Financing Decisions and The Cost of Capital

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Financing Decisions and The Cost of Capital
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Outline

• (1) Descriptive Data and Overview of Financing
• (2) The Debt versus Equity Decision
• Is debt a cheaper source of finance?

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Where do Firms Get Their Money?

• Self Financing (using internal cash flow)
• Accounts for 80 (avg.) of financing
• Difficult for start-up companies
• External Financing
• Borrowing from banks or issuing bonds
• Sharing the business with investors by issuing
  stock

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The Long-Term Financial Deficit (in 1999)
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Where Do Small Businesses Get Money?
Source 1987 SBA survey of firms with less than
500,000 in assets.
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What Happens As Firms Get Larger?
Firm Size
Information
Medium-sized
Small with growth potential
Large with Track record
Very small, no track record
Inside seed money
Self
Short-term commercial loans
Commercial paper
Short Debt
Intermediate-term commercial loans
Medium-term Notes
Inter- mediate Debt
Mezzanine Finance
Private Placements
Long-Term Debt
Bonds
Outside Equity
Public Equity
Venture Capital
Source FRB Report on Private Placements, Rea et.
al., 1993
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Size of U.S. Bond Market
Source Merrill Lynch Bond Indices, 10/96
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Privately Placed Debt

• Private placement debt is not placed with the
  public at large.
• In 1990, Rule 144a was passed which relaxed
  restrictions on the private placement market.
• Did not have to conform to GAAP accounting.
• Must be sold to qualified institutional buyers
  (QIBs).
• This made it more attractive for foreign issuers
  to enter the U.S. market.
• Private placements are mainly sold to insurance
  companies.

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Project Finance

• Financing structured for a project alone, rather
  than a whole firm.
• Must be physically isolated and provide the
  lender some type of tangible security.
• Used heavily for high dollar projects in oil,
  gas, infrastructure, and film making.
• Used extensively in high growth countries like
  China.

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New Stock Issues

• A firms first issue of public equity is called
  an initial public offering.
• Firm issues through primary market (almost
  always) using an underwriter.
• IPO's are underpriced, on average, by about 15.
• Example IPO of Cyrix in August 1993. Jumped over
  20 in first day.

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What is the Difference Between Debt and Equity?
Debt
Equity

• Fixed Promised payments
• Senior to equity
• Interest is deductible
• Only get control rights in default

• Uncertain residual cash flows
• Subordinated
• Dividends are not deductible
• Comes with control rights (can vote)

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Recent Trends in Financing

• This important question is difficult to answer
  definitively.
• Book or Market values?
• In general, financial economists prefer market
  values. Debt levels have fallen recently.
• However, many corporate treasurers find book
  values more appealing due to the volatility of
  market values. These have slightly risen
  recently.
• Whether we use book or market values, debt ratios
  for U.S. non-financial firms have remained below
  60 percent of total financing.

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Capital StructureHow should a firm structure
the liability side of the balance sheet?

• Debt vs. Equity
• We have seen how to do capital budgeting when the
  firm has debt in its capital structure.
• However, we have not figured out how much debt
  the firm should have.
• Can the firm create value for shareholders
  through its financing decisions?
• In particular, should the firm load up with low
  cost debt?

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One possible answerIt makes no difference.

• Assume PCM, importantly, there are no taxes, and
  that the firms investment policy is unaffected
  by how it finances its operations.
• Both Modigliani and Miller won the Nobel Prize
  for showing
• The value of a firm with debt is in this case
  equal to the value of the same firm without debt.
  MM Proposition I.
• The important idea is that since the assets are
  the same regardless of how they are financed so
  are the expected cash flows and so are the asset
  risks (asset betas) of a levered and
  unlevered firm.

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Irrelevance Proposition II

• What this means is that the expected return on
  equity rises with leverage according to (B/S
  leverage ratio -- market value of debt over
  market value of equity, r denotes expected
  return).

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WACC under Irrelevance
Let the expected return on the underlying assets
be 9 and the cost of debt be 6.
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MM Proposition II with No Corporate Taxes
Another View
Cost of capital r ()
r0
rB
rB
Debt-to-equity Ratio
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What About The Tax Deductibility of Interest?

• Interest is tax deductible (dividends are not).
• A valuable debt tax shield is created by
  substituting payments of interest for payments of
  dividends, i.e. debt financing for equity
  financing.
• Modigliani and Miller also showed that if the
  only change in their analysis is an
  acknowledgement of the US corporate tax
  structure, then
• The value of a levered firm is VL VU TcB
• the value of an equivalent unlevered firm PLUS
• the value of the tax shields from debt.
• Firm Value always rises with additional borrowing!

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Proposition II with Taxes

• When we take the tax deductibility of interest
  payments into account the equations we presented
  must change
• and

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Proposition II
Cost of capital r()
r0
rB
Debt-to-equityratio (B/S)
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Limits to The Use of Debt

• Given the treatment the U. S. corporate tax code
  gives to interest payments versus dividend
  payments, firms have a big incentive to use debt
  financing.
• Under the MM assumptions with corporate taxes the
  argument goes to extremes and the message
  becomes firms should use 100 debt financing.
• What other costs are associated with the use of
  debt?
• Bankruptcy costs and/or financial distress costs!

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Bankruptcy Costs

• Direct costs
• Legal fees
• Accounting fees
• Costs associated with a trial (expert witnesses)
• Indirect costs
• Reduced effectiveness in the market.
• Lower value of service contracts, warranties.
  Decreased willingness of suppliers to provide
  trade credit.
• Loss of value of intangible assets--e.g., patents.

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Agency costs of debt

• When bankruptcy is possible incentives may be
  affected.
• Example (Risk Shifting)
• Big Trouble Corp. (BTC) owes its creditors 5
  million, due in six months.
• BTC has liquidated its assets because it could
  not operate profitably. Its remaining asset is
  1 million cash.
• Big Bill, the lone shareholder and general
  manager is considering two possible investments.
  
• (1) Buy six month T-bills to earn 3 interest.
• (2) Go to Vegas and wager the entire 1 million
  on a single spin of the roulette wheel.
• Why might Bill consider the second investment?
• Would he have considered it in the absence of
  leverage?

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Under-investment Problem

• Example
• Slight Trouble Corp. (STC) has a small but
  significant chance of bankruptcy in the next few
  years. Its debt is trading far below par.
• Managers are evaluating an investment project
  that will cost 1 million to undertake. The
  alternative is to pay 1 million out as
  dividends.
• While the NPV of the project is positive it may
  be that the shareholders are better off with the
  dividend than if the project is taken.
• The reason is that while shareholders pay all the
  costs of the project, they will have to share the
  value with bondholders, the added value will
  raise bond prices as well as stock prices.

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Disciplinary Power of Debt

• On the other hand as economists are fond of
  saying, debt can be a disciplinary device.
• It has long been realized that an owner works
  harder and makes better decisions than does an
  employee.
• This was an often cited justification for the LBO
  wave of the mid 80s and early 90s.
• Idea is that one of the most contentious issues
  between managers and shareholders is the payout
  of excess cash.
• Debt allows manager to commit to the payout in a
  way that cannot be accomplished with a dividend
  policy.

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A Theory of Capital Structure

• The value of a levered firm can be thought of as
• the value of an equivalent but unlevered firm
• present value of tax shields (net)
• present value of expected bankruptcy
  costs and agency costs.

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The Value of the Firm with Costs of Financial
Distress
Value of firm (V)
VL VU TC B Value of firm under
MM with corporate Maximum taxes and
debt firm value V Actual value of
firm VU Value of firm with no debt
Debt (B) B Optimal
amount of debt The tax shield increases the value
of the levered firm. Financial distress costs
lower the value of the levered firm. The two
offsetting factors produce an optimal amount of
debt.
Present value of financial distress costs
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Financing Decisions

• Pecking Order Theory says that there is no
  optimal capital structure, just the culmination
  of all your financing decisions.
• Internally generated funds.
• External Debt.
• External Equity as a last resort.
• Data shows that preferences such as these are
  there but a subject of debate is whether they are
  necessarily inconsistent with there being an
  optimal capital structure.

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Choosing an Amount of Debt

• The theory provides no clear formula (unlike NPV)
  but the tradeoffs are clear the benefits versus
  the costs of debt.
• Use more debt if
• effective tax rates (without debt) are higher,
• operating cash flows are more predictable,
• agency costs can be controlled by contracts.
• A safe strategy might be to emulate the industry
  average. After all these are the firms who have
  survived. From there you make alterations as your
  own situation dictates.

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Example

• Ralphs firm has been in the food processing
  business for the last 10 years. It has
  maintained a conservative capital structure
  financing 60 of its value with equity.
• Ralph has recently considered investing in the
  IPO of a start-up company that will develop and
  manufacture internet infrastructure. In
  discussions with the start-ups manager, Ralphs
  nephew, it is revealed that the start-up will use
  either no or 20 debt financing. You have been
  called in to help identify an appropriate cost of
  capital for evaluating this investment.

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Ralphs Dilemma

• Currently Ralphs equity beta is estimated at
  0.95. There is no beta we can estimate for this
  private company (the start-up) but we know that
  Cisco has an equity beta of 1.92.
• The risk free rate is 6 and the market risk
  premium is 7. The tax rate for all corporations
  is 35.
• How can we approach determining the appropriate
  discount rate?

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Ralphs Dilemma cont

• Start with the following
• We can reasonably assume that the asset beta for
  Cisco will be a close estimate for the asset beta
  for the start-up.
• We know that the equity beta for Cisco is 1.92.
  What is Ciscos asset beta?

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Ralphs Dilemma cont

• Now we know that the asset beta for the start-up
  can be estimated at 1.92. What is the equity
  beta?
• We have two scenarios to consider, a debt to
  value ratio of either 0 or 20.
• If it is zero, the equity beta equals the asset
  beta or 1.92.
• If it is 20, we need to use

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Ralphs Dilemma cont

• Now we need a weighted average cost of capital.
• For the case of no debt rE rA rWACC
• rE 6 1.92(7) 19.44.
• With 20 debt
• rE 6 2.23(7) 21.61.
• rD 6 (since we assumed the debt was riskless).
• rWACC 21.61(.8) 6(1-.35)(.2) 18.07.
• Why was I sure that I did something wrong when I
  calculated the rWACC as 22.50 on my first try?

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Example BK Industries
If you recall, BK was evaluating a project in a
very different industry from its own with the
following incremental cash flows (FCF). At 10
we found an NPV of 5.2 million.
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Example BK Industries Revisited

• BK Industries is a conglomerate company with
  operations in marine power, pleasure boating,
  defense, and fishing tackle. BKs equity beta is
  1.0. BK has and will maintain a debt/equity
  ratio of 1.0.
• Can we use the company cost of capital to value
  the text editing project?
• Latec Inc. is a firm that makes only text editing
  systems. Latecs equity beta is 1.35. Latec has
  a debt to equity ratio of 0.75, and a marginal
  tax rate of 45.

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Delevered Betas with debt/equity ratios

• The formulas for obtaining asset betas from
  equity betas and vice versa provided earlier
  required dollars values for debt (B) and equity
  (S). What if you are only given the leverage
  ratio, L B/S? The formulas are restated as

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Unlever Latecs Beta to obtain the Beta of
Text-Editing Assets

• Latec has L 0.75, TC .45, and an equity beta
  of 1.35.

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Relever the asset Beta to reflect BKs capital
structure
Recalling that BK will keep its debt/equity
ratio equal to one, we can get

• This is the beta for a BK equity position in a
  text
• editing asset.
• Why is this equity beta greater than Latecs?

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BK Industries, Cont.

• Assume that the risk free rate is 8 and that
  BKs cost of debt is also 8. The market risk
  premium is 7. Then the required return on BKs
  equity is

The weighted average cost of capital for the text
editing venture (using the fact that B/S 1) is
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• Finally, we can evaluate the NPV of the text
  editing venture using the WACC that reflects the
  risk associated with this particular business.
  Using the cash flow estimates obtained earlier

• The NPV is positive, so proceed with the text
  editing business.
• Note also that the market value of the project
  will be 28.78 M.
• Notice that the selected discount rate of 11.38
  reflects
• The risk (beta) of text editing businesses, not
  BKs existing businesses.
• BKs capital structure, not that of the
  comparable firm.

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Questions

• BK Industries debt to equity ratio is 1.0 as it
  is for the project. BKs equity beta prior to
  starting the text editing business was 1.0
  (levered beta).
• What will happen to the beta of BK Industries
  after starting the text editing business?
• Suppose that BK uses its firm cost of capital to
  evaluate the text business? Would this favor the
  investment?
• Does BK diversifying into the text editor
  business help shareholders by providing them a
  more diversified portfolio?

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An Alternative Approach

• The Adjusted Present Value (APV)
• Follows from the MM equation VL VU
  TCB.
• Take the value of the project, if it were
  unlevered, then add the debt tax shields (more
  completely the additional effects of debt).
• Lets just do the exercise. We have cash flows
  for the unlevered firm but remember that the
  formulas are derived using a perpetuity (a
  simplification).
• If BKs project generates 3.39124 million each
  year forever its NPV is the same using the WACC.

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An Alternative Approach

• The unlevered NPV is now, using the perpetual
  equivalent cash flow derived as follows
• rA 8 .955(7) 14.69
• NPVU 3.39124/.1469 26 - 2.9 m
• APV NPVU TCB -2.9 .45(14.9m)
• 3.79 m.
• This approach is most useful when you know the
  dollar amount of debt that will be used each year
  rather than the debt ratio over the life of the
  project (perhaps an LBO or other highly levered
  transactions).