Capital Structure

1
Capital Structure

• MBA 253

2
The Financing Decision

• The firm has limited ways to raise funds
• Debt Bank Debt, Commercial Paper and Corporate
  Bonds
• Equity Owners Equity, Venture Capital, Common
  Stock and Warrants
• Hybrid Securities Mixtures of Debt and Equity
  Convertible Debt, Preferred Stock, Option Linked
  Bonds
• What mix of debt and equity should be used? (what
  is the firms Capital Structure)

3
Debt vs. Equity

• Debt
• Fixed Claim
• Tax Deductible
• High Priority in Financial Trouble
• Fixed Maturity
• No Management Control

• Equity
• Residual Claimant
• No Tax Deduction
• Lowest Priority in Financial Trouble
• No Maturity
• Management Control

4
Debt

• Bank Debt
• Small amounts, Intermediation for small firms, No
  ratings agencies - public information can be
  minimized
• Corporate Bonds
• Risk Sharing, special features
• Issues to be addressed
• Short or long term
• Fixed or Floating Rates
• Assets used as Security
• Special Features

5
Special Features of Debt

• Floating Rate Loans Rate Varies with Index
• Puttable Bonds Bond holders can receive face
  value
• Convertible / Exchangeable Can be converted into
  Equity
• Extendable Life of Bond can be extended by
  borrower
• Caps and Floors Limits rate movements of
  floatable bonds
• Swaps Exchange of fixed for floating and vice
  versa
• Reverse Floating Rate Notes Rate varies
  inversely with index
• Swapations Options on a swap

6
Equity

• Owners Equity
• returning earnings on the seed money to the firm
• Venture Capital
• capital provided in return for ownership share
• Common Stock
• Warrants
• Holders receive the right to buy shares in the
  company at a fixed price
• priced upon implied volatility
• create no financial obligation at time of issue
• Contingent value rights
• Investors can sell their stock at a fixed price

7
Warrants and Options

• Similar to a long term call option
• Difference is that exercising a warrant affects
  the value of the underlying asset (it increase
  the number of shares outstanding)

8
Hybrid Securities

• Convertible Debt
• Lowers the interest rate paid by the firm
• bondholder given the option to convert into stock
• Preferred Stock
• promised payment (like bonds)
• infinite life, limited voting privileges
• Option Linked Bonds
• Commodity linked bonds

9
Does Capital Structure Matter?

• WACC rd(1-t)wd rpswps rewe
• Generally Keeping the risk level the same, Debt
  is less expensive than Equity
• However, Increasing debt, increases the risk to
  the shareholders, the cost of equity should
  increase due to the higher risk.
• Which has a larger influence the decreased cost
  associated with the use of debt or increase cost
  associated with equity?

10
Debt Benefits and Cap Structure

• Debt ratios of firms with higher tax rates should
  be higher than those with lower tax rates
• Firms that have substantial non-debt tax shield
  (depreciation for example)should be less likely
  to use debt
• If tax rates increase over time so should debt
  ratios

11
The Costs of Debt

• Bankruptcy costs
• probability of bankruptcy
• Indirect and Direct Costs
• Agency Costs
• Creates tensions between shareholders and lenders
• Lost Flexibility
• Firms value the ability to take on new projects

12
Bankruptcy

• Probability Increases with
• The size of debt obligations relative to the size
  of operating cash flows
• The variability of cash flows
• Costs of Bankruptcy
• Direct Costs --Legal and administrative costs
• Indirect Costs -- decreased sales, availability
  of credit
• Indirect costs are higher when firms produce
• Durable products
• Products dependent on quality reputation
• Products requiring service and complementary
  products
• Products requiring support services

13
Bankruptcy and Cap Structure

• Firms in volatile industries should use debt less
  than firms in more stable industries
• If debt can be structured so that cash flows on
  debt increase and decrease with cash flows can
  borrow more
• If external protection from bankruptcy exists
  firms will borrow more
• Firms with non divisible and non marketable
  assets are more likely to use debt
• If products require long-term servicing should
  have lower leverage

14
Agency Costs

• Conflicts between Bondholders and Stockholders
• Investment decisions (risk shifting)
• Financing Decisions
• Dividend policy
• Agency costs are important when
• Bondholders believe that stockholder actions will
  increase chance of default
• Protective Covenants require monitoring costs and
  indirectly reduce flexibility
• The firms investments are not easily monitored
• projects are long term

15
Flexibility

• The ability to handle unforeseen contingencies
  that might arise
• Provides ability to undertake new projects
• Provides more breathing room
• Firms with large and unpredictable demands on
  cash flows will require higher flexibility
• As firms and industries mature the returns on
  projects become more stable and the desire of
  flexibility decreases

16
The Borrowing Trade off

• Advantages
• Tax Benefits
• Higher tax rate higher benefit
• Added Discipline
• The greater the separation between management and
  shareholders the greater the benefit

• Disadvantages
• Bankruptcy Costs
• Higher business risk implies
• Higher cost
• Agency Cost
• Greater separation between stockholders and
  lenders results in Higher Cost
• Loss of Flexibility
• Greater uncertainty implies Higher costs

17
Business Risk

• Business Risk
• The riskiness of the firms assets if it uses no
  debt
• Looked at in a stand alone context
• Measured by the standard deviation of the firms
  ROA

18
ROA vs. ROE

• ROA Return to Investors/Assets
• (Net Income to Shareholders Interest)/Assets
• Without the use of debt this becomes
• (Net Income to Shareholders /Assets
• Which is ROE
• W/O debt business risk can be measured by the
  firms ROE.

19
ROE

• Variability in ROE is determined by
• Demand Variability
• Sale Price Variability
• Input Cost Variability
• Ability to Adjust output prices
• Ability to develop new products
• Fixed Costs

20
Operating Leverage

• The portion of the firms costs that are fixed.
• Fixed costs must be paid regardless of sales
  this increases risk
• The Breakeven point is therefore important - it
  is the amount of sales needed to cover fixed
  cost.

21
Breakeven Point

• The breakeven point occurs where the firm earns
  just enough to cover fixed and variable cost
  (EBIT 0 and ROE 0)
• EBITPrice(Quant)-VaribCost(Q)-FixedC)
• Rearrange and solve for Q
• 0 pQ-VQ-F
• F (P-V)Q
• Q F/(P-V)

22
Financial Risk

• Financial Risk is the extra risk placed on
  shareholders when the firm decides to use debt.
• Above ROE NI/assetNI/equity
• (assets equity when debt 0)
• Now NI declines and as debt increases and equity
  decreases. The net effect is an increase in ROE

23
An example

• Stratsburg Electronics
• 175,000 in assets two choices
• 175,000 equity or 87,500 equity 87,500 debt
• Assume that the use of equity does not change the
  EBIT

24
Numerical Example
Debt and Equity All Equity
Expected EBIT 35,000 35,000
Interest (10) 8,700 0
EBT 26,250 35,000
Taxes(40) 10,500 14,000
Net Income 15,750 21,000
Expected ROE 15,750/87,500 18 21,000/175,000 12
25
The Capital Structure Question

• Is there an optimal capital structure?
• Modigilani and Miller
• Capital structure is irrelevant
• The decrease in cost of capital from debt is
  offset by the increase in the cost of equity.
• Trade off Theories
• The capital structure that minimizes the WACC
  will also produce the highest shareholder value
  and is the optimal capital structure.

26
Modigliani Miller

• Assumptions
• Firms can be classified by business risk
• All investors agree about the distribution of
  future earnings
• Perfect Capital Markets
• No Bankruptcy Costs
• No income taxes
• All cash flows are perpetuities
• EBIT is not changed by use of debt

27
MM two propositions

• Value of leveraged firm Value of Unleveraged
  Firm EBIT/ WACC EBIT / rSU
• rSL rSU (rSU - rd) (D/S)
• where
• rSL Cost of stock leveraged firm
• rSU cost of stock unleveraged firm
• rd Constant cost of debt
• D market value of debt
• S market value of stock

28
MM

• EBIT/WACC EBIT/KSU
• rSLrSU(rSU-rd)(D/S)
• Together this implies that the cost of capital
  doesnt change as the amount of borrowing
  increases.
• Assumed that EBIT doesnt change so WACC rSU
  regardless of the amount of debt used.
• WACC wd rd wsrSL

29
An ExampleEBIT/WACC EBIT/KSU
KSLKSU(KSU-Kd)(D/S)Assume that KSU 10 Kd
6

• 10 Debt
• KSLKSU(KSU-Kd)(D/S)
• KSL .10 (.10-.06)(1/9)
• KSL .104444
• WACC wd Kd ws KSL
• WACC .10(.06).9(.10444)
• WACC .10
• Value of firm EBIT/.10

• No Debt
• Value of firm EBIT/ KSU
• Value of firm EBIT/.10

30
Including Taxes

• What if the interest payments on debt are tax
  deductible? Then WACC will decrease at the
  percentage of debt increases.
• This implies that the value of the firm will
  increase as the amount of debt increases. In
  fact the optimal capital structure would be 100
  debt.
• Miller also showed that if personal income taxes
  are included that one possible scenario is still
  capital structure irrelevance. (see book for
  details)

31
If Debt Doesnt Matter

• The cost of capital is unaffected by changes in
  the proportions of debt and equity
• The value of the firm is unaffected by leverage
• The investment decision can be made independently
  of the financing decision.

32
Tradeoff Theory

• Initially adding debt causes the WACC to decline.
  The tax benefit of debt causes the WACC to
  decrease for now bankruptcy costs are low.
• As the firm uses more debt bankruptcy costs start
  to increase. The decrease in the WACC is less for
  every unit of debt added.
• As the amount of debt increase, so do bankruptcy
  costs Eventually the indirect and direct costs to
  the firm outweigh the tax benefits and the WACC
  increases.
• This implies that a minimum WACC exists, at this
  point the value of the firm (EBIT/WACC) will be
  maximized.

33
Trade Off Theory

• If this is the case the use of debt matters,
• The point were the WACC will be minimized will
  maximize the value of the firm

34
Empirical EvidenceThe Debt Ratio is

• Negatively correlated with the volatility in
  annual operating earnings as predicted by
  bankruptcy costs
• Positively related to the level of non-debt tax
  shields opposite of what was predicted
• Negatively related to advertising and RD
  expenses, as predicted by tradeoff theory
• Positively related to the marginal tax rate as
  predicted by the tradeoff theory
• Negatively related to the need for decision
  making flexibility as predicted by tradeoff
  theory
• Negatively related to variability in operating
  cash flows as predicted by tradeoff theory

35
Information Asymmetry

• Managers prefer retained earnings to external
  financing since external financing depends upon
  the market pricing the security
• If management believes that the market is
  overvaluing its securities it is more willing to
  issue new equity, even if projects dont exist
• If management believes that the market is
  underpricing its securities it is less willing to
  issue new equity even if good projects exist.

36
Signaling

• Therefore issuing securities signals the market
  that firms believe their security is overvalued
  and it is interpreted as a negative signal.
  (The market believes the firm has negative
  information not publicly available)
• The signal is more negative if there is a greater
  possibility of asymmetry (stocks for example).

37
Capital Structure Decisions

• Rank Source Principles Cited
• 1 Retained Earnings None
• 2 Straight Debt Max Security Prices
• 3 Convertible Debt Cash Flow and
• Survivability
• 4 External Common Avoiding Dilution
  of Equity
• 5 Straight Pref Stock Comparability
• 6 Convertible Pref None

38
Other Things to Consider

• Some final considerations in the capital
  structure decision
• 1) Long Run Viability
• 2) Managerial Conservatism
• 3) Lender and Rating Agency Attitudes
• 4) Financial Flexibility
• 5) Control
• 6) Asset Structure
• 7) Growth Rate
• 8) Profitability

39
Cap Structure Models and Applications

• Cost of Capital Approach
• Analysis based on the cost to the firm of
  financing new projects (the WACC calculated
  earlier)
• Adjusted Present Value
• Valuing the firm by starting without leverage
  then adjusting its value as more debt is added
• Comparative Analysis
• Comparing the debt ratio and other financial
  information to industry averages

40
The Cost of Capital Approach

• Basic Idea
• Attempt to maximize firm value by finding the
  level of debt that produces its minimum WACC.
• Procedure
• Calculate the cost of debt, cost of equity and
  the WACC at various levels of debt to identify
  its minimum WACC.

41
WACC

• The weighted average cost of capital is defined
  as the weighted average of the cost of the
  different components of financing
• WACC rdwd(1-t) rpswps rewe
• where
• rd before tax cost of debt wd of
  financing from debt
• rps cost of preferred stock wps of
  financing from Pref stock
• rd cost of debt equity wd weight of
  financing from equity
• t firms marginal tax rate

42
WACC and Firm Value

• The value of the firm is the present value of its
  future cash flows (FCFF) discounted at the WACC
  (the hurdle rate)
• Value of the firm S FCFF/(1WACC)t
• Notice as the WACC decreases the value of the
  firm will increase, if the WACC increases the
  value of the firm will decrease.

43
WACC and Firm Value

• According to the present value formula as the
  discount rate decreases the PV of a future sum
  (or series of cash flows) will increase.
• If the tradeoff theory is correct there is a
  minimum WACC
• Does this imply that the Firm Value will be
  maximized at the point where the WACC is
  minimized?

44
WACC and Firm Value

• If the cash flows to the firm do not depend on
  the financing mix, the value of the firm is
  maximized when the WACC is minimized
• The Debt Equity ratio might cause a change in the
  FCFF, if this is the case the minimum WACC will
  not necessarily maximize firm value

45
Estimating the Cost of Capital

• You need to estimate the WACC for different
  levels of debt.
• Develop an estimate for the cost of equity and
  various debt levels
• Develop an estimate for the cost of debt at
  various debt levels
• Combine 1 and 2 to find the WACC for various
  levels of debt.

46
Estimating the Cost of Equity

• Step 1 Estimate the equity beta (run regression
  or use analysts estimate)
• Step 2 Estimate the unlevered beta (Beta if the
  firm had no debt)
• bu bcurrent/1(1-t)D/E
• Step 3 Reestimate the levered beta for different
  levels of debt
• bLevered bu1(1-t)D/E
• Step 4 Use CAPM to estimate the costs of equity
  from the levered betas
• re rRF bLeveredE(rm)-rRF)

47
Disneys Optimal Capital Structure

• Step 1 Estimate Beta

48
Disneys Cost of Equity

• Step 2 Estimate the Unlevered beta
• ?u ?current/1(1-t)D/E
• Disneys D/E Ratio
• Long Term Debt 12.67 Billion
• Market Capitalization 65.74 Billion
• D/E 12.67/65.74 .19
• Assuming a 36 tax rate
• ?u ?current/1(1-t)D/E
• 1.0941(1-.36)(.19) 0.975

49
Disney Cost of Equity

• Step 3
• Reestimate the levered beta at different levels
  of debt
• ?Lev ?u1(1-t)D/E

50
Disneys Cost of Equity

• Step 4 Estimate cost of equity using ?Levered
  in the CAPM
• let rRF 5
• rM- rRF .0482
• RerRFb(rM-rRF)

51
Estimate the Cost of Debt

• Step 1 Compute the market value of the firm MV
  of firm MV of Debt MV of Equity
• Step 2 Compute value of debt at various debt
  ratios Value of Debt D/(DE)(MV of firm)
• Step 3 Compute the amount paid in interest at
  each debt ratio (Interest rate)(value of
  Debt)
• Step 4 Estimate the Interest Coverage Ratio
  EBIT/Interest Expense
• Step 5 Use the Interest coverage ratio to
  determine bond ratings and interest
  rate spreads
• Step 6 Use Spreads to find before tax cost of debt

52
A Viscous Circle

• You need the interest rate to calculate the
  interest payments. Then use the interest payment
  to determine the interest coverage and rating to
  find the interest rate.
• Use iterative procedure to find consistent rates,
  Assume AAA use rate then estimate rate, if they
  are not the same repeat the process...

53
Disneys Cost of Debt Step 1

• Step 1 Compute the market value of the firm MV
  of firm MV of Debt MV of Equity
• 12.67 Billion 65.74 Billion
• 78.41 Billion
• Use this as the current amount of financing
  undertaken by the firm (we want to find the
  value of debt at various debt ratios)

54
Disneys Cost of Debt Step 2

• Step 2 Compute value of debt at various debt
  ratios Value of Debt (Debt/(DE))(MV of firm)

55
Disneys Cost of Debt Step 3

• Step 3 Compute the amount paid in interest at
  each
• debt ratio (Interest Rate)(value of Debt)
• The problem is that you have to assume an
  interest rate then continue with Steps 4 and 5 to
  see if your assumption was correct. Your
  assumption of the rate is based upon the likely
  rating for the firm.
• Starting with the increase from 0 to 10 debt
  assume that the firm is ranked AAA. Then look at
  the table relating bond ratings to rates to
  estimate the rate.

56
Bond Ratings and Average Yield Spreads vs. US
Treasuries (long term bonds)

• Rating Spread Int Cov Rating Spread Int Cov
• AAA .35 gt12.5 B 2.5 2.5-3
• AA .50 9.5-12.5 B 3.25 2-2.5
• A .70 7.5-9.5 B- 4.25 1.5-2
• A .85 6.0-7.5 CCC 5.00 1.25-1.5
• A- 1.00 4.5-6.0 CC 6.00 0.8-1.25
• BBB 1.5 4-4.5 C 7.5 0.5-0.8
• BB 2.0 3-3.5 D 10.0 lt0.5

57
Disneys Cost of Debt Step 3

• A rating of AAA implies a 5.35 interest rate for
  the firm (0.35 spread over the long term rate)
• Given the interest rate you can calculate the
  interest expense (Interest Rate)( Value of
  Debt) (0.0535)(7.84) .4194 Billion
• Use this number to calculate the interest
  coverage ratio in step 4

58
Disneys Cost of Debt Steps 4 5

• Step 4 Estimate the Interest Coverage Ratio
  EBIT/Interest Expense
• Disneys EBIT 5.301 Billion
• Interest coverage ratio at 10 D/(DE)
  5.301/0.4194 12.634
• An interest coverage ratio of 12.634 implies a
  bond rating of AAA, so 5.35 is correct.
• If the interest coverage ratio did not imply the
  same rating as your assumption, go back to step 3.

59
Ratings and Interest Coverage Ratios

• Rating Coverage ratio Interest rate
• AAA 12.5 to infinity 5.35
• AA 9.5 to 12.5 5.50
• A 7.5 to 9.5 5.70
• A 6.0 to 7.5 5.85
• A - 4.5 to 6.0 6.00
• BBB 4.0 to 4.5 6.50

12.63
Implies a bond rating of AAA
60
A Second Example

• Using a 20 D/(DE) and still the assumption that
  the firms debt will be ranked AAA implying a
  5.35 cost of debt
• The value of debt is 15.682 Billion
• Implying expense of 15.682(.0535) .83898
  Billion
• The interest coverage ratio is 5.301/.83898
  6.3183866 which implies a bond rating of ...

61
Ratings and Interest Coverage Ratios

• Rating Coverage ratio Interest rate
• AAA 12.5 to infinity 5.35
• AA 9.5 to 12.5 5.50
• A 7.5 to 9.5 5.70
• A 6.0 to 7.5 5.85
• A - 4.5 to 6.0 6.00
• BBB 4.0 to 4.5 6.50

6.31
Implies a bond rating of A
62
Ratings and Interest Coverage Ratios

• Since the interest coverage ratio implies that
  the bond should be rated A assume that the rate
  is 6.00
• The value of debt is 15.682 Billion
• Implying expense of 15.682(.0585) .91739
  Billion
• The interest coverage ratio is 5.301/.91739
  5.77 Checking the table.

63
Ratings and Interest Coverage Ratios

• Rating Coverage ratio Interest rate
• AAA 12.5 to infinity 5.35
• AA 9.5 to 12.5 5.50
• A 7.5 to 9.5 5.70
• A 6.0 to 7.5 5.85
• A - 4.5 to 6.0 6.00
• BBB 4.0 to 4.5 6.50

5.77
Implies a bond rating of A-
64
A Second Example

• Using a 20 D/(DE) and still the assumption that
  the firms debt will be ranked A- implying a 6.00
  cost of debt
• The value of debt is 15.682 Billion
• Implying expense of 15.682(.06) .94092Billion
• The interest coverage ratio is 5.301/.94092
  5.63 which implies a bond rating of ...

65
Ratings and Interest Coverage Ratios

• Rating Coverage ratio Interest rate
• AAA 12.5 to infinity 5.53
• AA 9.5 to 12.5 5.50
• A 7.5 to 9.5 5.70
• A 6.0 to 7.5 5.85
• A - 4.5 to 6.0 6.00
• BBB 4.0 to 4.5 6.50

5.63
Still Implies a bond rating of A- !!!
66
Ratings and Interest Coverage Ratios

• Since the assumed rate and the corresponding
  actual rate agree, the cost of debt for a weight
  in debt of 20 is then set to be 6.00 and the
  process is repeated for 25 debt, 30 debt etc
• Remember that these are before tax cost of debt,
  and they will need to be adjusted in the cost of
  capital formula.

67
Disneys Cost of Debt

• Steps 3 and 4 for debt from 10 to 60 - complete
  this for a range from 0 to 100 debt

68
Cost of Capital

• Using the cost of equity and cost of debt at
  various debt levels you can find the WACC of each
  level of debt.
• Remember, the debt level determine the weights of
  each type of financing (the capital structure).

69
WACC at Different Debt Levels
70
Optimal Debt Ratio
71
Minimum WACC

• The minimum WACC occurs at approximately 25
  debt. This is the Optimal amount of debt for
  the firm
• The value of the firm could then be found
  assuming that the future FCFF can be estimated.

72
FCFF

• FCFF EBIT(1-t) Depreciation - Capital
  Spending
• Disneys 2005 financial statements show that
• EBIT 5.301 Billion
• Depreciation 1.339 Billion
• Capital Spending 1.823 Billion
• Assuming a tax rate of 36
• FCFF 5.301(1-.36)1.339 1.823 2.9086

73
Firm Value and WACC

• In General the value of the firm is the present
  value of its discounted cash flows
• If the cash flows are constant over time similar
  to a perpetuity this reduces to

74
Constant growth in FCFF

• This is the same formula as for valuing stocks
  with constant growth in dividends (now the cash
  flows being discounted are FCFF instead of
  Dividends.
• Let g be the constant rate of growth in FCFF then
  the value of the firm is given by

75
Annual Savings

• Disney is currently operating at a debt level of
  16. But its optimal debt level is 30
• The annual financing cost at the current debt
  ratio is 78.41(.09242) 7.2466 Billion
• At a debt level of 25 (WACC .08985)
• The annual financing costs would be equal to
  78.41(.08985) 7.0421 Billion
• This implies an annual savings of
• 7.2466B-7.0421 201.46 Million
• IF the firm moves to its optimal capital
  structure

76
Implied Growth Rate

• Rearrange to find the growth rate

77
Implied Growth Rate

• Use the current MV of the firm from before as the
  PV PV78.41 B, FCFF 2.9086 Billion, WACC
  .08985

78.41
2.9086
08985
.
?
?
?
?
.05087
2.9086
?
78.41
78

• Assuming that the annual savings also grows at
  the implied growth rate of 7.36, the PV of the
  annual savings will represent an increase in the
  value of the firm since it reduces its yearly
  interest expense.

79
Share Price

• The value of the firm increased by 5.431 Billion,
  this can be transformed to a per share value by
  dividing by the number of shares outstanding.
• The resulting number should represent an increase
  in the share price of the firm. It would be the
  increase in the PV of the future cash flows to
  the firm.
• Given 2.1 Billion Shares issued
• 5.431/2.113 2.57
• The share price should increase by 2.57 or
  2.57/31.45 8.1

80
Final Thoughts

• The model assumes that the relationship between
  bond ratings and risk premiums is the same over
  time
• The model assumes that all debt will be
  refinanced at the new level of interest rates
• Is this the optimal capital ratio if the bonds
  are ranked below investment grade?

81
Adjusted Present Value

• Start with the PV of the firm assuming that there
  is no debt
• As debt is added adjust the present value to
  account for the positive and negative effects of
  adding debt.
• Assuming that the largest benefit of borrowing is
  the tax saving and the largest source of costs
  are bankruptcy costs
• Value of Value of PV of
  PV of
• Levered Unlevered Tax Benefits - Bankruptcy
• Firm Firm of debt
  Costs

82
Value of Unlevered Firm

• Assumes that the firm has no debt. this requires
  an estimate of the unlevered cost of equity.
• The unlevered cost of equity is found by using
  the unlevered beta in the CAPM
• The value of the unlevered firm is then

83
Tax Benefit

• The expected tax benefit from borrowing is based
  upon the level of debt in the firm.
• Each years tax savings equal the tax rate
  multiplied by the amount of debt multiplied by
  the cost of debt
• The benefit should be discounted at the cost of
  debt
• PV of tax benefit (Tax rate)(Cost of
  Debt)(Debt) Cost of Debt (Tax
  Rate)(Debt)
• Note The cost of debt changes as the level of
  debt changes

84
Expected Bankruptcy Costs

• The expected bankruptcy costs depends upon the
  probability of default
• The probability of default will increase as the
  firm increases its use of debt.
• The expected bankruptcy cost is the probability
  of default multiplied by the PV of the bankruptcy
  costs if the firm defaults.
• PV of Expected Probability PV of
  
• Bankruptcy of x
  Bankruptcy
• Costs Bankruptcy
  Costs

85
Optimal Debt Ratio

• To find the optimal debt ratio the adjusted value
  of the firm needs to be calculated at various
  levels of debt
• The level of debt that maximizes the adjusted
  value of the levered firm is the one that is the
  optimal level of debt.

86
Disney

• Step 1 Using our numbers from before estimate
  the value of the unlevered firm
• Value of Value of PV of
  PV of
• Levered Unlevered Tax Benefits -
  Bankruptcy
• Firm Firm of debt
  Costs
• Rearranging
• Value of Value of PV of
  PV of
• UnLevered Levered - Tax Benefits
  Bankruptcy
• Firm Firm of debt
  Costs

87
Disney The Numbers

• Value of Levered Firm MV of the Firm 78.41 B
• PV of Tax benefits (value of debt)(tax rate)
  15.682(0.36) 5.6551B
• PV of Bankruptcy Costs 78.41B(.25)(.0053)
  .10389M Based on bankruptcy cost of 25 of firm
  value and the probability of default (from your
  textbook) associated with A rated debt
• Value of Value of PV of
  PV of
• UnLevered Levered - Tax Benefits
  Bankruptcy
• Firm Firm of debt
  Costs
• 72.8788 B 78.41 - 5.6651 .10389

88
Step 2

• Estimate the tax benefits and expected
  bankruptcy costs at various levels of debt.
• Start with the Value of the unlevered firm then
  adjust for the PV of tax Benefit and PV of
  Bankruptcy Costs

89
Step 3

• Estimate the value of the levered firm at various
  debt levels

90
Adjusted Present Value
91
Comparative Analysis

• Compare debt ratio to similar firms, Easiest
  approach is to compare to the industry average.
• The most important thing is to then investigate
  why the firm might have a higher or lower debt
  ratio than the average.

92
The Financing Details

• If the firm is not at its optimal level of debt
  it must decide if it wants to move toward its
  optimal level. Outside pressure often plays a
  key role in making this decision.
• If it decides to move toward its optimal level it
  has two choices.
• Gradual Change --Change only new projects or also
  adjust existing ones?
• Quick Change

93
Immediate or Gradual

• The decision of an unlevered firm to change its
  debt ratio is based upon
• Degree of Confidence in the Optimal Estimate
• Comparability of Peer Groups
• Likelihood of a takeover
• Need for flexibility (financing slack)

94
?? Speed of Change ??

• Assume that a firm which currently has more debt
  than identified as its optimal level has
  substantial indirect bankruptcy costs. Is the
  speed that it attempts to return to its optimal
  level affected by its bankruptcy costs?

95
Increasing Leverage Quickly

• Borrowing money and buying back stock
• Debt for Equity Swap
• Using the proceeds from the sales of assets to
  buyback stock

96
Why Increase Leverage Quickly?

• Often to avoid a hostile takeover bid. Firms
  with large cash balances are prime targets for
  takeover. Some recent examples of increased
  leverage to fight a takeover are
• CBS Inc. in 1986 Bought back 21 of Stock
• Goodyear Tire 1986 Sold three units and bought
  back 20 Million shares
• Phillips Petrol. 1984 Doubled debt to buy back
  shares

97
Decreasing Leverage Quickly

• Creates a problem since the it signals that the
  firm is desperate to decrease its debt level (It
  might not survive if it doesnt decrease its debt
  level)
• Most often this happens in one of two ways
• Renegotiating debt agreements. Convincing
  lenders to take an equity stake in the firm
• Selling assets and using proceeds to retire some
  debt
• Which assets should the firm sell? Worst
  performing, Best performing or most liquid?

98
Increasing Leverage Gradually

• The ability to increase the the firms leverage
  gradually allows the firm to look for quality
  projects. Some possible ways of increasing the
  portion of debt include
• Increasing the Dividend Payout Ratio
• Repurchasing stock each year
• Increasing Capital expenditures

99
Decreasing Leverage Gradually

• Firms can finance new projects with retained
  earnings, lowering the amount of debt used by the
  firm. Lowering (or suspending) dividend is
  another approach (although not one favored by
  shareholders) to decreasing the debt level.

100
Details of New Finance

• The firm needs to specify the details that
  outline either its new equity (common stock,
  warrants or contingency rights) or debt
  (maturity, fixed or floating, conversion
  options....)
• Will discuss a series of steps that will help in
  the decision making process

101
Details

• Examine the Cash Flow Characteristics
• Want to match Cash Flows and Liabilities
  (duration, fixed or floating rates, inflation,
  currency risk...)
• Examine the tax implications
• Consider the response of Rating Agencies
• Examine the effects of Asymmetric Information
• Consider any Agency Costs
• A Sensitivity Analysis