Financing Decisions and The Cost of Capital

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Financing Decisions and The Cost of Capital
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Where do Firms Get Money?

• Self Financing (using internal cash flow)
• Accounts for 80 (avg.) of financing in the U.S.
• Difficult for start-up companies
• External Financing
• Borrowing from banks or issuing bonds
• Sharing ownership by issuing stock
• Net new issues of these securities accounts for
  the other 20 on average
• About 80 of what is raised or generated and
  retained is used for capital spending and the
  rest for working capital and other uses

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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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A Life Cycle of Financing
Firm Size/Age
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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The Capital Structure Question

• How should a firm structure the left hand side of
  its balance sheet?
• Debt vs. Equity the choice for our purposes.
• 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 use.
• Can the firm change shareholder value through its
  financing decisions?
• In particular, should the firm load up with low
  cost debt?

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One possible answer It makes no difference!

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

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Irrelevance Proposition II

• What this means is that the expected return on
  equity rises with leverage according to (where,
  B/S leverage ratio -- market value of debt over
  market value of equity, r denotes expected return
  or appropriate discount rate).
• I will try to use r0 not rA for consistency with
  the text.

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MM Proposition II

• Why does the expected return on equity rise?
• The SML tells us that the expected return on an
  asset changes only when what characteristic of
  the asset changes?
• The beta of a portfolio is the weighted sum of
  the individual betas
• Rearrange this to find

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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 generated by the use
  of debt.
• Firm Value rises with additional borrowing! Why?

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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 costs are associated with the use of debt?
• Bankruptcy costs and/or costs of financial
  distress!

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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 likely incentives may be
  altered.
• Example (Over-investment)
• 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
  high leverage?

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Under-investment Problem

• 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 its
  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 is well recognized that an owner works harder
  and makes better decisions than an employee.
• This was an often cited justification for the LBO
  wave of the mid 80s and early 90s.
• The idea is that one of the most contentious
  issues between managers and shareholders is the
  payout of excess cash. Consider Hollinger
  International and Conrad Blacks behavior.
• Debt allows manager to commit to the payout in a
  way that cannot be accomplished with a dividend
  policy.

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MM with Taxes and Costs of Financial Distress
Value of firm underMM with corporatetaxes and
debt
Value of firm (V)
Present value of taxshield on debt
VL VU TCB
Maximumfirm value
Present value offinancial distress costs

V Actual value of firm
VU Value of firm with no debt
0
Debt (B)
B
Optimal amount of debt
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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.
• The theory does tell us to use more debt if
• effective tax rates (without debt) are higher,
• operating cash flows are more predictable,
• tangible assets make up most of your asset base,
• 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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Leverage Ratios for Selected Industries

• Industry B/(SB)
• High Leverage
• Building Construction 52.8
• Hotels and Lodging 56.0
• Air transport 47.7
• Gold-Silver mining 42.2
• Paper 51.9
• Low Leverage
• Drugs 4.7
• Electronics 9.8
• Biological products 4.0
• Computers 8.2
• Apparel 5.3

Source Ibbotson Associates 2003
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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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Example

• Ralphs firm has been in the food processing
  business for 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.
• For simplicity, assume the firm is expected to
  generate free cash flow of 1M each year in
  perpetuity.
• 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. We cannot estimate the beta for this
  private company (the start-up) directly 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 rS rA r0 rWACC
• rS 6 1.92(7) 19.44.
• With 20 debt
• rS 6 2.23(7) 21.61.
• rB 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 20.50 on the first try?

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Valuations

• Using the 1M per year perpetual free cash flow
  assumption the valuation of this firm is easily
  done.
• With no debt in the start-up firms capital
  structure its value is
• With 20 debt

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An Alternative Valuation

• The Adjusted Present Value (APV)
• Follows from the MM equation VL VU TCB.
• Take the value of the firm or project, if it were
  unlevered, then add the value of the debt tax
  shields (more completely the additional effects
  of debt).
• This can be a very useful approach to valuation
  in some situations.

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APV Versus WACC

• The difference between these valuation techniques
  lies in how we value the tax shields associated
  with the use of debt financing.
• In the WACC approach we use Free Cash Flow and a
  discount rate (WACC) that is below the unlevered
  cost of capital (r0). The lower discount rate
  inflates the present value of the future free
  cash flows by just enough to account for the
  value of the tax shields associated with the
  chosen debt to equity ratio.
• In the APV we value the Free Cash Flow at the
  appropriate discount rate for an unlevered firm
  (r0) which gives us the correct present value of
  the Free Cash Flow. We then add the value of the
  tax shields associated with the firms use of
  debt financing.

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APV Example

• To implement this approach we do two things.
  First, find the value of the firm if it is
  unlevered. Second, find the present value of the
  debt tax shields that will be generated by the
  use of debt financing.
• The value of the unlevered firm, as before, is
• With 1.1M in debt capital used by the start-up
  firm its value would become

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The Alternative Approach

• The APV approach is most useful when you know the
  dollar amount of debt that will be used each year
  over the life of the project.
• e.g., an LBO or other highly levered
  transactions.
• The WACC approach is easier to use when the firm
  has a target debt ratio that it can reasonably be
  expected to maintain.