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Leverage and WACC

FINC361 Fall2016
Professor Mahdi Mohseni

Discount rate for the entire firm


Mix of debt and equity =
Capital structure of a firm

From your investment class:


Return on a portfolio = weighted average return of its
individual securities

Assets financed by a portfolio of debt and equity


Weighted average cost of capital (WACC)
1. Cost of debt
2. Cost of equity
Weights = Market values of debt and equity

WACC (no tax)


Formula
rwacc

Fraction of Firm Value


Financed
by
Equity

E
D
rE +
rD
E + D
E + D

Equity Fraction of Firm Value

Cost
of
Capital
Financed
by
Debt

where:
1. E = Market value of equity
2. D = Market value of debt
Market value of debt Book value of debt

Remark: If no debt (D=0) then rWACC=rE


Simplification: No taxes here

Debt

Cost
of
Capital

Wait a minute
Usually: Cost of debt << cost of equity
Example: Southwest
YTM = 3.25%
From Yahoo! Finance: Beta = 1.23
Rf = current YTM of a 10-year U.S. government bond
Market risk premium = 5%
CAPM: E(R)= Rf+beta*[Rm-Rf]= 2% + 1.23*5% = 8.15%
rD << rE

Cant we decrease the overall cost of capital by


loading up on debt?!?

WACC and the marginal cost fallacy


If there are no frictions in capital markets
No taxes, no bankruptcy cost, no transaction costs, etc.

You cannot reduce your cost of capital simply by


increasing the amount of debt financing!
Why?
Because increasing debt makes equity riskier
The required rate of return on the remaining equity portion
of financing goes up to compensate investors

You cannot look at the cost of debt in isolation

Case 1: 100% Equity


1,000.00

Free Cash Flow for equity holders:


(Logarithmic scale to represent better volatility)

Between 2000
and 2001,
there was a
40% drop in
free cash flows

100.00

10.00

1.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Cash Flow To Equity

Equity holders have 100% of firm. In that case:


Volatility of free cash flows from underlying business
= Volatility of free cash flows of equity holders

Case 2: Introduction of debt


Free Cash Flows for equityholders (red) and
debtholders (blue)
Axis Title

$100.00

Cash Flow To Equity

$10.00

Cash Flow to Debt


$1.00
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

$100.00

Axis Title

Between 2000
and 2001, there
was a 40% drop
in free cash
flows

$10.00

Cash Flow To Equity

Between 2000
and 2001, that
same drop
corresponds to a
90% drop in cash
flows left for the
remaining equity
portion!

$1.00

Equity holder = Residual claimants (paid only after debtholders)


Their cash flows are much more volatile now
They will require a much higher rate of return!

Modigliani-Miller
The ModiglianiMiller theorem (of Franco Modigliani, Merton
Miller) is a theorem on capital structure, arguably forming the
basis for modern thinking on capital structure.
Assumptions: There are no taxes, bankruptcy costs, agency
costs, and asymmetric information

Proposition I
The basic theorem states that under certain assumptions the
value of a firm is unaffected by how that firm is financed
=

is the value of an unlevered firm (a firm composed only of equity)


is the value of a levered firm (a firm that is composed of a mix of debt and equity)

Modigliani-Miller
MM Proposition II
Leverage and the cost of equity

RL

Expected return on
leveraged equity

D
=
RU
+
( RU RD )

Expected return on
unleveraged equity

Additional risk premium


due to leverage

where RD : Expected return on debt

A picture is worth a 1000 words


Case 1: All equity

Case 1:
rWACC=15%

Case 2: 50% equity, 50% debt

Case 2:
rWACC=15%

What is
happening
here?
Think of the
riskiness of
cash flows for
debtholders

Far reaching consequences of


Modigliani-Miller
With perfect capital markets (no market frictions):
1. Capital structure decisions do not affect firm value
2. (capital structure) = Repackaging of cash flows
You cannot reduce your cost of capital just by changing your
capital structure without relying on some sort of friction!

Far reaching consequences of


Modigliani-Miller (continued)
M&M Propositions:

They tell us when capital structure choices affect firm value!

Capital structure matters in the presence of frictions:


1.
2.
3.
4.

Taxes
Bankruptcy or financial distress costs
Manager-shareholder conflict
Asymmetry in information

Reasoning here: Insiders know more than outsiders


When management issues a certain type of security, they can reveal
something about the underlying cash flows

Butcapital structure does matter in practice!

Why? Taxes!
Recall:
Corporations pay taxes
on their profits after
interest payments are
made
Interest expense
reduces the amount of
corporate taxes
TAX SHIELD BENEFIT
OF DEBT

Increasing firm value with


tax shield benefit of debt

Safeway, Inc.

/d
/
Safeways marginal corporate tax rate was 35%

Lower net income with leverage but

Recall: What matters are the cash flows distributed to


bondholders and shareholders:

Safeway managed to increase the size of the cash


&&D
DD
Tax shield benefit of debt
Interest Tax Shield

Corporate Tax Rate u Interest Payments

Tax shield benefit of debt:


Impact on firm value

Safeway managed to increase the total size of the cash distribution


to its capital providers (i.e. Free Cash Flows) D

Example over several years

Solution

Valuing the interest tax shield

When a firm uses debt, the interest tax shield provides a


corporate tax savings every year
Firm value increases by the PV of all future interest tax shields

VLev

VUnlev  PV (Interest Tax Shield)

Firm value with tax benefit:


Simple formula

With a few assumptions:


Get simple expression for the tax shield benefit of debt

Assume:
1. Constant marginal tax rate
2. Firm borrows a permanent dollar amount of debt D

That means the firm would refinance D with new debt when
it comes to maturity

3. Cost of debt = rD

Firm value with tax benefit:


Simple formula
Every year, you save:
Interest Tax shield Corporate Tax Rate u Interest Payments
W u Interest Payments W u rD u D

The stream of cash flow is aperpetuity!


Interest tax shield fluctuates with debt
Hence same riskiness
Hence same discount rate: rD

PV (Interest Tax Shield)

VLev

W u rD u D
rD

VUnlev  W u D

Firm value with tax shield benefit of debt


Value of leveraged firm
with corporate
taxes

Value of firm (V)


Present value of tax
shield on debt

VL = VU + D

VU = Value of firm with no tax benefit

Debt (D)

In practice:
How is the tax shield benefit of debt
incorporated in DCF valuation?
Recall:
Free Cash Flows (FCFs) do not reflect any effect of
the choice of financing
Free Cash Flow EBIT u (1 - W c )
 Depreciation
 Increases in Net Working Capital
 Capital expenditures

All the effect will be through the discount rate


WACC with taxes

Tax benefit of debt and WACC


^
1. 10% interest rate
/
Pre-
If 
You have effectively lowered your interest rate to 6.5%

Effective after-tax borrowing rate = rDW)


WACC with taxes:

rwacc

E
D
rE 
rD (1  W )
E  D
E  D

WACC with taxes


With tax-deductible interest, the effective
after-tax borrowing rate is rd(1 W) and the
weighted average cost of capital becomes:
rwacc

rwacc

E
D
rE 
rD (1  W c )
E  D
E  D
E
D
D
rE 
rD 
rDW c
E  D

E  D
E  D



Pretax WACC

Reduction Due
to Interest Tax Shield

PictureofWACCwithtaxes

Taxes matter:
Capital structure can affect firm value
Increase in debt Less taxes (lower WACC) Higher firm value
Remark: No cost of bankruptcy here

Incentives to increase your debt to a higher target leverage

What is the optimal level of debt?

Now that taxes matter, it seems we should load


up massively on debt, no?!

LimitstotheTaxBenefitofDebt
Toreceivethefulltaxbenefitsofleverage,a
firmdoesnotneedtouse100%debt
financing.However,thefirmdoesneedto
havetaxableearnings.
Thismaylimittheamountofdebtneededto
maximizethetaxshield.

TaxSavingswithDifferentAmountsofLeverage

Withnoleverage,thefirmreceivesnotaxbenefit.
Withhighleverage,thefirmsaves$350intaxes.
Withexcessleverage,thefirmhasanetoperatinglossand
thereisnoincreaseinthetaxsavings.

DebttoValueRatio[D/(E+D)]forSelectIndustries

Source: Capital IQ, 2012.

InterestPaymentsasaPercentageofEBITandPercentageof
FirmswithNegativePretaxIncome,S&P50019752011

Source: Compustat.

What is the optimal level of debt?

It appears that firms have far less leverage than our


analysis of interest tax shield would predict. Why?

Debt offers tax savings but there are clear limits


to the use of debt:
With high leverage, the probability of bankruptcy and
financial distress goes up

Costs of bankruptcy and more generally financial distress


will offset the tax shield benefits of debt