1. Corporate Finance COST OF CAPITAL AND CAPITAL STRUCTURE Lesson 6 Corporate Finance Castellanza, 13 th October, 2010

2. Corporate Finance Cost of capital Def: is the expected rate of return that the market requires in order to attract funds to a particular investment. (cost of capital/rate of return) Characteristics: it is it is market driven it is forward-looking it is usually measured in nominal terms (including expected inflation) Capital refers to the components of a capital structure: debt and equity

3. Corporate Finance Cost of equity (Ke) indirect way (CAPM) opportunity cost: the cost of foregoing the next best alternative investment at a specific level of risk r f = free risk return P = premium Ke = r f + P

4. Corporate Finance i = interest rate t = tax rate of the company (interests are tax- deductible expenses) Kd = f. interest rate bankruptcy risk tax benefits Cost of debt (Kd) Kd = i( 1-t )

5. Corporate Finance Weighted average cost of capital (WACC) To be used when the objective is to value the entire capital structure of a company. E = equity, D = net financial debt or Net Financial Position Ke > WACC > Kd WACC = [Ke E/(E+D)] + [Kd D/(E+D)]

6. Corporate Finance Capital structure Def: the capital structure of a firm is broadly made up of its amounts of equity and debt Components: equity (shareholder’s equity, corporate reserves, earnings) debt (ST and LT debts, corporate bonds, commercial papers …) quasi-equity (convertible bonds, mezzanine financing)

7. Corporate Finance Capital structure (cont’d) Debt versus Equity Residual claims Lowest priority on cash flows No tax deductible Infinite life Management control Fixed claims High priority on cash flows Tax deductible Fixed Maturity No management control _____________________________________________ Debt Hybrids (Quasi-equity) Equity

8. Corporate Finance Capital structure – costs and benefits of debt (cont’d) Benefits of debt Tax benefits when you borrow money, you are allowed to deduct interest expenses from your income to arrive a taxable income. This reduces your taxes. When you use equity you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income Adds discipline to management if you are manager of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and investing in poor projects Costs of debt Bankruptcy costs Agency costs Loss of future flexibility

9. Corporate Finance The financing mix question In deciding to raise financing for a business, is there an optimal mix of debt and equity? What is the trade-off that let us determine the optimal mix? If yes

10. Corporate Finance If: taxes = 0 and extraord. rev.-exp. = 0 Maximization of shareholders’ return (ROE) ROE = [ROI + (D/E) * (ROI – i)] ROI = EBIT CI ROE = Net profit E i = Interests expenses Net Debt Leverage = D E D = Net Debt or Net Financial Position E = Equity i = interest rate paid on Net Debt CI = Capital invested = D + E

11. Corporate Finance Relationship between ROE and ROI (cont’d) Considering taxes: ROE = [ROI + (D/E) * (ROI – i)] * (1-t) t = tax rate (taxes/EBT) Considering extraordinary revenues/expenses: ROE = [ROI + (D/E) * (ROI – i)] * (1-t) * (1-s) s = (net extraordinary rev.-exp./earnings before net extraordinary rev.-exp.)

12. Corporate Finance Relationship between ROE and ROI : Example

13. Corporate Finance Relationship between ROE and ROI : Example ROE = [ ROI + ( D / E ) * ( ROI – i) ] * (1 – t) ROE = [11,2% + (12.000/10.300) * (11,2% – 5,0%)] * (1-31,6%) ROE = [11,2% + (1,17) * (6,2%)] * (68,4%) ROE = [11,2% + 7,2%] * (68,4%) ROE = 18,4% * 68,4% = 12,6%

14. Corporate Finance 14 Relationship between ROE and ROI Decrease ROI Increase cost of debt Decrease ROE Decrease self-financing Increase of debt

15. Corporate Finance 15 Leverage Leverage = D / E D = total financial debt or Net Financial Position E = equity Using leverage it is possible to increase debt in order to increase return on equity D/E = 1 neutral situation D/E > 1 situation to monitor D/E < 1 situation to exploit

16. Corporate Finance Modigliani – Miller theory Hp: in an environment where there are no taxes, bankruptcy risk or agency costs (no separation between stockholders and managers), capital structure is irrelevant. the value of a firm (V) is independent of its debt ratio (D/E). The cost of capital of the firm will not change with leverage. VaVa D/E V

17. Corporate Finance Modigliani – Miller theory (cont’d) The effect of taxes Vi =Vu + Vats Vi = value of levered firm Vu = value of unlevered firm Vats = actual value of tax shields VaVa D/E V ViVi

18. Corporate Finance Trade-off theory The effect of bankruptcy costs Vl = Vu+Vats-Vabc Vabc = actual value of bankruptcy costs Vats = actual value of tax shields VuVu D/E V ViVi Value of levered firms without bankruptcy costs Value of levered firms Value of unlevered firms V ats V abc VlVl

19. Corporate Finance Picking order theory 1.Self-financing 2.Debt 3.Increase of equity Financing sources Internal External ProfitabilityNet Debt Level

20. Corporate Finance Financing mix decision 1.Macroeconomic context (capital markets) 2.Industry (maturity, capex, risk, etc.) 3.Firm’s characteristics (market position, financial-economic situation…) 4.Financial needs’ characteristics