543 PV of Cash Flow = $10,000/0.12 = $83,333 NPV = -$54,543 + $83,333 = $28,790 > 0 YES! • MBAM614 Class 8 - 22 11 Example: Bombardier’s WACC As of January 31, 1994, Bombardier’s consolidated balance sheet looked like: Assets Current Long-term Liabilities & Equity Current $1,746 Def Taxes 111 Long-term debt 1,254 Equity Preferred 33 Common 699 R/E 650 Total $4,493 $3,517 976 Total $4,493 • MBAM614 Class 8 - 23 Example: Bombardier’s WACC Market Value Weights: Since the target capital structure for Bombardier is unknown, must use market value weights. For each security, this is the number of securities multiplied by the security’s market price. Bombardier has 1,324,200 preferred and 164,974,351 common shares outstanding. Most of Bombardier’s bonds are not traded so we cannot find their market value directly. A possible estimate is book value for bonds. This is generally NOT true for stock. • MBAM614 Class 8 - 24 12 Example: Bombardier’s WACC Market Value Weights Security Debt Preferred Common Outstanding 1,324,200 164,974,351 Price $25 $29 Mk Val $1,365 33 4,784 $6,182 Weight 22.08% 0.54% 77.38% (This includes Deferred Taxes as Long-term debt) Cost of Debt: Amount Bombardier would have to pay to issue debt now. Cannot observe so use debt of similar risk or rating. In May/95, 15-year corporate debt cost 9.25% • MBAM614 Class 8 - 25 Example: Bombardier’s WACC Cost of Preferred Shares Preferred shares carried a dividend of $1.88 and were priced at $25 Rp = Dp/ Pp = $1.88/$25 = 7.5% Cost of Common Shares Use 2 methods: - CGM using current dividend of $0.40 and estimate growth - Analysts’ forecasts - Historical growth in EPS - CAPM • MBAM614 Class 8 - 26 13 Example: Bombardier’s WACC CGM with Analysts’ forecasts: Analysts’ forecasts for g = 15% Re = D0(1+g)/P0 + g = ($0.40)(1.15)/$29 + 0.15 = 16.6% CGM with Historical Average Growth: 1994 1993 1992 1991 1990 1989 2.24 1.70 1.46 1.41 1.36 0.78 31.8% 16.4% 3.5% 3.7% 74.4% -22% 1988 1987 1986 1985 1984 1.00 0.64 0.33 0.17 0.15 56.3% 93.9% 94.1% 13.3% g = average = 36.5% Re = D0(1+g)/P0 + g = ($0.40)(1.365)/$29 + 0.365 = 38.4% • MBAM614 Class 8 - 27 Example: Bombardier’s WACC CAPM: Bombardier has a beta of 1.56, the risk-free rate is 7.3%, and the historical market risk premium is 6.58%. Re = Rf + βe* [E(RM) - Rf] Re = 7.3% + (1.56)(6.58%) = 17.6% Cost of Equity: Two of 3 give reasonably similar results. The third reflects supernormal growth which cannot be expected to continue. Use the average of the two reasonable estimates. Re = (16.6% + 17.6%)/2 = 17.1% • MBAM614 Class 8 - 28 14 Example: Bombardier’s WACC Bombardier’s WACC: WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) + (P/V) × Rp Need Bombardier’s tax rate to determine the after-tax cost of debt. Use last year’s effective tax rate of 15.25% (from I/S) WACC = (0.7738)(17.1%) + (0.2208)(9.25%)(1.0-0.1525) + (0.0054)(7.5%) = 15.00% • MBAM614 Class 8 - 29 Efficient Markets An Efficient Capital Market is one where market prices fully reflect available information There is no costless way to consistently beat the market The Efficient Markets Hypothesis (EMH) asserts that modern capital markets are efficient – implication is that securities are NPV=0 investments – securities return exactly their risk-adjusted required rate of return – due to competition between investors and traders • MBAM614 Class 8 - 30 15 Price Reaction in Efficient Markets Price ($) 220 180 Overreation and correction Delayed reaction 140 100 –8 –6 –4 –2 0 +2+4 +6 +7 Days relative to announcement day Efficient market reaction • MBAM614 Class 8 - 31 Forms of Market Efficiency Strong Form Efficiency says that prices reflect ALL information – if this was true, inside information would have no value Semi-strong Form Efficiency says that prices reflect all publicly available information – this includes past prices, weather reports, accounting info, etc. – you can’t win knowing what everyone else knows Weak Form Efficiency says that knowing past prices won’t help you beat the market • MBAM614 Class 8 - 32 16 Key Points 1. When calculating WACC and fA , always use target capital structure 2. Can estimate the target capital structure with market value weights 3. Always use the WACC that reflects the systematic risk of the project - use firm’s WACC if risk is similar to overall firm’s risk - use divisional WACC if risk is similar to a division’s risk - use the WACC of a suitable pure play - use subjective assignment to risk classes 4. Flotation costs are project expenses and must be included in project cash flows • MBAM614 Class 8 - 33 MBAM 614 Finance Capital Structure Policy • MBAM614 Class 8 - 34 17 Agenda 1. 2. 3. 4. The Capital Structure Question Impact of Financial Leverage Homemade Leverage Capital Structure and the Cost of Equity With No Taxes • MBAM614 Class 8 - 35 Why Manage the Capital Structure? Using market values: V=D+E Because debt payments are fixed, any residual cash flow gains (source of increase in V) belong to the shareholders (increase in E) Thus, maximizing the value of the firm, V, is equivalent to maximizing the value of the equity, E Maximizing the value of the firm is the goal of managing the Capital Structure • MBAM614 Class 8 - 36 18 What is the Optimal Capital Structure? The Optimal Capital Structure is the Debt/Equity (D/E) ratio that maximizes the value of the firm – assuming the firm’s assets, and thus, expected cash flows, remain constant Since V = PV(Expected CFs) discounted at the WACC, maximizing V is the same as minimizing WACC Alternatively, the Optimal Capital Structure is the D/E ratio that minimizes WACC • MBAM614 Class 8 - 37 Effects of Financial Leverage A firm is considering financial restructuring (changing its capital structure) by issuing debt to re-purchase some of its stock in the following manner: Current $5,000,000 0 5,000,000 0 $10 500,000 n/a Proposed $5,000,000 2,500,000 2,500,000 1 $10 250,000 10% Use $2,500,000 to re-purchase 250,000 shares Assume, for now, no ∆ in share price Assets Debt Equity D/E Ratio Share Price Shares Outstanding Interest Rate Conduct a scenario analysis to determine how this change affects remaining shareholders • MBAM614 Class 8 - 38 19 Effects of Financial Leverage Assuming no taxes and that capital spending equals depreciation, the amount of cash left over per share is the EPS EPS = NI/# Shares = $300,000/500,000 Current Struct Recession Expected Expansion $300,000 $650,000 $800,000 EBIT ROE = EPS/Price 0 0 0 Interest = $0.60/$10 $300,000 $650,000 $800,000 Net Income Range of EPS is $0.60 to $1.60 $0.60 $1.30 $1.60 EPS 6% 13% 16% ROE Proposed Struct $300,000 $650,000 $800,000 EBIT 250,000 250,000 250,000 Interest Net Income EPS ROE • MBAM614 Range of EPS is $0.20 to $2.20 Maximum is higher but minimum is also lower Leverage added RISK Class 8 - 39 $50,000 $0.20 2% $400,000 $1.60 16% $550,000 $2.20 22% Effects of Financial Leverage EPS ($) 3 2.5 2 Break-even EBIT ($500,000) D/E = 1 Debt is an advantage Must pay interest even if EBIT=0 1.5 1 0.5 0 – 0.5 –1 0 0.2 0.4 0.6 0.8 1 D/E = 0 Debt is a disadvantage EBIT ($ millions no taxes) • MBAM614 Class 8 - 40 20 Effects of Financial Leverage Effect of financial leverage depends on EBIT – When EBIT is high (greater than break-even), leverage increases EPS and ROE – When EBIT is low (less than break-even), leverage decreases EPS and ROE Regardless, financial leverage increases the variability of EPS and ROE Financial leverage increases the risk of equity • MBAM614 Class 8 - 41 Homemade Leverage Since leverage increases the risk of equity, capital structure would appear to be important It is possible, however, for investors to create (or eliminate) their own leverage if they can borrow and lend at the same rate the firm borrows at This implies that firms need not manage capital structure Eg. Say the firm does not go ahead with the proposed restructuring but you would like to have the same range of EPS outcomes that the firm would have had. Simply structure your investment in the firm using the proposed capital structure. That is, borrow half the money you invest in the firm. • MBAM614 Class 8 - 42 21 Example: Creating Homemade Leverage You put up $500 (your equity) and borrow $500 (your debt) to buy 100 shares ($1000 worth) EPS unlevered firm $0.60 Earnings for 100 shares $60.00 Less interest on $500 @ 10% $50.00 Net Earnings $10.00 ROE 2% $1.30 $130.00 $50.00 $80.00 16% $1.60 $160.00 $50.00 $110.00 22% The ROE is the same as for the levered firm! • MBAM614 Class 8 - 43 Example: Homemade Leverage To reverse leverage if the firm adopts the proposed structure, simply lend and invest in equity in the same proportions the firm has borrowed and issued equity Firm adopts proposed strategy, you put up $1000 (your equity) lending $500 at 10% and buying 50 shares ($500 worth) EPS levered firm $0.20 Earnings for 50 shares $10.00 Plus interest on $500 @ 10% $50.00 Net Earnings $60.00 ROE 6% $1.60 $80.00 $50.00 $130.00 13% $2.20 $110.00 $50.00 $160.00 16% The ROE is the same as for the unlevered firm! • MBAM614 Class 8 - 44 22 Example: Levered vs Unlevered Investment You are considering investing in one of two firms, U and L. Both have identical assets and identical EBIT under all circumstances. Firm U is all-equity financed while firm L uses both debt and equity (it doesn’t matter how much). Ignoring taxes, what do you get if you buy 10% of U’s equity? What if you buy 10% of L’s equity and L’s debt? VU = EU and VL = EL + DL Buying 10% of EU gives you : - 10% of VU - 10% of EBIT • MBAM614 Class 8 - 45 Example: Levered vs Unlevered Investment Buying 10% of EL and 10% of DL gives you : - (10% EL) + (10% DL) = 10%(EL + DL) = 10% VL - 10% of (EBIT-interest) because of EL - 10% of interest because of DL - Total is 10%[(EBIT-interest)+interest] = 10% of EBIT Since both investments have the same payoff (10% EBIT), they must both have the same market price 10% VU = 10% VL or VU = VL • MBAM614 Class 8 - 46 23 Miller & Modigliani Proposition I This is MM Proposition I: In the absence of taxes and other unpleasantries (most notably, unequal borrowing and lending rates), the value of the firm is unaffected by its financial policy (capital structure) Corollary: In the absence of taxes, capital restructuring doesn’t create value • MBAM614 Class 8 - 47 MM Proposition II If Proposition I is true, then WACC must be constant regardless of capital structure (remember, Prop. I assumes no taxes so we continue the assumption here) When D = 0, WACC = (E/V) × Re + (D/V) × Rd × (1 - TC) Assume Re = RA so RA TC = 0 WACC = RA = (E/V) × Re + (D/V) × Rd is also called the unlevered Increasing debt Re = RA + (RA - Rd) × (D/E) cost of equity, increases Re RU Two parts to Re : “Business Risk” & “Financial Risk” • MBAM614 Class 8 - 48 24 MM Proposition II Cost of Capital Re = RU + (RU - Rd) × (D/E) Financial Risk Premium WACC = RA Rd Rf Leverage, D/E Business Risk Premium • MBAM614 Class 8 - 49 The SML and MM Proposition II Proposition II: CAPM: Re = RA + (RA - Rd) × (D/E) Re = Rf + βe* [E(RM) - Rf] RA = Rf + βA* [E(RM) - Rf] where βA is the “asset” beta or beta when the firm is all-equity financed (sometimes called the “un-levered beta, βU”) Assuming Rd = Rf and solving for βe gives Business Risk due to riskiness of firm’s assets • MBAM614 βe = βA + βA × (D/E) Financial Risk due to use of debt - amplifies systematic risk Class 8 - 50 25 Key Points 1. The Optimal Capital Structure is the mixture of debt and equity (D/E) that maximizes the value of the firm. Equivalently, the optimal capital structure minimizes the WACC. 2. Financial leverage amplifies the systematic risk of equity 3. Equity returns have two components: a Business Risk component and a Financial Risk component 4. If taxes and other financial imperfections are ignored, firm value under all capital structures is the same. Capital structure is irrelevant. • MBAM614 Class 8 - 51 26