Lecture No. 36 Review of Capital Structure, Leverage, WACC, & Betas Financial Management Lecture No. 36 Review of Capital Structure, Leverage, WACC, & Betas Copyright: M. S. Humayun

Recap of WACC & Firm Risk WACC % = rD XD + rE XE + rP XP . 3 Basic Forms of Raising Capital: D=Debt, E=Common Equity, & P=Preferred Equity. Uses Required ROR’s adjusted by Taxes and Transaction Costs. “x” represent fractions of MARKET VALUES of Debt or Equity. Should NOT use the Book Values from Financial Statements used in Financial Accounting. Two Ways to Raise Equity Capital: (1) Retained Earnings which is cheap way to raise equity AND (2) New Stock Issue which is more costly Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory / SML : rE = rRF + (rM – rRF)Beta Total Stand Alone Risk of Firm = Business Risk + Financial Risk Business Risk = Standard Deviation of ROE of Un-levered Firm Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases Business Risk. Small Change in Sales Causes Large Change in Operating Income & ROE. OL can be Good when Sales > Breakeven. Financial Risk = Total Risk for Levered Firm - Business Risk Financial Leverage = Market Value of Debt / Market Value of Total Assets = D / (D+E): FL increases Financial Risk. Small Change in EBIT Causes Large Change in ROE. FL can be Good when EBIT/Assets > Interest. Leverage Rises. Financial Distress & Higher chance of Bankruptcy. Banks charge Higher Interest Rates. Higher Cost of Debt. Higher Risk. Higher Beta. Higher Required Return on Equity ( rE ). Higher Cost of Equity. Copyright: M. S. Humayun

Recap of Capital Structure Theories Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets Capital Structure, DEBT, & Corporate Financing have NO AFFECT on Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, & Investment Decisions Remember that in Efficient Markets, the Fair Value of a Firm (calculated using NPV) is approximately equal to the Market Value. The Firm’s Value is determined by the Future Cash Flows generated by the Firm (or Real Assets) and NOT by the way the cash flows are split or divided amongst the Debt and Equity Holders. Market Value of Firm = V = EBIT / WACC . As Debt Increases, Risk Increases so rD and rE and WACC should increase. BUT Debt is cheaper than equity (recall Risk Theory) so as Debt Increases, WACC should decrease ! Net Effect is No Change in WACC and No Change in Value ! Major Assumptions: No Taxes, No Bankruptcy Costs, Equal Information, Efficient Markets MM Theory with Taxes Corporate Tax favors Debt Financing because of Interest Tax Shield. Personal Tax favors Equity Capital. Net Effect is that Taxes favors raising Capital through Debt Financing. Tradeoff Theory (With Taxes & Financial Distress / Bankruptcy) When Excessive Leverage (Debt or Borrowing) then Bankruptcy Costs begin to Outweigh Benefits of Interest Tax Shield or Savings. At first, Firm’s Value Rises because of Interest Tax Savings but as Debt increases, the Value reaches a Maximum Point (where WACC is minimum) and then at excessive Debt levels, the Value begins to fall. Signaling Theory (Market Signals) New Equity Issue gives signal to Market Investors that Firm’s financial future looks bad so Market Price of Stock often falls. Cost of Equity and Required ROR on Equity (rE ) increases. Debt Financing signals strong future earnings. Firms should save some Spare or Reserve Debt Capacity in case they find an attractive Project or Investment. Save Some Spare or ReserveDebt Capacity for good investment opportunity. Give right signal to market. Copyright: M. S. Humayun

Effect of Leverage on Cost of Debt & Equity Effect of Financial Leverage (or Debt) on Cost of Debt (rD): At Low Leverage, Increase in Leverage leads to Slight Increase in Overall Risk and Return of Firm. At Higher Leverage, Risk of Financial Distress & Bankruptcy. Banks Raise Interest Rate Charges. Cost of Debt Rises Faster. Required ROR of Firm’s Debt Holders (rD ) Rises Faster. Effect of Financial Leverage (or Debt) on Cost of Equity (rE): Firm’s Total Risk Rises Slowly at Low Leverage and Faster when Leverage becomes Excessive and Risk of Financial Distress arises. Firm’s Stock Beta Rises. Firm’s Stock Required ROR (rE ) Rises. WACC = rDxD + rExE (assuming no Preferred Equity): Effect of Debt on WACC changes depending on choice of Theory. Pure MM Theory: WACC does Not Change. WACC curve is Flat. Traditionalist Theory (and Tradeoff Theory): WACC curve is broad U-shaped Parabola with Minimum WACC point. Copyright: M. S. Humayun

Traditionalist View - Example FIRM’S VALUE = EBIT / COST OF CAPITAL (Also known as MM Proposition I) MORE LEVERAGE (OR DEBT) MEANS MORE RISK WHICH MEANS HIGHER COST OF CAPITAL AND THEREFORE LOWER VALUE Traditionalist View is based on Practical Reality. Leverage provides Interest Tax Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to Bankruptcy Risk. Increase in Risk will Change Value of Firm and WACC. Traditionalists Formulas for Equity: E = NI / rE,L Note: NI = EBIT - Interest - Tax = EBT - Tax NI = (EBIT - xD rD ) (1 - Tc). rE,L = WACCu + xD (WACCu - rD ) (1 - Tc). Traditionalists Formula for WACC: WACCL = xD rD (1 - Tc) + xE rE . (1-Tc) is the Tax Discount Factor. Note: V = D + E xD = D /V = D / (D+E) xD + xE = 1 V = Market Value of Firm D = Market Value of Debt E = Market Value of Equity xD = Fraction of Debt = A Measure of Leverage Copyright: M. S. Humayun

Tradeoff Theory Graph – Linked to Traditionalist Theory of Leverage & Optimal Capital Structure Slightly Leveraged Firm: Interest Tax Shield Benefit. Total Return to Investors Rises so Stock Value Rises. Total Return = Net Income (paid to Shareholders) + Interest (paid to Debt Holders) Excessively Leveraged Firm: Threat of Bankruptcy has Real Costs. Less Investor Confidence and Lower Share Price. Value of Firm or Price of Stock Firm Remains 100% Equity (Un-Levered) Financial Leverage = Debt / Assets = D/(D+E) OPTIMAL Capital Structure - MAXIMUM VALUE & MINIMUM WACC Copyright: M. S. Humayun

Traditionalist Theory - Real Markets WACC Graph Bankruptcy Risk & Costs. Higher Required Return on Equity. Steeper Rise. Cost of Capital (%) rE,L = Cost of Equity = WACCU + xD(WACCU -rD) (1-TC) WACCL = rD(1-Tc)xD + rExE rE rD = Cost of Debt rD Interest Tax Shield Advantage Debt / Equity = A Measure of Leverage = D/E = xD / ( 1- xD ) 100% Equity Firm Optimal Capital Structure = Minimum WACC and Maximum Value Copyright: M. S. Humayun Note: xD = D / (D+E)

MM View - Ideal Markets Example COST OF DEBT IS GENERALLY LESS THAN COST OF EQUITY. COST OF EQUITY IS PROPORTIONAL TO RISK PREMIUM (Known as MM Proposition II) SO, MORE LEVERAGE (OR DEBT) MEANS LOWER WEIGHTED AVERAGE COST OF CAPITAL. TRADITIONALISTS SAID THAT MORE LEVERAGE (OR DEBT) MEANS MORE RISK AND HIGHER COST OF CAPITAL. MM COMBINED BOTH EFFECTS AND SAID THAT THE NET EFFECT IS NO CHANGE IN COST OF CAPITAL AND VALUE ! CHANGES IN CAPITAL STRUCTURE CAN’T AFFECT FIRM’S VALUE BECAUSE OTHERWISE RATIONAL INVESTORS WOULD MAKE EASY MONEY FROM ARBITRAGE. Assuming Pure MM View - Ideal Markets. Total Market Value of Assets of Firm (V) is UNCHANGED. VU = VL . Also, WACC UNCHANGED by Capital Structure and Debt. WACCU = WACCL rE,L =WACC + D/E (WACC - rD,L) AND rE= (WACC- rD xD)/ xE Cost of Equity for Levered Firm = Risk Free Interest Rate + Business Risk Premium + Financial Risk Premium. rE,L Increases because Required ROR for Stock Increased because of Financial Risk Copyright: M. S. Humayun

Pure MM Theory - Ideal Markets WACC Graph Financial Risk. Higher Required Return on Equity. Higher rE Cost of Capital (%) rE = Cost of Equity =WACC+D/E (WACC-rD) WACC = rDxD + rExE rE rD = Cost of Debt rD Debt / Equity = A Measure of Leverage = D/E = xD / ( 1- xD ) 100% Equity Firm Copyright: M. S. Humayun

Traditionalists - Real Markets Effect of Leverage on WACC Traditionalist Capital Structure Theory: Interest Tax Savings Increase, Cost of Interest or Mark-up Increases, and Cost of Equity Increase. Depending on the Rate of Increase, they can affect computation of Firm’s Market Value (V) and WACC in different ways - either making them Increase or Decrease. Traditionalist Capital Structure Theory: Effect of Increasing Leverage (as measured by D/E or xD = D/V) on MARKET VALUE of Firm (V) is Uncertain. Based on Combination of EBIT, Tax Rate, Leverage, and Relative Costs of Debt & Equity. Traditionalist Capital Structure Theory: Practically speaking, Initially Leverage adds Interest Tax Savings Benefit so Value (V) Rises but after some point the Cost associated with Financial Distress and Bankruptcy Risk makes the Value Fall. MARKET VALUE of Firm (V) typically reaches a MAXIMUM VALUE where WACC is MINIMUM. This is the Optimal Capital Structure. Copyright: M. S. Humayun

Capital Structure – 2 Approaches for Estimating Numerical WACC & Value NI Approach Starting Point is EBIT (which is given) EBIT  NI (=EBIT–Interest–Tax)  EL (=NI/rE assuming no change in rE levered or un-levered !)  VL (=EL+D where D is given)  WACCL (=rD,L(1-Tc)xD + rExE ). Note WACCU = rE Tax Shield Approach (or NOI Approach) Starting Point is Market Value of Un-levered Firm Vu which is given VL (= VU + TC D. Assumes that VL will keep increasing with D ! TcD = Tax Shield Advantage from Debt)  EL (=VL – D)  rE,L (= NI /E)  WACCL (= rD,L(1-Tc)xD + rE,LxE . Note WACCL =WACCU (1-Tc) xD Copyright: M. S. Humayun

Other Short-cut Formulas & Link Between Capital Structure & Betas Cost of Equity (After Tax) Estimates and STOCK BETAS rE,L = WACCU + xD (WACCU -rD) (1-TC) rE,L = rE,U + D/E (rE,U -rD) (1-TC) rE,U = rRF + BETAE ( rM - rRF ) Recall from CAPM Theory WACC (After Tax) Estimates AND FIRM BETA WACCL = rD,L(1-Tc)xD + rE,LxE WACCL = rRF + BETAWACC,L ( rM - rRF ) Note: Overall Beta for the Firm = BETAWACC,L = BetaD xD + BetaE xE Copyright: M. S. Humayun