WK - 5 - Cost of Capital Capital Structure PDF
WK - 5 - Cost of Capital Capital Structure PDF
WK - 5 - Cost of Capital Capital Structure PDF
Sample size
But the shorter the period, the more updated the estimate.
1970-2010
Business risk!!
D1
ke = RE =
+g
P0
Market-driven and using current data (no need for historical data)
Easy to use and understand
Bond price =
Coupon
Coupon
+
(1+YTM)
1+YTM 2
Pps,0 =
Dps
Rps
k ps = R ps =
Dps
Pps,0
E
k
E+D+PS e
D
k
E+D+PS d
1 TC +
PS
k
E+D+PS PS
Capital Structure
Capital restructuring
Capital restructuring involves changing the amount of leverage a
firm has without changing the firms long-term assets.
A firm can increase its financial leverage by issuing debt and buying
back outstanding shares.
A firm can decrease its financial leverage by retiring outstanding
debt and issuing new shares.
How does a firms capital restructure affect its risk and value?
Capital Structure
Modigliani and Miller theory of capital structure
Three cases of capital structure with respect to assumptions
regarding corporate taxes and bankruptcy costs:
Case 1: No corporate taxes; no bankruptcy costs
Capital Structure
Case 1: No corporate taxes; no bankruptcy costs
M&M Proposition I (firm value): The value of the firm is not
affected by changes in the capital structure.
M&M Proposition II (cost of capital): The WACC of the firm is not
affected by capital structure.
Intuition: In the absence of market frictions, the firms cash flows do
not change when its capital structure changes. Therefore, the firms
value doesnt change (two pie models of capital structure) and its
overall cost of capital (that depends on the riskiness of the cash
flows) does not change.
Capital Structure
Equations for the cost of capital
E
D
WACC = R A =
R +
R
D+E E D+E D
D
RE = RA + RA RD
E
RA: the cost of the firms business risk (i.e., the risk of its assets).
(RA RD)(D/E): the cost of the firms financial risk - the additional
return required by stockholders for taking the risk of leverage.
Capital Structure
Capital Structure
Case 2: With corporate taxes, but no bankruptcy costs
The tax effect on cash flows
Interest expenses are tax deductible, so when a firm adds debt, it
reduces its income taxes, all else being equal.
Capital Structure
M&M Proposition I (firm value): The value of the firm increases
by the present value of the annual interest tax shield.
Value of levered firm
= Value of unlevered firm + Value of interest tax shield
M&M Proposition II (cost of capital): WACC decreases as D/E
increases (due to government subsidy on interest payments.)
E
D
RE +
R D 1 TC
D+E
D+E
D
RE = R0 + R0 RD
1 TC
E
WACC =
Capital Structure
R0
R0
R0
Cost of Capital & Capital Structure 27
Capital Structure
Example
East Asia, Inc. has constant operating earnings of $550,000 every
year forever, and hence its fixed assets and working capital will
remain unchanged in the future. The company can borrow at 12%.
With no debt, East Asias cost of equity is 20%. The tax rate is 16%.
East Asia plans to borrow $400,000 and use the proceeds to
repurchase shares. Determine the WACC after recapitalization.
Unlevered firm value = 550,000(1 - 0.16)/0.20 = $2,310,000
Levered firm value = 2,310,000 + (400,000)(16%) = $2,374,000
D/V = 400,000/2,374,000 = 0.1685
D/E = 400,000/(2,374,000 - $400,000) = 0.2026
RE = 0.20 + (0.20 0.12)(0.2026)(1 - 0.16) = 21.36%
WACC = 0.2136(1 0.1685) + 0.12(0.1685) (1 - 0.16) = 19.46%
DCF and Bond and Stock Valuation 28
Capital Structure
Case 3: With both corporate taxes & bankruptcy costs
Financial distress & financial distress costs
When a firm is having significant problems in meeting its debt
obligations, we say that it is experiencing financial distress (though
such firms do not necessarily file for bankruptcy).
Financial distress costs include direct bankruptcy costs (legal and
administrative costs) and indirect bankruptcy costs associated with
going bankrupt or experiencing financial distress.
Capital Structure
The static theory of capital structure
At some point, the additional value of the interest tax shield will
be offset by the increase in expected bankruptcy cost. At this
point, the value of the firm will start to decrease, and the WACC
will start to increase as more debt is added.
A firm borrows up to the point where the tax benefit from an extra
dollar in debt is exactly equal to the cost that comes from the
increased probability of financial distress.
Capital Structure
R0
R0
Capital Structure
VLevered = VUnlevered + ITS BFDC
ITS: value of interest tax shield
BFDC: expected bankruptcy and financial-distress costs
EV
Optimal D/(D+E)
0%
D/(D+E)
Capital Structure
Summary
Case 1: no taxes or bankruptcy costs
There is no optimal capital structure.
A =
E
D
E +
D
E+D
E+D
E = A +
D
A D
E
Levered = Unlevered 1 + 1 TC
We do the following two-step adjustment:
Step 1. Apply the formula to the comparable firm to obtain the
unlevered beta, which is the same for all firms of the same
business.
Step 2. With the unlevered beta, apply the formula again (but to our
investment) to obtain the relevered beta for our investment.
D ($bill)
E ($bill)
D/(D+E)
Churchs Chicken
0.75
0.004
0.096
0.04
McDonalds
1.00
2.300
7.700
0.23
Wendys
1.08
0.210
0.790
0.21
Unlevered = Levered 1 + 1 TC
Churchs Chicken:
McDonalds:
Wendys:
E = Relevered
D
E
= UnLevered 1 + 1 TC
= 0.83 1 + 0.4 1 0.34
= 1.049