Session 8: Weights and Cost of Capital Dynamics

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Session 8 Weights and Cost of Capital Dynamics
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Weights for Cost of Capital Calculation

• The weights used in the cost of capital
  computation should be market values.
• There are three specious arguments used against
  market value
• Book value is more reliable than market value
  because it is not as volatile While it is true
  that book value does not change as much as market
  value, this is more a reflection of weakness than
  strength
• Using book value rather than market value is a
  more conservative approach to estimating debt
  ratios For most companies, using book values
  will yield a lower cost of capital than using
  market value weights.
• Since accounting returns are computed based upon
  book value, consistency requires the use of book
  value in computing cost of capital While it may
  seem consistent to use book values for both
  accounting return and cost of capital
  calculations, it does not make economic sense.

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Disney From book value to market value for debt

• In Disneys 2008 financial statements, the debt
  due over time was footnoted.
• Disneys total debt due, in book value terms, on
  the balance sheet is 16,003 million and the
  total interest expense for the year was 728
  million. Assuming that the maturity that we
  computed above still holds and using 6 as the
  pre-tax cost of debt
• Estimated MV of Disney Debt

No maturity was given for debt due after 5 years.
I assumed 10 years.
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And operating leases

• The pre-tax cost of debt at Disney is 6.
• Debt outstanding at Disney
• MV of Interest bearing Debt PV of Operating
  Leases
• 14,962 1,720 16,682 million

Year Commitment Present Value
1 392.00 369.81
2 351.00 312.39
3 305.00 256.08
4 265.00 209.90
5 198.00 147.96
6 7 309.50 424.02
Debt Value of leases   1,720.17
Disney reported 619 million in commitments after
year 5. Given that their average commitment over
the first 5 years of 302 million, we assumed two
years _at_ 309.5 million each.
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Current Cost of Capital Disney

• Equity
• Cost of Equity Riskfree rate Beta Risk
  Premium 3.5 0.9011 (6) 8.91
• Market Value of Equity 45.193 Billion
• Equity/(DebtEquity ) 73.04
• Debt
• After-tax Cost of debt (Riskfree rate Default
  Spread) (1-t)
• (3.52.5) (1-.38) 3.72
• Market Value of Debt 16.682 Billion
• Debt/(Debt Equity) 26.96
• Cost of Capital 8.91(.7304)3.72(.2696)
  7.51

45.193/ (45.19316.682)
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Dealing with Hybrids and Preferred Stock

• When dealing with hybrids (convertible bonds, for
  instance), break the security down into debt and
  equity and allocate the amounts accordingly.
  Thus, if a firm has 125 million in convertible
  debt outstanding, break the 125 million into
  straight debt and conversion option components.
  The conversion option is equity.
• When dealing with preferred stock, it is better
  to keep it as a separate component. The cost of
  preferred stock is the preferred dividend yield.

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Decomposing a convertible bond

• Assume that the firm that you are analyzing has
  125 million in face value of convertible debt
  with a stated interest rate of 4, a 10 year
  maturity and a market value of 140 million. If
  the firm has a bond rating of A and the interest
  rate on A-rated straight bond is 8, you can
  break down the value of the convertible bond into
  straight debt and equity portions.
• Straight debt (4 of 125 million) (PV of
  annuity, 10 years, 8) 125 million/1.0810
  91.45 million
• Equity portion 140 million - 91.45 million
  48.55 million

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Debt ratios for private businesses

• While the temptation is to go with book values
  for debt and equity, you should steer away from
  them. There are three alternatives you can
  employ.
• Use the industry average market debt ratio,
  obtained by looking at publicly traded companies
  in the sector, to estimate the cost of equity and
  capital.
• Use an estimated market value of equity, based
  upon applying a multiple (say a PE ratio) to your
  private companys earnings to arrive at a debt to
  equity ratio.
• Use your DCF estimates of equity and debt value
  to compute your cost of capital. Since you will
  need the cost of capital to arrive at these
  estimates, this will create circularity in your
  valuation. If you are willing to use the
  iteration function in Excel, you should be still
  able to work with the circularity.

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Target versus Actual Debt Ratios

• The actual debt ratio for a firm reflects what
  the current management of the firm has chosen as
  the appropriate debt ratio. To the extent that
  the managers have either been too conservative or
  too extreme in the use of debt, the right debt
  ratio for the firm may be different from the
  actual.
• To estimate this right or target debt ratio,
  analysts use one of three choices
• An arbitrary number, based upon gut feeling and
  experience
• An industry average for the industry in which
  your company operates
• An optimal debt ratio that minimizes your cost
  of capital

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Computing an optimal debt ratio
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Should you value your business using the target
or optimal?

• If you are valuing a business for a sale or
  acquisition, it does make sense to use the target
  debt ratio, since the acquirer can reset the debt
  ratio at the time of the acquisition.
• If you are valuing a business as a passive
  investor or observer, you may be better off using
  the actual debt ratio, since the existing
  managers will continue to run the firm (and
  presumably keep intact their views of debt).
• If you are uncertain about who will be running
  the business in the future (existing managers or
  a new owner), you can either
• Change the debt ratio gradually over time from
  the actual to the optimal
• Do two valuations, one with the actual and one
  with the optimal, and take an expected value.

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Changing risk profiles changing costs of capital

• When valuing young, growth firms, the cost of
  capital at the start of your valuation should
  reflect the high risk of the firms (high costs of
  equity) and their inability to borrow money (low
  or no debt). As a result, your cost of capital
  will be high.
• As you bring down the growth rate of the firm
  over time and make it a more mature business
  (with higher revenues profits), you should
  expect
• The cost of equity to change over time, as your
  risk moves towards the average for the sector or
  the market.
• The debt ratio to rise, as earnings and cash
  flows go up
• The cost of capital to drift down towards the
  average for the market (or the sector).

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