SESSION 3

SESSION 3

Dr ASHISH VARMA
 The Cost of Capital
The Cost of Capital
• Cost of Capital Components
Cost of Capital Components
– Debt
– Preferred
– Common Equity
• WACC

2
 What types of long‐term capital do 
firms use?
• Long
Long‐term
term debt
debt
• Preferred stock
• Common equity
C i

3
 Capital Components
Capital Components
• Capital
Capital components are sources of funding that 
components are sources of funding that
come from investors.
• Accounts payable, accruals, and deferred taxes are 
p y , ,
not sources of funding that come from investors, so 
they are not included in the calculation of the cost of 
capital.
• We do adjust for these items when calculating the 
cash flows of a project, but not when calculating the 
h fl f b h l l h
cost of capital.

4
 Should we focus on before‐tax or 
after‐tax capital costs?
f i l ?
• Tax
Tax effects associated with financing can be 
effects associated with financing can be
incorporated either in capital budgeting cash 
flows or in cost of capital.
• Most firms incorporate tax effects in the cost 
of capital.  Therefore, focus on after‐tax costs.
• Only cost of debt is affected.

5
Should we focus on historical (embedded) costs or 
new (marginal) costs?
( i l) ?

• The
The cost of capital is used primarily to make 
cost of capital is used primarily to make
decisions which involve raising and investing 
new capital So we should focus on marginal
new capital.  So, we should focus on marginal 
costs.

6
 Cost of Debt
Cost of Debt
• Method
Method 1: Ask an investment banker what the 
1: Ask an investment banker what the
coupon rate would be on new debt.
• Method 2: Find the bond rating for the 
Method 2: Find the bond rating for the
company and use the yield on other bonds 
with a similar rating.
• Method 3: Find the yield on the company’s 
debt, if it has any.

7
Is preferred stock more or less risky to 
investors than debt?
h d b
• More
More risky; company not required to pay 
risky; company not required to pay
preferred dividend.
• However, firms want to pay preferred 
However firms want to pay preferred
dividend.  Otherwise, (1) cannot pay common 
dividend (2) difficult to raise additional funds
dividend, (2) difficult to raise additional funds, 
and (3) preferred stockholders may gain 
control of firm
control of firm.

8
 Why is yield on preferred
l
lower than r
h d?
• Corporations
Corporations own most preferred stock, because 
own most preferred stock, because
70% of preferred dividends are nontaxable to 
corporations.
• Therefore, preferred often has a lower 
B‐T yield than the B‐T yield on debt.
• The A‐T yield to investors and A‐T cost to the issuer 
are higher on preferred than on debt, which is 
consistent with the higher risk of preferred.
h h h h k f f d

9
What are the two ways that companies can raise 
common equity?
i ?
• Directly
Directly, by issuing new shares of common 
by issuing new shares of common
stock.
• Indirectly, by reinvesting earnings that are not 
Indirectly by reinvesting earnings that are not
paid out as dividends (i.e., retaining earnings).

10
 Why is there a cost for reinvested 
earnings?
• Earnings
Earnings can be reinvested or paid out as 
can be reinvested or paid out as
dividends.
• Investors could buy other securities, earn a 
Investors could buy other securities earn a
return.
• Thus, there is an opportunity cost if earnings 
Th h i i if i
are reinvested.

11
 Cost for Reinvested Earnings 
(
(Continued)
d)
• Opportunity
Opportunity cost:  The return stockholders 
cost: The return stockholders
could earn on alternative investments of equal 
risk.
risk
• They could buy similar stocks and earn rs, or 
company could repurchase its own stock and
company could repurchase its own stock and 
earn rs.  So, rs, is the cost of reinvested 
earnings and it is the cost of equity
earnings and it is the cost of equity.

12
 Issues in Using CAPM
Issues in Using CAPM
• Most
Most analysts use the rate on a long
analysts use the rate on a long‐term
term (10 
(10
to 20 years) government bond as an estimate 
of rRF For a current estimate go to
of rRF.  For a current estimate, go to 
www.bloomberg.com, select “U.S. Treasuries” 
from the section on the left under the heading
from the section on the left under the heading 
“Market.”

More…
13
 Issues in Using CAPM (Continued)
Issues in Using CAPM (Continued)
• Most
Most analysts use a rate of 5% to 6.5% for the 
analysts use a rate of 5% to 6 5% for the
market risk premium (RPM)
• Estimates of beta vary, and estimates are 
Estimates of beta vary and estimates are
“noisy” (they have a wide confidence interval).  
For an estimate of beta go to
For an estimate of beta, go to 
www.bloomberg.com and enter the ticker 
symbol for STOCK QUOTES
symbol for STOCK QUOTES.

14
 Estimating the Growth Rate
Estimating the Growth Rate
• Use
Use the historical growth rate if you believe 
the historical growth rate if you believe
the future will be like the past.
• Obtain analysts
Obtain analysts’ estimates: Value Line, Zack
estimates: Value Line Zack’ss, 
Yahoo.Finance.
• Use the earnings retention model, illustrated 
U h i i d l ill d
on next slide.

15
Earnings Retention Model (Continued)
Earnings Retention Model (Continued)
• Retention growth rate:
g

g = ROE(Retention rate) 

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.  Think of bank 
account paying 15% with retention ratio = 0.  What is 
g of account balance? If retention ratio is 100%
g of account balance?  If retention ratio is 100%, 
what is g?

16
Could DCF methodology be applied if g 
is not constant?
• YES
YES, nonconstant g stocks are expected to 
nonconstant g stocks are expected to
have constant g at some point, generally in 5 
to 10 years
to 10 years.
• But calculations get complicated.  See “FM11 
Ch 9 Tool Kit xls”.
Ch 9 Tool Kit.xls

17
Determining the Weights for the WACC
Determining the Weights for the WACC
• The
The weights are the percentages of the firm 
weights are the percentages of the firm
that will be financed by each component.
• If possible, always use the target weights for 
If possible always use the target weights for
the percentages of the firm that will be 
financed with the various types of capital
financed with the various types of capital. 

18
 Estimating Weights for the Capital 
Structure
• If
If you don
you don’tt know the targets, it is better to 
know the targets it is better to
estimate the weights using current market 
values than current book values
values than current book values.
• If you don’t know the market value of debt, 
then it is usually reasonable to use the book
then it is usually reasonable to use the book 
values of debt, especially if the debt is short‐
term.
term

(More...)
19
 What factors influence a company’s 
WACC?
• Market
Market conditions, especially interest rates 
conditions especially interest rates
and tax rates.
• The firm
The firm’ss capital structure and dividend 
capital structure and dividend
policy.
• The firm’s investment policy.  Firms with 
Th fi ’ i li Fi ih
riskier projects generally have a higher WACC.

20
 Should the company use the composite WACC 
as the hurdle rate for each of its divisions?
h h dl f h f i di i i ?
• NO!
NO!  The composite WACC reflects the risk of 
The composite WACC reflects the risk of
an average project undertaken by the firm.
• Different divisions may have different risks.  
Different divisions may have different risks
The division’s WACC should be adjusted to 
reflect the division’ss risk and capital structure.
reflect the division risk and capital structure

21
 What procedures are used to determine the risk‐
adjusted cost of capital for a particular division?
dj t d t f it l f ti l di i i ?

• Estimate
Estimate the cost of capital that the division 
the cost of capital that the division
would have if it were a stand‐alone firm.  
• This requires estimating the division
This requires estimating the division’ss beta, 
beta
cost of debt, and capital structure.

22
Pure Play Method for Estimating Beta for a 
Division or a Project
i ii j
• Find
Find several publicly traded companies 
several publicly traded companies
exclusively in project’s business.
• Use average of their betas as proxy for 
Use average of their betas as proxy for
project’s beta.
• Hard to find such companies.
H d fi d h i

23
 What are the three types of project 
risk?
k
• Stand
Stand‐alone
alone risk
risk
• Corporate risk
• Market risk
k ik

24
 How is each type of risk used?
How is each type of risk used?
• Stand‐alone
Stand alone risk is easiest to calculate.
risk is easiest to calculate.
• Market risk is theoretically best in most 
situations.
• However, creditors, customers, suppliers, and 
employees are more affected by corporate
employees are more affected by corporate 
risk.
• Therefore, corporate risk is also relevant.
Therefore, corporate risk is also relevant.

25
 Why is the cost of internal equity from reinvested 
earnings cheaper than the cost of issuing new 
g p g
common stock?
• When
When a company issues new common stock 
a company issues new common stock
they also have to pay flotation costs to the 
underwriter.
underwriter
• Issuing new common stock may send a 
negative signal to the capital markets which
negative signal to the capital markets, which 
may depress stock price.

26
 Comments about flotation costs:
Comments about flotation costs:
• Flotation
Flotation costs depend on the risk of the firm and the 
costs depend on the risk of the firm and the
type of capital being raised.
• The flotation costs are highest for common equity.  
g q y
However, since most firms issue equity infrequently, 
the per‐project cost is fairly small.
• We will frequently ignore flotation costs when 
calculating the WACC.

27
 Four Mistakes to Avoid
Four Mistakes to Avoid
• Current
Current vs. historical cost of debt
vs historical cost of debt
• Mixing current and historical measures to 
estimate the market risk premium
estimate the market risk premium
• Book weights vs. Market Weights
• Incorrect cost of capital components

• See next slides for details.
(More ...)
28
 Four Mistakes to Avoid
Four Mistakes to Avoid
• Mistake
Mistake 1: When estimating the cost of debt, don
1: When estimating the cost of debt, don’tt 
use the coupon rate on existing debt. Use the current 
interest rate on new debt.
• Mistake 2: When estimating the risk premium for the 
CAPM approach, don’t subtract the current long‐
term T‐bond rate from the historical average return 
on common stocks.

(More ...)
29
 Mistake 2 (Continued)
Mistake 2 (Continued)
• For
For example, if the historical r
example if the historical rM 
M has been 
has been
about 12.2% and inflation drives the current 
rRF up to 10%, the current market risk 
up to 10% the current market risk
premium is not 12.2% ‐ 10% = 2.2%!

(More ...)
30
 Mistake 3: Estimating Weights
Mistake 3: Estimating Weights
• Use
Use the target capital structure to determine the 
the target capital structure to determine the
weights.
• If you don’t know the target weights, then use the 
y g g ,
current market value of equity, and never the book 
value of equity. 
• If you don’t know the market value of debt, then the 
book value of debt often is a reasonable 
approximation, especially for short‐term debt. 
ll f h d b

(More...)
31
 Mistake 4: Capital components are sources of funding 
th t
that come from investors.
f i t

• Accounts
Accounts payable, accruals, and deferred taxes are 
payable, accruals, and deferred taxes are
not sources of funding that come from investors, so 
they are not included in the calculation of the WACC.
• We do adjust for these items when calculating the 
cash flows of the project, but not when calculating 
the WACC.

32
 Why are ratios useful?
Why are ratios useful?
• Standardize numbers; facilitate comparisons
Standardize numbers; facilitate comparisons
• Used to highlight weaknesses and strengths

33
 Five Major Categories of Ratios
Five Major Categories of Ratios
• Liquidity:
Liquidity:  Can we make required payments as 
Can we make required payments as
they fall due?
• Asset management:  Do we have the right 
Asset management: Do we have the right
amount of assets for the level of sales?

(More…)
34
 Ratio Categories (Continued)
Ratio Categories (Continued)
• Debt
Debt management:  Do we have the right mix 
management: Do we have the right mix
of debt and equity?
• Profitability:  Do sales prices exceed unit costs, 
Profitability: Do sales prices exceed unit costs
and are sales high enough as reflected in PM, 
ROE and ROA?
ROE, and ROA?
• Market value:  Do investors like what they see 
as reflected in P/E and M/B ratios?
fl d i P/E d M/B i ?

35
 Analysis of Common Size Balance 
Sheets
h
• Computron
Computron has higher proportion of inventory 
has higher proportion of inventory
and current assets than Industry.
• Computron now has more equity (which 
Computron now has more equity (which
means LESS debt) than Industry.
• Computron has more short
Computron has more short‐termterm debt than 
debt than
industry, but less long‐term debt than 
industry.

36
 Explain the Du Pont System
Explain the Du Pont System
• The Du Pont system focuses on:
The Du Pont system focuses on:
– Expense control (PM)
– Asset utilization (TATO)
Asset utilization (TATO)
– Debt utilization (EM)
• It
It shows how these factors combine to 
h h th f t bi t
determine the ROE.

37
 Potential Problems and Limitations of 
Ratio Analysis?
l
• Comparison
Comparison with industry averages is difficult 
with industry averages is difficult
if the firm operates many different divisions.
• “Average”
Average  performance is not necessarily 
performance is not necessarily
good.
• Seasonal factors can distort ratios
S lf di i

(More…)
38
Problems and Limitations (Continued)
Problems and Limitations (Continued)
• Window dressing techniques can make statements 
g q
and ratios look better.
• Different accounting and operating practices can 
distort comparisons
distort comparisons.
• Sometimes it is difficult to tell if a ratio value is 
“good” or “bad.”
• Often, different ratios give different signals, so it is 
difficult to tell, on balance, whether a company is in 
a strong or weak financial condition.
g

(More…)
39
 Qualitative Factors
Qualitative Factors
• Are
Are the company
the company’ss revenues tied to a single 
revenues tied to a single
customer?
• To what extent are the company
To what extent are the company’ss revenues 
revenues
tied to a single product?
• To what extent does the company rely on a 
T h d h l
single supplier?

(More…)
40
 Qualitative Factors (Continued)
Qualitative Factors (Continued)
• What
What percentage of the company
percentage of the company’ss business is 
business is
generated overseas?
• What is the competitive situation?
What is the competitive situation?
• What does the future have in store?
• What is the company’s legal and regulatory 
environment?

41
Corporate Valuation: A company owns two 
types of assets.
f
• Assets‐in‐place
Assets in place
• Financial, or nonoperating, assets  

42
 Assets in Place
Assets‐in‐Place
• Assets‐in‐place
Assets in place are tangible, such as buildings, 
are tangible such as buildings
machines, inventory.
• Usually they are expected to grow.
Usually they are expected to grow
• They generate free cash flows.
• The PV of their expected future free cash 
flows, discounted at the WACC, is the value of 
operations.

43
 Nonoperating Assets
Nonoperating Assets
• Marketable
Marketable securities
securities
• Ownership of non‐controlling interest in 
another company
another company
• Value of nonoperating assets usually is very 
close to figure that is reported on balance 
l fi h i d b l
sheets.

44
 Total Corporate Value
Total Corporate Value
• Total corporate value is sum of:
Total corporate value is sum of:
– Value of operations
– Value of nonoperating assets
Value of nonoperating assets

45
 Claims on Corporate Value
Claims on Corporate Value
• Debtholders have first claim.
Debtholders have first claim
• Preferred stockholders have the next claim.
• Any remaining value belongs to stockholders.
i i l b l kh ld

46
 Data for Valuation
Data for Valuation
• FCF0 = $20 million
= $20 million
• WACC = 10%
• g = 5%
%
• Marketable securities = $100 million
• Debt = $200 million
• Preferred stock = $50 million
Preferred stock  $50 million
• Book value of equity = $210 million

47
 Market Value Added (MVA)
Market Value Added (MVA)
• MVA
MVA = Total corporate value of firm minus 
= Total corporate value of firm minus
total book value of firm
• Total book value of firm = book value of equity 
Total book value of firm = book value of equity
+ book value of debt + book value of preferred 
stock
• MVA = $520 ‐ ($210 + $200 + $50)
= $60 million

48
 Breakdown of Corporate Value
Breakdown of Corporate Value

600 MVA

500 Book equity

q y
400
Equity (Market)
300
Preferred stock
200

100 Debt

0
Marketable
Sources Claims Market securities
of Value on Value vs. Book Value of operations

49
 Horizon Value
Horizon Value
• Free
Free cash flows are forecast for three years in 
cash flows are forecast for three years in
this example, so the forecast horizon is three 
years.
years
• Growth in free cash flows is not constant 
during the forecast so we can’tt use the 
during the forecast, so we can use the
constant growth formula to find the value of 
operations at time 0
operations at time 0. 

50
 Horizon Value (Cont.)
Horizon Value (Cont.)
• Growth
Growth is constant after the horizon (3 years), 
is constant after the horizon (3 years)
so we can modify the constant growth formula 
to find the value of all free cash flows beyond
to find the value of all free cash flows beyond 
the horizon, discounted back to the horizon. 

51
 Horizon Value Formula
Horizon Value Formula

FCFt(1+g)
HV = VOp at time t = 
((WACC ‐ g)

• Horizon value is also called terminal value, 
or continuing value.
ti i l
52
 Value‐Based
Value Based Management (VBM)
Management (VBM)
• VBM
VBM is the systematic application of the 
is the systematic application of the
corporate valuation model to all corporate 
decisions and strategic initiatives
decisions and strategic initiatives.
• The objective of VBM is to increase Market 
Value Added (MVA)
Value Added (MVA)

53
 MVA and the Four Value Drivers
MVA and the Four Value Drivers
• MVA is determined by four drivers:
MVA is determined by four drivers:
– Sales growth
– Operating profitability (OP=NOPAT/Sales)
Operating profitability (OP=NOPAT/Sales)
– Capital requirements (CR=Operating capital / 
Sales)
– Weighted average cost of capital

54
 Improvements in MVA due to the 
Value Drivers
l
• MVA will improve if:
MVA will improve if:
– WACC is reduced
– operating profitability (OP) increases
operating profitability (OP) increases
– the capital requirement (CR) decreases

55
 The Impact of Growth (Cont.)
The Impact of Growth (Cont.)
• If
If the second term in brackets is negative, then 
the second term in brackets is negative then
growth decreases MVA.  In other words, 
profits are not enough to offset the return on
profits are not enough to offset the return on 
capital required by investors.
• If the second term in brackets is positive, then 
If the second term in brackets is positive then
growth increases MVA.

56
 Analysis of Growth Strategies
Analysis of Growth Strategies
• The
The expected ROIC of Division A is less than the 
expected ROIC of Division A is less than the
WACC, so the division should postpone growth 
efforts until it improves EROIC by reducing capital 
requirements (e.g., reducing inventory) and/or 
improving profitability.
• The expected ROIC of Division B is greater than the 
WACC, so the division should continue with its 
growth plans
growth plans.

57
Two Primary Mechanisms of Corporate 
Governance
• “Stick”
Stick
– Provisions in the charter that affect takeovers.
– Composition of the board of directors.
Composition of the board of directors
• “Carrot”
– Compensation plans.

58
 Entrenched Management
Entrenched Management
• Occurs
Occurs when there is little chance that poorly 
when there is little chance that poorly
performing managers will be replaced.
• Two causes:
Two causes:
– Anti‐takeover provisions in the charter
– Weak board of directors
W k b d f di

59
 How are entrenched managers 
h
harmful to shareholders?
f l h h ld
• Management consumes perks:
Management consumes perks:
– Lavish offices and corporate jets
– Excessively large staffs
Excessively large staffs
– Memberships at country clubs
• M
Management accepts projects (or 
t t j t (
acquisitions) to make firm larger, even if MVA 
goes down.
d

60
 Anti‐Takeover
Anti Takeover Provisions
Provisions
• Targeted share repurchases (i.e., greenmail)
Targeted share repurchases (i e greenmail)
• Shareholder rights provisions (i.e., poison pills)
• Restricted voting rights plans
i d i i h l

61
 Board of Directors
Board of Directors
• Weak
Weak boards have many insiders (i.e., those 
boards have many insiders (i e those
who also have another position in the 
company) compared with outsiders
company) compared with outsiders.
• Interlocking boards are weaker (CEO of 
company A sits on board of company B CEO
company A sits on board of company B, CEO 
of B sits on board of A).

62
 Stock Options in Compensation Plans
Stock Options in Compensation Plans
• Gives
Gives owner of option the right to buy a share 
owner of option the right to buy a share
of the company’s stock at a specified price 
(called the exercise price) even if the actual
(called the exercise price) even if the actual 
stock price is higher.
• Usually can
Usually can’tt exercise the option for several 
exercise the option for several
years (called the vesting period).

63
 Stock Options (Cont.)
Stock Options (Cont.)
• Can’t
Can t exercise the option after a certain 
exercise the option after a certain
number of years (called the expiration, or 
maturity date)
maturity, date).

64
 Basic Definitions
Basic Definitions
• V = value of firm
V = value of firm
• FCF = free cash flow
• WACC = weighted average cost of capital
CC i h d f i l
• rs and rd are costs of stock and debt
• we and wd are percentages of the firm that are 
financed with stock and debt.

65
 A Preview of Capital Structure Effects
A Preview of Capital Structure Effects
• The
The impact of capital structure on value 
impact of capital structure on value
depends upon the effect of debt on:
– WACC
– FCF

(Continued…)
66
 The Effect of Additional 
Debt on WACC
b
• Debtholders
Debtholders have a prior claim on cash flows relative 
have a prior claim on cash flows relative
to stockholders. 
– Debtholders’ “fixed” claim increases risk of stockholders’ 
“residual” claim.
– Cost of stock, rs, goes up.
• Firm’s can deduct interest expenses.
– Reduces the taxes paid
– Frees up more cash for payments to investors
F hf t t i t
– Reduces after‐tax cost of debt

(Continued…)
67
 The Effect on WACC (Continued)
The Effect on WACC (Continued)
• Debt increases risk of bankruptcy
Debt increases risk of bankruptcy
– Causes pre‐tax cost of debt, rd, to increase
• Adding
Adding debt increase percent of firm financed 
debt increase percent of firm financed
with low‐cost debt (wd) and decreases percent 
financed with high cost equity (we)
financed with high‐cost equity (w
• Net effect on WACC = uncertain.

(Continued…)
68
 The Effect of 
Additional Debt on FCF
dd l b
• Additional
Additional debt increases the probability of 
debt increases the probability of
bankruptcy.
– Direct costs: Legal fees, 
Direct costs: Legal fees “fire”
fire  sales, etc.
sales etc
– Indirect costs: Lost customers, reduction in 
productivity of managers and line workers
productivity of managers and line workers, 
reduction in credit (i.e., accounts payable) offered 
by suppliers 

(Continued…)
69
• Impact of indirect costs
Impact of indirect costs
– NOPAT goes down due to lost customers and drop 
in productivity
in productivity
– Investment in capital goes up due to increase in 
net operating working capital (accounts payable
net operating working capital (accounts payable 
goes down as suppliers tighten credit).

(Continued…)
70
• Additional debt can affect the behavior of managers.
g
– Reductions in agency costs: debt “pre‐commits,” or 
“bonds,” free cash flow for use in making interest 
payments Thus managers are less likely to waste FCF on
payments.  Thus, managers are less likely to waste FCF on 
perquisites or non‐value adding acquisitions.
– Increases in agency costs: debt can make managers too 
risk‐averse, causing “underinvestment” in risky but 
ik i “ d i t t” i i k b t
positive NPV projects. 

(Continued…)
71
 Asymmetric Information 
and Signaling
d l
• Managers
Managers know the firm
know the firm’ss future prospects better 
future prospects better
than investors.
• Managers would not issue additional equity if they 
g q y y
thought the current stock price was less than the 
true value of the stock (given their inside 
information).
• Hence, investors often perceive an additional 
issuance of stock as a negative signal, and the stock 
f k l d h k
price falls. 

72
Business risk: Uncertainty about future pre‐tax 
operating income (EBIT).
i i (EBIT)

Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects. 73
 Factors That Influence Business Risk
Factors That Influence Business Risk
• Uncertainty about demand (unit sales).
Uncertainty about demand (unit sales)
• Uncertainty about output prices.
• Uncertainty about input costs.
i b i
• Product and other types of liability.
• Degree of operating leverage (DOL).

74
 What is operating leverage, and how does it 
affect a firm’s business risk?
ff fi ’ b i i k?
• Operating
Operating leverage is the change in EBIT 
leverage is the change in EBIT
caused by a change in quantity sold.
• The higher the proportion of fixed costs within 
The higher the proportion of fixed costs within
a firm’s overall cost structure, the greater the 
operating leverage
operating leverage.

(More...)

75
 Higher operating leverage leads to higher 
expected EBIT and higher risk.
d EBIT d hi h i k

Low operating leverage

Probability
High
g operating
p g leverage
g

EBITL EBITH

76
 Business Risk versus Financial Risk
Business Risk versus Financial Risk
• Business risk:
Business risk:
– Uncertainty in future EBIT.
– Depends on business factors such as competition, 
operating leverage, etc.
• Financial risk:
– Additional business risk concentrated on common 
stockholders when financial leverage is used.
– Depends on the amount of debt and preferred stock 
Depends on the amount of debt and preferred stock
financing.

77
 Impact of Leverage on Returns
Impact of Leverage on Returns

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3 000
$3,000 $1 800
$1,800
Taxes (40%) 1 ,200 720
NI $1 800
$1,800 $1 080
$1,080

ROE 9 0%
9.0% 10 8%
10.8%
78
Why does leveraging increase return?
Why does leveraging increase return?
• More EBIT goes to investors in Firm L.
More EBIT goes to investors in Firm L
– Total dollars paid to investors:
• U: NI = $1,800.
U: NI = $1 800
• L: NI + Int = $1,080 + $1,200 = $2,280.
– Taxes paid:
Taxes paid:
• U:  $1,200;  L:  $720.
• Equity $ proportionally lower than NI.
Equity $ proportionally lower than NI

79
• Now
Now consider the fact that EBIT is not known 
consider the fact that EBIT is not known
with certainty.  What is the impact of 
uncertainty on stockholder profitability and
uncertainty on stockholder profitability and 
risk for Firm U and Firm L?

Continued…
80
 Conclusions
• Basic
Basic earning power (EBIT/TA) and ROIC 
earning power (EBIT/TA) and ROIC
(NOPAT/Capital = EBIT(1‐T)/TA) are unaffected by 
financial leverage.
• L has higher expected ROE: tax savings and smaller 
equity base.
• L has much wider ROE swings because of fixed 
interest charges.  Higher expected return is 
accompanied by higher risk.
db h h k

(More...)
81
 Capital Structure Theory
Capital Structure Theory
• MM theory
MM theory
– Zero taxes
– Corporate taxes
p
– Corporate and personal taxes
• Trade
Trade‐off
off theory
theory
• Signaling theory
• Debt financing as a managerial constraint
Debt financing as a managerial constraint

82
 MM Theory: Zero Taxes
MM Theory:  Zero Taxes
• MM
MM prove, under a very restrictive set of 
prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected by its 
financing mix:
– VL = VU.
• Therefore, capital structure is irrelevant.
• Any increase in ROE resulting from financial leverage 
is exactly offset by the increase in risk (i.e., rs), so 
WACC is constant.

83
 MM Theory: Corporate Taxes
MM Theory:  Corporate Taxes

• Corporate tax laws favor debt financing over equity 
financing.
financing
• With corporate taxes, the benefits of financial 
leverage exceed the risks: More EBIT goes to
leverage exceed the risks:  More EBIT goes to 
investors and less to taxes when leverage is used.
• MM show that: V
s o a L = VU + TD.
• If T=40%, then every dollar of debt adds 40 cents of 
extra value to firm.

84
MM relationship between capital costs and leverage 
when corporate taxes are considered.
h t t id d

Cost of
Capital (%)
rs

WACC
rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
85
 Miller’s Theory: Corporate and 
Personal Taxes
l
• Personal
Personal taxes lessen the advantage of 
taxes lessen the advantage of
corporate debt:
– Corporate taxes favor debt financing since 
Corporate taxes favor debt financing since
corporations can deduct interest expenses.
– Personal taxes favor equity financing, since no 
Personal taxes favor equity financing since no
gain is reported until stock is sold, and long‐term 
gains are taxed at a lower rate.

86
 Trade‐off
Trade off Theory
Theory
• MM theory ignores bankruptcy (financial distress) 
y g p y( )
costs, which increase as more leverage is used.
• At low leverage levels, tax benefits outweigh 
b k
bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax 
benefits.
benefits
• An optimal capital structure exists that balances 
these costs and benefits.

87
 Signaling Theory
Signaling Theory
• MM assumed that investors and managers have the 
g
same information.
• But, managers often have better information.  Thus, 
they would:
h ld
– Sell stock if stock is overvalued.
– Sell bonds if stock is undervalued.
Sell bonds if stock is undervalued
• Investors understand this, so view new stock sales as 
a negative signal.
• Implications for managers?

88
 Debt Financing and Agency Costs
Debt Financing and Agency Costs
• One
One agency problem is that managers can use 
agency problem is that managers can use
corporate funds for non‐value maximizing 
purposes.
purposes
• The use of financial leverage:
– Bonds “free cash flow.”
B d “f h fl ”
– Forces discipline on managers to avoid perks and 
non value adding acquisitions
non‐value adding acquisitions.

(More...)
89
• A
A second agency problem is the potential for 
second agency problem is the potential for
“underinvestment”.
– Debt increases risk of financial distress.
Debt increases risk of financial distress
– Therefore, managers may avoid risky projects 
even if they have positive NPVs
even if they have positive NPVs. 

90
 The Cost of Equity at Different Levels of Debt: 
Hamada’s Equation
d ’
• MM
MM theory implies that beta changes with 
theory implies that beta changes with
leverage.
• bU is the beta of a firm when it has no debt 
is the beta of a firm when it has no debt
(the unlevered beta)
• bL = b
bU [1 + (1 ‐
[1 (1 T)(D/S)]

91
 Wealth of Shareholders
Wealth of Shareholders
• Value
Value of the equity declines as more debt is 
of the equity declines as more debt is
issued, because debt is used to repurchase 
stock.
stock
• But total wealth of shareholders is value of 
stock after the recap plus the cash received in
stock after the recap plus the cash received in 
repurchase, and this total goes up (It is equal 
to Corporate Value on earlier slide)
to Corporate Value on earlier slide).

92
 Stock Price for wd = 20%
Stock Price for w 20%
• The
The firm issues debt, which changes its WACC, 
firm issues debt which changes its WACC
which changes value.
• The firm then uses debt proceeds to 
The firm then uses debt proceeds to
repurchase stock.
• Stock price changes after debt is issued, but 
S k i h f d b i i d b
does not change during actual repurchase (or 
arbitrage is possible). 
bi i ibl )

(More…)
93
 Stock Price for wd = 20% (Continued)
Stock Price for w 20% (Continued)
• The
The stock price after debt is issued but before 
stock price after debt is issued but before
stock is repurchased reflects shareholder 
wealth:
– S, value of stock
– Cash paid in repurchase.
Cash paid in repurchase

(More…)
94
Stock Price for wd = 20% 
Stock Price for w 20% (Continued)

• D0 and n0 are debt and outstanding shares 
before recap
before recap.
• D ‐ D0 is equal to cash that will be used to 
repurchase stock.
h t k
• S + (D ‐ D0) is wealth of shareholders’ after the 
debt is issued but immediately before the 
repurchase.
(More…)
95
 Number of Shares Repurchased
Number of Shares Repurchased
## Repurchased = (D 
Repurchased = (D ‐ D0) / P
)/P
# Rep. = ($531,915  – 0) / $26.596
= 20,000. 
20 000
# Remaining = n = S / P
n = $2,127,660 / $26.596
= 80,000.
80 000

96
 Other Factors to Consider when Setting the 
T
Target Capital Structure
C i lS
• Debt
Debt ratios of other firms in the industry.
ratios of other firms in the industry
• Pro forma coverage ratios at different capital 
structures under different economic
structures under different economic 
scenarios.
• Lender and rating agency attitudes
L d d i i d
(impact on bond ratings).

97
• Reserve
Reserve borrowing capacity.
borrowing capacity
• Effects on control.
• Type of assets:  Are they tangible, and hence 
f h ibl dh
suitable as collateral?
• Tax rates.

98
 What is “distribution
What is  distribution policy
policy”??
• The distribution policy defines:
The distribution policy defines:
– The level of cash distributions to shareholders
– The form of the distribution (dividend vs. stock 
The form of the distribution (dividend vs stock
repurchase)
– The stability of the distribution
The stability of the distribution

99
Do investors prefer high or low payouts?  There 
are three theories:
h h i
• Dividends
Dividends are irrelevant: Investors don
are irrelevant: Investors don’tt care 
care
about payout.
• Bird‐in‐the‐hand: Investors prefer a high 
Bird in the hand: Investors prefer a high
payout.
• Tax preference: Investors prefer a low payout, 
T f I f l
hence growth.

100
 Dividend Irrelevance Theory
Dividend Irrelevance Theory
• Investors
Investors are indifferent between dividends and 
are indifferent between dividends and
retention‐generated capital gains.  If they want cash, 
they can sell stock.  If they don’t want cash, they can 
use dividends to buy stock.
• Modigliani‐Miller support irrelevance.
• Theory is based on unrealistic assumptions (no taxes 
or brokerage costs), hence may not be true.  Need 
empirical test.
l

101
 Bird‐in‐the‐Hand
Bird in the Hand Theory
Theory
• Investors
Investors think dividends are less risky than 
think dividends are less risky than
potential future capital gains, hence they like 
dividends.
dividends
• If so, investors would value high payout firms 
more highly i e a high payout would result in
more highly, i.e., a high payout would result in 
a high stock price.

102
 Tax Preference Theory
Tax Preference Theory
• Low
Low payouts mean higher capital gains. 
payouts mean higher capital gains
Capital gains taxes are deferred.
• This could cause investors to prefer firms with 
This could cause investors to prefer firms with
low payouts, i.e., a high payout results in a low 
stock price
stock price.

103
 Which theory is most correct?
Which theory is most correct?
• Empirical
Empirical testing has not been able to 
testing has not been able to
determine which theory, if any, is correct.
• Thus, managers use judgment when setting 
Thus managers use judgment when setting
policy.
• Analysis is used, but it must be applied with 
A l i i d b i b li d i h
judgment.

104
 What’ss the 
What the “clientele
clientele effect
effect”??
• Different
Different groups of investors, or clienteles, prefer 
groups of investors, or clienteles, prefer
different dividend policies.
• Firm’s past dividend policy determines its current 
p p y
clientele of investors.
p g g p y
• Clientele effects impede changing dividend policy.  
Taxes & brokerage costs hurt investors who have to 
switch companies due to a change in payout policy.

105
 What’s the “information content,” or 
“ i li ” h
“signaling,” hypothesis?
h i?
• Investors
Investors view dividend changes as signals of 
view dividend changes as signals of
management’s view of the future.  Managers 
hate to cut dividends so won’tt raise dividends 
hate to cut dividends, so won raise dividends
unless they think raise is sustainable.
• Therefore, a stock price increase at time of a 
Therefore a stock price increase at time of a
dividend increase could reflect higher 
expectations for future EPS not a desire for
expectations for future EPS, not a desire for 
dividends.

106
 What’s the “residual distribution 
model”?
d l”
• Find
Find the reinvested earnings needed for the 
the reinvested earnings needed for the
capital budget.
• Pay out any leftover earnings (the residual) as 
Pay out any leftover earnings (the residual) as
either dividends or stock repurchases.
• This policy minimizes flotation and equity 
Thi li i i i fl i d i
signaling costs, hence minimizes the WACC.

107
 Using the Residual Model to 
Calculate Distributions Paid
l l b d

Target Total
Net
Distr. =              – equity capital
.
income
ratio
ti b d t
budget

108
 Advantages and Disadvantages of the 
Residual Dividend Policy
id l i id d li
• Advantages:
Advantages:  Minimizes new stock issues and 
Minimizes new stock issues and
flotation costs.
• Disadvantages:  Results in variable dividends, 
Disadvantages: Results in variable dividends
sends conflicting signals, increases risk, and 
doesn’tt appeal to any specific clientele.
doesn appeal to any specific clientele
• Conclusion:  Consider residual policy when 
setting target payout, but don’t follow it 
i b d ’ f ll i
rigidly.

109
 Stock Repurchases
Stock Repurchases
• Repurchases:  Buying own stock back from 
p y g
stockholders.

• Reasons for repurchases:
• As an alternative to distributing cash as dividends.
• To dispose of one‐time cash from an asset sale.
• To make a large capital structure change.

110
 Advantages of Repurchases
Advantages of Repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be 
maintained.
• Repurchased stock can be used in takeovers or resold 
to raise cash as needed.
• Income received is capital gains rather than higher‐
I i di it l i th th hi h
taxed dividends.
• Stockholders may take as a positive signal
Stockholders may take as a positive signal‐‐
management thinks stock is undervalued.

111
 Disadvantages of Repurchases
Disadvantages of Repurchases
• May be viewed as a negative signal (firm has poor 
y g g ( p
investment opportunities).
• IRS could impose penalties if repurchases were 
primarily to avoid taxes on dividends.
l d d d d
• Selling stockholders may not be well informed, hence 
be treated unfairly
be treated unfairly.
• Firm may have to bid up price to complete purchase, 
p y g
thus paying too much for its own stock.

112
 Setting Dividend Policy
Setting Dividend Policy
• Forecast capital needs over a planning horizon, often 
p p g
5 years.
• Set a target capital structure.
• Estimate annual equity needs.
Estimate annual equity needs
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges.  
Generally, some dividend growth rate emerges.
Maintain target growth rate if possible, varying 
capital structure somewhat if necessary.

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 Stock Dividends vs. Stock Splits
Stock Dividends vs. Stock Splits
• Stock
Stock dividend:  Firm issues new shares in lieu 
dividend: Firm issues new shares in lieu
of paying a cash dividend.  If 10%, get 10 
shares for each 100 shares owned
shares for each 100 shares owned.
• Stock split:  Firm increases the number of 
shares outstanding say 2:1 Sends
shares outstanding, say 2:1.  Sends 
shareholders more shares.

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• Both stock dividends and stock splits increase the 
p
number of shares outstanding, so “the pie is divided 
into smaller pieces.”
• Unless the stock dividend or split conveys 
l h kd d d l
information, or is accompanied by another event like 
higher dividends, the stock price falls so as to keep
higher dividends, the stock price falls so as to keep 
each investor’s wealth unchanged.
• But splits/stock dividends may get us to an “optimal 
price range.”

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 When should a firm consider splitting 
its stock?
k
• There’s
There s a widespread belief that the optimal 
a widespread belief that the optimal
price range for stocks is $20 to $80.
• Stock splits can be used to keep the price in 
Stock splits can be used to keep the price in
the optimal range.
• Stock splits generally occur when 
S k li ll h
management is confident, so are interpreted 
as positive signals.
ii i l

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 Open Market Purchase Plan
Open Market Purchase Plan
• Dollars
Dollars to be reinvested are turned over to 
to be reinvested are turned over to
trustee, who buys shares on the open market.
• Brokerage costs are reduced by volume 
Brokerage costs are reduced by volume
purchases.
• Convenient, easy way to invest, thus useful for 
C i i h f lf
investors.

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 New Stock Plan
New Stock Plan
• Firm
Firm issues new stock to DRIP enrollees, keeps 
issues new stock to DRIP enrollees keeps
money and uses it to buy assets.
• No fees are charged, plus sells stock at 
No fees are charged plus sells stock at
discount of 5% from market price, which is 
about equal to flotation costs of underwritten
about equal to flotation costs of underwritten 
stock offering.

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• Optional
Optional investments sometimes possible, up 
investments sometimes possible, up
to $150,000 or so.
• Firms that need new equity capital use new 
Firms that need new equity capital use new
stock plans.
• Firms with no need for new equity capital use 
Firms with no need for new equity capital use
open market purchase plans.
• Most NYSE listed companies have a DRIP.  
Most NYSE listed companies have a DRIP.
Useful for investors.

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