Financing Decisions and The Cost of Capital

Where do Firms Get Money? Self Financing (using internal cash flow) Accounts for 80% (avg.) of financing in the U.S. Difficult for start-up companies External Financing Borrowing from banks or issuing bonds Sharing ownership by issuing stock Net new issues of these securities accounts for the other 20% on average About 80% of what is raised or generated and retained is used for capital spending and the rest for working capital and “other” uses

Where Do Small Businesses Get Money? Source: 1987 SBA survey of firms with less than $500,000 in assets.

A Life Cycle of Financing Firm Size/Age Information Very small, no track record Small with growth potential Medium-sized Large with Track record Self Inside seed money Short Debt Short-term commercial loans Commercial paper Intermediate-term commercial loans Medium-term Notes Inter- mediate Debt Mezzanine Finance Private Placements Long-Term Debt Bonds Outside Equity Venture Capital Public Equity Source: FRB Report on Private Placements, Rea et. al., 1993

The Capital Structure Question: How should a firm structure the left hand side of its balance sheet? Debt vs. Equity – the choice for our purposes. We have seen how to do capital budgeting when the firm has debt in its capital structure. However, we have not figured out how much debt the firm should use. Can the firm change shareholder value through its financing decisions? In particular, should the firm load up with ‘low cost’ debt?

One possible answer: It makes no difference! Assume PCM: there are no differential taxes and the firm’s investment policy is unaffected by how it finances its operations. Both Modigliani and Miller won a Nobel Prize for showing: The value of a firm with debt is, under these circumstances, equal to the value of the same firm without debt. MM Proposition I. Since the assets are the same, regardless of how they are financed, so are the expected cash flows and the asset risks (asset betas) of equivalent “levered” and “unlevered” firms.

Irrelevance Proposition II What this means is that the expected return on equity rises with leverage according to: (where, B/S = leverage ratio -- market value of debt over market value of equity, r denotes expected return or appropriate discount rate). I will try to use r0 not rA for consistency with the text.

MM Proposition II Why does the expected return on equity rise? The SML tells us that the expected return on an asset changes only when what characteristic of the asset changes? The beta of a portfolio is the weighted sum of the individual betas: Rearrange this to find:

MM Proposition II with No Corporate Taxes: Another View Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio

What About The Tax Deductibility of Interest? Interest is tax deductible (dividends are not). A valuable “debt tax shield” is created by substituting payments of interest for payments of dividends, i.e. debt financing for equity financing. Modigliani and Miller also showed that if the only change in their analysis is an acknowledgement of the US corporate tax structure, then: The value of a levered firm is: VL = VU + TcB the value of an equivalent unlevered firm PLUS the value of the tax shields generated by the use of debt. Firm Value rises with additional borrowing! Why?

Proposition II with Taxes When we take the tax deductibility of interest payments into account the equations we presented must change: and

Proposition II Cost of capital: r (%) r0 rB Debt-to-equity ratio (B/S)

Limits to The Use of Debt Given the treatment the U. S. corporate tax code gives to interest payments versus dividend payments, firms have a big incentive to use debt financing. Under the MM assumptions with corporate taxes the argument goes to extremes and the message becomes: firms should use 100% debt financing. What costs are associated with the use of debt? Bankruptcy costs and/or costs of financial distress!

Bankruptcy Costs Direct costs: Indirect costs: Legal fees Accounting fees Costs associated with a trial (expert witnesses) Indirect costs: Reduced effectiveness in the market. Lower value of service contracts, warranties. Decreased willingness of suppliers to provide trade credit. Loss of value of intangible assets--e.g., patents.

Agency Costs of Debt When bankruptcy is likely incentives may be altered. Example (Over-investment): Big Trouble Corp. (BTC) owes its creditors $5 million, due in six months. BTC has liquidated its assets because it could not operate profitably. Its remaining asset is $1 million cash. Big Bill, the lone shareholder and general manager is considering two possible investments. (1) Buy six month T-bills to earn 3% interest. (2) Go to Vegas and wager the entire $1 million on a single spin of the roulette wheel. Why might Bill consider the second “investment”? Would he have considered it in the absence of high leverage?

Under-investment Problem Slight Trouble Corp. (STC) has a small but significant chance of bankruptcy in the next few years. Its debt is trading far below par. Managers are evaluating an investment project that will cost $1 million to undertake. The alternative is to pay $1 million out as dividends. While the NPV of the project is positive it may be that the shareholders are better off with the dividend than if the project is taken. The reason is that while shareholders pay all the costs of the project, they will have to share its value with bondholders, the added value will raise bond prices as well as stock prices.

Disciplinary Power of Debt “On the other hand” as economists are fond of saying, debt can be a disciplinary device. It is well recognized that an owner works harder and makes better decisions than an employee. This was an often cited justification for the LBO wave of the mid 80’s and early 90’s. The idea is that one of the most contentious issues between managers and shareholders is the payout of excess cash. Consider Hollinger International and Conrad Black’s behavior. Debt allows manager to commit to the payout in a way that cannot be accomplished with a dividend policy.

MM with Taxes and Costs of Financial Distress Value of firm under MM with corporate taxes and debt Value of firm (V) Present value of tax shield on debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt Debt (B) B* Optimal amount of debt

Choosing an Amount of Debt The theory provides no clear formula (unlike NPV) but the tradeoffs are clear; the benefits versus the costs of debt. The theory does tell us to use more debt if: effective tax rates (without debt) are higher, operating cash flows are more predictable, tangible assets make up most of your asset base, agency costs can be controlled by contracts. A safe strategy might be to emulate the industry average. After all these are the firms who have survived. From there you make alterations as your own situation dictates.

Leverage Ratios for Selected Industries Industry B/(S+B) High Leverage Building Construction 52.8 Hotels and Lodging 56.0 Air transport 47.7 Gold-Silver mining 42.2 Paper 51.9 Low Leverage Drugs 4.7 Electronics 9.8 Biological products 4.0 Computers 8.2 Apparel 5.3 Source: Ibbotson Associates 2003

Financing Decisions Pecking Order Theory says that there is no optimal capital structure, just the culmination of all your financing decisions. Internally generated funds. External Debt. External Equity as a last resort. Data shows that preferences such as these are there but a subject of debate is whether they are necessarily inconsistent with there being an optimal capital structure.

Example Ralph’s firm has been in the food processing business for 10 years. It has maintained a conservative capital structure financing 60% of its value with equity. Ralph has recently considered investing in the IPO of a start-up company that will develop and manufacture internet infrastructure. In discussions with the start-up’s manager, Ralph’s nephew, it is revealed that the start-up will use either no or 20% debt financing. For simplicity, assume the firm is expected to generate free cash flow of $1M each year in perpetuity. You have been called in to help identify an appropriate cost of capital for evaluating this investment.

Ralph’s Dilemma Currently Ralph’s equity beta is estimated at 0.95. We cannot estimate the beta for this private company (the start-up) directly but we know that Cisco has an equity beta of 1.92. The risk free rate is 6% and the market risk premium is 7%. The tax rate for all corporations is 35%. How can we approach determining the appropriate discount rate?

Ralph’s Dilemma cont… Start with the following: We can reasonably assume that the asset beta for Cisco will be a close estimate for the asset beta for the start-up. We know that the equity beta for Cisco is 1.92. What is Cisco’s asset beta?

Ralph’s Dilemma cont… Now we know that the asset beta for the start-up can be estimated at 1.92. What is the equity beta? We have two scenarios to consider, a debt to value ratio of either 0% or 20%. If it is zero, the equity beta equals the asset beta or 1.92. If it is 20%, we need to use:

Ralph’s Dilemma cont… Now we need a weighted average cost of capital. For the case of no debt rS = rA = r0 = rWACC: rS = 6% + 1.92(7%) = 19.44%. With 20% debt: rS = 6% + 2.23(7%) = 21.61. rB = 6% (since we assumed the debt was riskless). rWACC = 21.61%(.8) + 6%(1-.35)(.2) = 18.07%. Why was I sure that I did something wrong when I calculated the rWACC as 20.50% on the first try?

Valuations Using the $1M per year perpetual free cash flow assumption the valuation of this firm is easily done. With no debt in the start-up firm’s capital structure its value is: With 20% debt:

An Alternative Valuation The Adjusted Present Value (APV): Follows from the MM equation VL = VU + TCB. Take the value of the firm or project, if it were unlevered, then add the value of the debt tax shields (more completely the additional effects of debt). This can be a very useful approach to valuation in some situations.

APV Versus WACC The difference between these valuation techniques lies in how we value the tax shields associated with the use of debt financing. In the WACC approach we use Free Cash Flow and a discount rate (WACC) that is below the unlevered cost of capital (r0). The lower discount rate inflates the present value of the future free cash flows by just enough to account for the value of the tax shields associated with the chosen debt to equity ratio. In the APV we value the Free Cash Flow at the appropriate discount rate for an unlevered firm (r0) which gives us the correct present value of the Free Cash Flow. We then add the value of the tax shields associated with the firm’s use of debt financing.

APV – Example To implement this approach we do two things. First, find the value of the firm if it is unlevered. Second, find the present value of the debt tax shields that will be generated by the use of debt financing. The value of the unlevered firm, as before, is: With $1.1M in debt capital used by the start-up firm its value would become:

The Alternative Approach The APV approach is most useful when you know the dollar amount of debt that will be used each year over the life of the project. e.g., an LBO or other highly levered transactions. The WACC approach is easier to use when the firm has a target debt ratio that it can reasonably be expected to maintain.