Leveraged Recapitalization

Unit – 14
Contents – Unit 14
• Cost of Capital Computation under alternative Debt Ratios
• Changing Bond Rating and Probability of Default and Cost of Debt
• Merton Extension Model
• Levered and Unlevered Beta and Cost of Equity
Cost of capital - Computation
• Cost of capital represents the opportunity cost that investors face for investing their funds in one particular business instead of others
with similar risk.

• The most important principle underlying successful implementation of the cost of capital is consistency between the components of
WACC and free cash flow.

• Since free cash flow is the cash flow available to all financial investors (debt, equity, and hybrid securities), the company’s WACC must
include the required return for each investor.

• In addition, the duration and risk of the financial securities used to estimate the WACC must match that of the free cash flow being
discounted
Cost of capital - Computation
To assure consistency, the cost of capital must meet several criteria:

• It must include the opportunity costs from all sources of capital— debt, equity, and so on—since free cash flow is available to all
investors, who expect compensation for the risks they take.

• It must weight each security’s required return by its target market based weight, not by its historical book value.

• It must be computed after corporate taxes (since free cash flow is calculated in after-tax terms). Any financing-related tax shields not
included in free cash flow must be incorporated into the cost of capital or valued separately (as done in the adjusted present value).

• It must be denominated in the same currency as free cash flow.

• It must be denominated in nominal terms when cash flows are stated in nominal terms.
Cost of capital - Computation
• For most companies, discounting free cash flow at the WACC is a simple, accurate, and robust method of corporate valuation.

• If, however, the company’s target capital structure is expected to change significantly, for instance in a leveraged buyout (LBO), a
constant WACC can overstate (or understate) the impact of interest tax shields.

• To determine the weighted average cost of capital, calculate its three components: the cost of equity, the after-tax cost of debt, and the
company’s target capital structure.

• Since none of the variables are directly observable, we employ various models, assumptions, and approximations to estimate each
component.
Cost of capital - Computation
Cost of equity
CAPM
Beta – Risk assessment
• Risk is the degree of uncertainty associated with the outcome of an investment. It consists of two components:
• diversifiable, or nonsystematic, risk, such as strikes and lawsuits that are specific to a firm; and
• a nondiversifiable, or systematic, risk, such as inflation and war, that affects all firms.

• In theory, risk specific to a firm can be eliminated by investors selecting a portfolio of stocks whose cash flows are uncorrelated.

• β is a measure of non-diversifiable risk, or the extent to which a firm’s financial return changes because of a change in the general stock
market’s return.

• While all stocks are impacted by stock market fluctuations, the extent of the impact on each stock will differ resulting in wide variation
in the magnitude of β from one stock to the next.

• β are commonly estimated by regressing the percent change in the total return on a specific stock with that of a broadly defined stock
market index
Beta – Effect of leverage
• If a firm’s stockholders bear all the risk from operating and financial leverage and interest paid on debt is tax deductible, then leveraged
and unleveraged β can be calculated as follows for a firm whose debt-to-equity ratio is denoted by D/E:
Cost of debt
• To estimate the cost of debt, use the yield to maturity of the company’s long-term, option-free bonds.

• Technically speaking, yield to maturity is only a proxy for expected return, because the yield is actually a promised rate of return on a
company’s debt (it assumes all coupon payments are made on time and the debt is paid in full).

• An enterprise valuation based indirectly on the yield to maturity is therefore theoretically inconsistent: expected free cash flows should
not be discounted by a promised yield.

• For companies with highly rated debt, however, this inconsistency is immaterial, especially when compared with the estimation error
surrounding beta and the market risk premium.

• Thus, for estimating the cost of debt for a company with investment-grade debt (debt rated at BBB or better), yield to maturity is a
suitable proxy.
Cost of debt
• Ideally, yield to maturity should be calculated on liquid, option-free, long-term debt. If the bond is rarely traded, the bond price will be
stale.

• Using stale prices will lead to an outdated yield to maturity.

• Yield to maturity will also be distorted when corporate bonds have attached options, such as callability or convertibility, as their value
will affect the bond’s price but not its promised cash flows.
Debt ratings and YTM
• For companies with only short-term bonds or bonds that rarely trade, determine yield to maturity by using an indirect method.

• First, determine the company’s credit rating on unsecured long-term debt.

• Next, examine the average yield to maturity on a portfolio of long-term bonds with the same credit rating. Use this yield as a proxy for
the company’s implied yield on long-term debt.
Debt ratings and YTM
• Using the company’s bond ratings to determine the yield to maturity is a good alternative to calculating the yield to maturity directly.

• Never, however, approximate the yield to maturity using a bond’s coupon rate.

• Coupon rates are set by the company at time of issuance and only approximate the yield if the bond trades near its par value.

• When valuing a company, you must estimate expected returns relative to today’s alternative investments.

• Thus, when you measure the cost of debt, estimate what a comparable investment would earn if bought or sold today.
Debt ratings and YTM
• In practice, few financial analysts distinguish between expected and promised returns.

• But for debt below investment grade, using the yield to maturity as a proxy for the cost of debt can cause significant error.

• To better understand the difference between expected returns and yield to maturity, consider the following example.

• You have been asked to value a one-year zero-coupon bond whose face value is $100. The bond is risky; there is a 25 percent chance
the bond will default and you will recover only half the final payment. Finally, the cost of debt (not yield to maturity), estimated using
the CAPM, equals 6 percent. Based on this information, you estimate the bond’s price by discounting expected cash flows by the cost of
debt:
Debt ratings and YTM
• Next, to determine the bond’s yield to maturity, place promised cash flows, rather than expected cash flows, into the numerator. Then
solve for the yield to maturity:

The $82.55 price leads to a 21.1 percent yield to maturity, much higher than the cost of debt.
Debt ratings and YTM
So what drives the yield to maturity?

Three factors:
• the cost of debt
• the probability of default
• and the recovery rate.

When the probability of default is high and the recovery rate is low, the yield to maturity will deviate significantly from the cost of debt.

Thus, for companies with high default risk and low ratings, the yield to maturity is a poor proxy for the cost of debt.
Merton Extension Model
(a) The Merton model is an analysis model used to assess the credit risk of a company's debt.

(b) Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its
debt, and weighing the general possibility that it will go into credit default.

(c) In 1974, economist Robert C. Merton proposed this model for assessing the structural credit risk of a company by modeling the
company's equity as a call option on its assets.

(d) This model was later extended by Fischer Black and Myron Scholes to develop the Nobel-prize winning Black-Scholes pricing model
for options.
Black-Scholes Model
When the price process is continuous (i.e., price changes become smaller as time periods get shorter), the binomial model for pricing
options converges on the Black-Scholes model.

The model, named after its cocreators, Fischer Black and Myron Scholes, allows us to estimate the value of any option using a small
number of inputs, and has been shown to be robust in valuing many listed options.
Black-Scholes Model
While the derivation of the Black-Scholes model is far too complicated to present here, it is based on the idea of creating a portfolio of the
underlying asset and the riskless asset with the same cash flows, and hence the same cost, as the option being valued.

The value of a call option in the Black-Scholes model can be written as a function of the five variables:

S = Current value of the underlying asset