Capital Budgeting and Capital Structure

Financial Management 6301 Dr. Carolyn Reichert

Company Cost of Capital

Firm value = sum of the value of the assets Weighted Average Cost of Capital (WACC)
Opportunity cost of capital for existing assets Use: value new assets with the same risk as the old ones rWACC = rportfolio = (B/V)rB + (S/V)rS V = B + S where V, B and S are all market values rS = rf + S(rm - rf) rS = ro + [(B/S)(ro - rB )] Exclude taxes for now (so tax rate = 0)
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Asset beta
Beta of a portfolio of all of the firms debt & equity Relationship between asset and equity betas
ASSET = WACC = (B/V)B+(S/V)S
Where V = B + S V, B and S are all market values

Can rearrange to get S = o + [(B/S)(o - B )] No tax adjustment

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No-Tax Cost of Capital

Unlevered Cost of Capital ro:
Expected return investors want from a project if it was all-equity financed

No tax world (M&M): ro = rWACC Unlevered cost of capital and asset beta are the same for the levered and unlevered firm.
Affected only by business risk
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Cost of Capital Implications

You can lever and unlever the WACC. Return on equity and equity beta are different for the levered and unlevered firm.
Affected by financial risk. Firms with more debt have higher equity betas

Cost of Capital Example

Coyote Corporation has a value of $200M. Debt has a market value of $50M and a return of 6%. Equity has a beta of .75. The risk-free return is 3% and the market risk premium is 9%. Find the original weighted average cost of capital. If they issue $50M to re-buy equity, find the new return on equity. The return on debt does not change

Cost of Capital Answer

Find the return on equity.
rS = 3% + .75(9%) = 9.75%

Original WACC
rWACC = (50/200)6% + (150/200)9.75% = 8.81%

New return on equity

rWACC = 8.81% = (100/200)6% +(100/200) rS Can use rS = ro + [(B/S)(ro - rB )] rS = 8.81% + (100/100)(8.81%-6%) = 8.81% + 2.81% 11.62%
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Measuring Equity Betas

Linear regression of the stock's returns against the corresponding market returns.
Choice of market index

Least-squares regression produces a line of best fit called the characteristic line. Equity beta: Slope of the characteristic line
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Regression Information
Intercept (Jensens Alpha)
Simple measure of performance If > rf (1-), stock did better than expected If = rf (1-), stock did as well as expected If < rf (1-), stock did worse than expected

R2 is the proportion of variance that can be explained by market risk (1-R2): proportion of variance that is firm specific
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Measuring Betas
Dell Computer Dell return (%) Price data: Dec 97 - Apr 04

R2 = .27 = 1.61
Slope determined from plotting the line of best fit.

Market return (%)

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Beta Estimation: Problems

Want predicted beta
Assume betas move towards one in the long term Estimate betas from the bottom up Use firm characteristics to estimate beta

Sample size may be inadequate

Use more sophisticated statistical techniques

Financial leverage & business risk change over time Estimation error
Use Industry betas (more reliable)
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Differences in Published Betas

Use different time periods
Longer: more data but firm changes over time Shorter: Easily influenced by specific events

Use different return intervals (day, week, month)

Shorter: More data but more noise

Use different adjusting methods

Simple adjustment towards one Adjust using fundamental information about the firm
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Determinants of Asset Beta

Look at the business risk
Cyclical firms have higher betas
Cyclical firms do well in the expansion phase of the business cycle and poorly in the contraction phase Cyclicality is not the same as variability

Consider product type

Firms with discretionary products have higher betas

Higher operating leverage results in higher betas

Magnifies the effect of cyclicality on beta
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Division Betas
Use an industry beta to estimate a division's cost of capital. A diversified firm's cost of capital does not measure the risk of any specific division

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Atypical Projects
If a similar asset is traded, estimate beta from past price data or comparable firms Use accounting earnings Use bottom-up beta estimation
Use fundamental risk considerations to get a rough estimate of beta.

Avoid fudge factors

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Accounting Betas
Regress changes in firm (division) earnings against changes in earnings for the market Problems
Accounting earnings are smoothed (bias beta)
Bias up for safe firms and down for risky firms

Influenced by accounting decisions Few observations for regression (quarterly data)

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Bottom-Up Betas
Identify businesses that comprise the firm or project Estimate unlevered betas for other firms in the same business (comparables) Weighted average of unlevered betas (use market values, sales) Lever the estimate using the debt/equity ratio
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Optimal Capital Budget & Risk

True cost of capital depends on how funds are used Cost of capital (WACC) is appropriate for projects with similar risk to the firms average risk Cost of capital rule:
Invest if project return > cost of capital

Not average risk: Use CAPM with project beta

Account for project risk

CAPM rule:
Invest if project return > required return based on the projects beta
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Cost of Capital vs. CAPM

Required return 15

SML Company Cost of Capital (WACC)

Project Beta

1.0
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WACC vs. CAPM

A project has an IRR of 18%. Knights cost of capital (WACC) is 15%. The project has a beta of 1.2. The risk-free return is 5%; market risk premium is 10% Using the company cost of capital (WACC), will they take the project? Using the CAPM to determine the required return, will they take the project?
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WACC vs. CAPM Answer

COC rule: Accept the project since the IRR of 18% > cost of capital of 15%. Using CAPM: r = 5% + (1.210%) = 17% Accept the project since the IRR of 18% > CAPM of 17%.

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Weighted Average Cost of Capital

Weighted-average of the cost of funds Affected by tax savings and the financing decision

S B rWACC = rS + (1 TC )rB V V
Beta relationships become
ASSET = WACC = [(S/V)S ] + [(B/V)(1-TC)B] S = o + [(B/S)(1-TC)(o - B )]
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Tax Impact on Return and Beta

Unlevered firm:
Present value of the interest tax shields (PVITS) = 0. In this case rWACC = ro = rS and WACC = o = S

Levered firm:
The business risk of the assets has not changed Unlevered cost of capital for the assets has not changed Additional asset (PVITS) generated as a result of the financing decisions made by the firm.

Result: Business risk of the assets does not change. Debt impacts value through tax savings.
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Evaluating Levered Investments

Value is created by good investment decisions Destroy value by poor financing decisions Financial policy should support business strategy Three Valuation Approaches:
Weighted Average Cost of Capital (WACC) Adjusted Present Value (APV) Flow to Equity (FTE)

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General form of the WACC

Weighted-average of the component costs of debt, preferred stock, retained earnings and common stock rWACC = [(E/V)rE ]+[(S/V)rS]+[(B/V)(1-TC)rB]+ [(P/V)rP]
Added term for preferred stock P Equity split into retained earnings (E) and stock issue (S) Proportions must add to 1 Not all securities may be used (omit terms)
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Components: Debt and Preferred

Debt:
Find yield to maturity. If it is compounded semiannually, use effective rate. This is rB Cost of debt is reduced in the WACC equation because interest is tax-deductible

Preferred:
rP = Dividend divided by the net price Net price is the price less issue costs
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Component: Retained Earnings

Opportunity cost Dividend valuation model: rE = (D1/P0) + g CAPM: rE = rf + [S(rm - rf)] Non-dividend paying stocks: P0= Pt/(1+r)t so rE = [(Pt/P0)(1/t)] -1 rE = bond yield + risk premium
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Component: Issue Common Stock

Constant growth with the net price rS = (D1/Pnet) + g Net price is the price less the issue costs Issue costs are also called flotation costs

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WACC Example: Nook

Nook plans a $100 million expansion using 25% debt and 75% common stock issue.
Debt: Bonds with a 12% yield Stock: Expect dividends of $3.80 next year. Growth rate is 8%. Current stock price is $40. Flotation costs are 5% to issue stock. Tax rate is 40%. Find weighted average cost of capital.
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WACC Answer: Nook

Debt: yield = rB = 12%. Common: rs =
3.80 + .08 40 (1 .05)

Flotation costs are another name for issue costs Net price = 40(1-.05) = 38

Get rWACC = (.2512%(1-.4)) + (.7518%) 15.3%

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Weighted Average Cost of Capital

WACC value

UCFt = (1 + rWACC )t t =1
where UCFt is after-tax unlevered cash flow and rWACC is the weighted average cost of capital.
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WACC Steps
Steps
Calculate unlevered cash flows Calculate WACC Find NPV by discounting cash flows at the WACC

Only appropriate as a discount rate when

Project & Firm: Same systematic business risk Project & Firm: Same debt capacity Firm: Target debt to value is relatively stable
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Adjusted Present Value (APV)

APV value = base-case NPV + NPV of financing
Base-case NPV = project value if use only equity

=
t =1

UCF t t + PV(Financi ng effects) (1 + r 0)

where UCFt is after-tax unlevered cash flow and ro is the unlevered cost of capital.
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APV Steps
Steps
Calculate unlevered cash flows Find NPV by discounting cash flows at the unlevered cost of capital Adjust for the PV of financing side effects

Only appropriate as a discount rate when

Projects debt level is known over the life of the project

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Financing Side Effects

Financing Side Effects
Tax deduction for interest Effects of subsidized financing Issue costs for new debt and equity Financial distress costs

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Flows to Equity (FTE)

FTE: PV of cash flows to stockholders in the levered firm discounted by rS. Levered Equity value =

t =1

LCFt t (1 + r S )

LCFt is after-tax, after-interest cash flow to levered equity and rS is return on levered equity. FTE = Levered Equity Value Firms Investment
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Flows to Equity (FTE) Steps

Find levered cash flows (LCF). LCF is cash flow to stockholders after interest and taxes are paid. LCF = Unlevered cash flows [(1-Tc) rBB] Find cost of levered equity rS = ro + (B/S)(1-Tc)(ro - rB). This is affected by business and financial risk Find value of the LCF discounted at rS. Subtract the amount of cash supplied by the firm
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Example: Levered Project for Cat

A project costs $6 million
EBIT is $1,600,000 every year forever. Unlevered cost of capital is 16%. Issue $5,000,000 in debt with interest rate of 10%. Tax rate is 30%. With no debt, Cat has a value of 7,000,000. Debt ratio (debt to value) is 58.8%. Use WACC, APV and FTE to find the projects value.
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Levered Project APV Answer

1.

2.

3.

Base-case NPV: All-Equity Value UCF = $1,120,000 NPV = (UCF/ro)- I = (1,120,000/.16) - 6M = 1M Present value of the financing side effect NPVF = PVITS = TC(rBB)/rB = TCB = .3(5M) = $1.5M Adjusted present value APV = base-case NPV + NPVF APV = 1M + 1.5M = $2.5M
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Levered Project WACC Answer

UCF = 1.6M(1-.3) = 1.12M Get WACC. For cost of equity: use M&M With Tax rS = 16% + (5M/3.5M)(1-.3)(16%-10%) = 22% rWACC = (5M/8.5M)(1-.3)(10%) + (3.5M/8.5M)(22%) rWACC = 13.18% V =(UCF/ rWACC) 6M V =($1.12M/.1318) 6M = $2,500,000
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Unlevered Cash Flow and Value

UCF = 1.6M(1-.3) = 1.12M VL = VU + (TCB) = 7M + (.35M) = 8.5M VL = 8.5M = S + B = S + 5M so S = 3.5M Notice that
B/VL = 5M/8.5M = 58.8% VU = (1.12M/.16) = 7M Once the project is taken, Cat gets the value of the remaining cash flows
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Flow-to-Equity Answer #1
1. Find Levered Cash Flows (LCF) LCF = UCF [(1-TC) rBB] LCF = 1,120,000 [(1-.3).15M] = 770,000 OR USE LCF = (EBIT-rBB)(1-TC) LCF = (1.6M-(.15M))(1-.3) = 770,000

2. Find cost of levered equity

B/S = 5M/3.5M = 1.428 OR USE B/V = .588, so B/S = .588/(1-.588) = .588/.412 = 1.427 rS = ro + (B/S)(1-T)(ro - rB) = 0.16+[1.427(1-.3)(.16-.10)] rS = 22%
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Flow-to-Equity Approach #2
3. Levered Equity Value = LCF/rS=

$770,000/.22= $3.5M

4. Subtract the cash supplied by the firm.

Invest $6M but borrow $5M, so firm supplies 6M-5M = $1M

5. FTE value = $3.5M - $1M = $2,500,000
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Summary: APV, WACC, & FTE

All three determine value in the presence of debt financing APV Initial Investment Cash Flows Discount Rates PV of financing All UCF ro Yes WACC All UCF rWACC No FTE Equity Portion LCF rS No

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Rule of Thumb
Use WACC or FTE if the firms target debt-tovalue ratio applies to the project over its life (constant debt ratio).
WACC: most common method used FTE: used for firms with extensive leverage

Use APV if the projects level of debt is known over the life of the project (constant debt level).
APV: Special situations like subsidies and leases
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Non-Perpetual Debt Example

A project costs $6 million
Unlevered after-tax cash flows of $3,120,000 every year for 3 years. Unlevered cost of capital is 16%. Kit issues $5,000,000 in 3-year debt with an interest rate of 10%. Tax rate is 30%. Debt-to-Equity = B/S = 2.10 Use WACC, APV and FTE to find the projects value.
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APV Non-Perpetual Debt Answer

1.

2.

Base-case NPV: All-Equity Value NPV(.16,3120000,3120000,3120000) - $6M = $1,007,175 Present value of interest tax shield
Interest Tax Shield = Tc rB B =.3 .1 5M = 150,000

3.

PV(.1,3,-150000) = 373,028 Adjusted present value APV = base-case NPV + PVITS APV = 1,007,175 + 373,028 = $1,380,203
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Levered Project WACC Answer

UCF = 3.12M Get WACC. Cost of equity: use M&M With Tax rS = 16% + [2.10(1-.3)(16%-10%)] = 24.82% B/S = 2.1 so S/V = .323 and B/V = .677 rWACC = [(.677)(1-.3)(10%)] + [.32324.82%] = 12.76% Value with WACC: NPV(.1276,3120000,3120000,3120000) - $6M = $1,397,443
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FTE Non-Perpetual Debt

1. Find Levered Cash Flows (LCF) LCF = UCF [(1-T) rBB] LCF=3,120,000[(1-.3).15M] LCF =2,770,000 in years 1 & 2 LCF = 2,770,000-5,000,000 = (2,230,000) in year 3 Must repay the loan

2. Find cost of levered equity

B/S = 2.10 rS = ro + (B/S)(1-T)(ro - rB) = 0.16+[2.10(1-.3)(.16-.10)] rS = 24.82%
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Flow-to-Equity Approach #2
3. Levered Equity Value NPV(.2482,2770000,2770000,-2230000) NPV = $2,850,354 4. Subtract the cash supplied by the firm.

Invest $6M but borrow $5M, so firm supplies 6M-5M = $1M

5. FTE value = $2,850,354 - 1M = $1,850,354
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