Optimal Financing Mix

1
Optimal Financing Mix

• 05/23/07
• Ch. 19

2
The search for an optimal financing mix

• The Cost of Capital Approach
• The optimal debt ratio (D/DE) is chosen to
  minimize cost of capital and is calculated based
  on the weights and costs of each component of
  capital.
• Why does the cost of capital matter?
• Value of a Firm Present Value of Cash Flows to
  the Firm, discounted back at the cost of capital.
• If the cash flows to the firm are held constant,
  and the cost of capital is minimized, the value
  of the firm will be maximized.

3
Mechanics of cost of capital estimation

• Estimate the equity and debt weights at different
  debt levels
• Estimate the Cost of Equity at different levels
  of debt
• Estimate the levered beta for different levels of
  debt
• The cost of equity will increase with the debt
  ratio since the levered beta increases
• Estimate the Cost of Debt at different levels of
  debt
• Default risk will go up and bond ratings will go
  down as debt goes up -gt Cost of Debt will
  increase.
• To estimating bond ratings, we will use the
  interest coverage ratio (EBIT/Interest expense)
• Estimate the Cost of Capital at different levels
  of debt

4
Estimating the equity and debt weights

• In estimating the weights of equity and debt at
  different levels of debt, we can assume
• that the firm maintains its current value and
  issues equity / pays off debt to reduce the debt
  ratio or buys back equity / issues debt to
  increase the debt ratio
• OR that the firm increases firm market value by
  taking on additional debt.

5
Estimating the cost of equity

• Calculate the unlevered beta for the firm
• Use this unlevered beta and different D/E levels
  to estimate the levered beta at different debt
  levels
• The CAPM is then used to estimate a cost of
  equity at each debt ratio.

6
Estimating the cost of debt

• To estimate the cost of debt at different debt
  levels, we construct synthetic ratings for our
  firm at different debt levels.
• Cost of debt is estimated by the following
  process
• Calculate the firms current EBIT
• Estimate the firms interest coverage ratio at
  various levels of debt
• Interest expense for each debt level must be
  calculated to determine the interest coverage
  ratio at that debt level
• Using interest coverage ratio estimates, obtain
  firm ratings at different debt levels
• Calculate the after-tax costs of debt using the
  current treasury bond rate, the default spread
  and marginal tax rate
• There is a circularity to these calculations.
  Without a starting assumption, we cannot
  calculate costs of debt. Our starting assumption
  is that at the lowest level of debt considered,
  the company is AAA-rated.

7
Estimating cost of capital

• With the estimated costs of equity, after-tax
  costs of debt and debt/equity weights at
  different debt levels, we can estimate the cost
  of capital at these different debt levels.

8
Effect of moving to the optimal on firm value

• Re-estimate firm value at the optimal debt ratio,
  using the optimal cost of capital.
• For a stable growth firm, this would be
• Firm Value CF to Firm (1 g) / (WACC -g)
• For a high growth firm, this would require that
  the cash flows during the high growth phase be
  estimated and discounted back.
• The increase in firm value of moving to the
  optimal cost of capital
• Firm Valueopt WACC- Firm Valueorig WACC

9
Firm value inputs

• Cash flow to firm
• CF to firm EBIT(1-t) Depr.Amort. Chg in WC
  Cap Exp
• Growth rate (g)
• The estimate of growth used in valuing a firm can
  clearly have significant implications for the
  final number.
• One way to bypass this estimation is to estimate
  the growth rate implied in todays market value.
  For instance, assuming a perpetual growth model,

10
A framework for analyzing a companys capital
structure
Is the actual debt ratio greater than or lesser
than the optimal debt ratio?
Actual gt Optimal
Actual lt Optimal
Overlevered
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes
No
Yes
No
Reduce Debt quickly
Increase leverage
Does the firm have good
Does the firm have good
1. Equity for Debt swap
quickly
projects?
projects?
2. Sell Assets use cash
1. Debt/Equity swaps
Positive NPV or
Positive NPV or
to pay off debt
2. Borrow money
IRR gt Cost of Capital
IRR gt Cost of Capital
3. Renegotiate with lenders
buy shares.
Yes
No
Yes
No
Take good projects with
1. Pay off debt with retained
Take good projects with
new equity or with retained
earnings.
debt.
earnings.
2. Reduce or eliminate dividends.
Do your stockholders like
3. Issue new equity and pay off
dividends?
debt.
Yes
No
Pay Dividends
Buy back stock
11
Chapter 19

• We will only cover the cost of capital approach
  pgs. 574 - 589