1. Estimating and Reducing The Cost of Capital
DBS Bank
Estimating and Reducing The Cost of Capital
Prof. Ian Giddy
New York University

2. PT Astra International?

3. New Equity for Astra What investors? What returns should they expect?
Portfolio investors
Financial investors
Corporate investors
What returns should they expect?
= Risk-free rate
+ Corporate risk
+ Financial risk (leverage/debt mismatch)
+ “Agency cost” premium
+ Country risk
What restructuring?

4. Measuring the Cost of Capital
Cost of funding equal return that investors expect
Expected returns depend on the risks investors face (risk must be taken in context)
Cost of capital
Cost of equity
Cost of debt
Weighted average (WACC)

5. A $1 Investment in Different Types of Portfolios: 1926-1996
Index ($)
Small Company Stocks
$4,495.99
$1,370.95
Large Company Stocks
Long-Term Government Bonds
$33.73
$13.54
$8.85
Treasury Bills
Year-End
Inflation

6. Equity Risk
The risk (variance) on any individual investment can be broken down into two sources. Some of the risk is specific to the firm, and is called firm-specific, whereas the rest of the risk is market wide and affects all investments.
The risk faced by a firm can be fall into the following categories –
(1) Project-specific; an individual project may have higher or lower cash flows than expected.
(2) Competitive Risk, which is that the earnings and cash flows on a project can be affected by the actions of competitors.
(3) Industry-specific Risk, which covers factors that primarily impact the earnings and cash flows of a specific industry.
(4) International Risk, arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced
(5) Market risk, which reflects the effect on earnings and cash flows of macro economic factors that essentially affect all companies
This is the critical second step that all risk and return models in finance take.
As examples,
Project-specific Risk: Disney’s new Animal Kingdom theme park: To the degree that actual revenues at this park may be greater or less than expected.
Competitive Risk: The competition (Universal Studios, for instance) may take actions (like opening or closing a park) that affect Disney’s revenues at Animal Kingdom.
Industry-specific risk: Congress may pass laws affecting cable and network television, and affect expected revenues at Disney and ABC, as well as all other firms in the sector, perhaps to varying degrees.
International Risk: As the Asian crisis deepens, there may be a loss of revenues at Disneyland (as tourists from Asia choose to stay home) and at Tokyo Disney
Market risk: If interest rates in the US go up, Disney’s value as a firm will be affected.
From the perspective of an investor who holds only Disney, all risk is relevant.
From the perspective of a diversified investor, the first three risks can be diversified away, the fourth might be diversifiable (with a globally diversified portfolio) but the last risk I not.

7. Equity versus Bond Risk
Assets
Liabilities
Debt
Uncertain
value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

8. Corporate Cash Flow Valuation: The Steps
Estimate the discount rate or rates to use in the valuation
Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm)
Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real
Discount rate can vary across time.
Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm)
Estimate the future earnings and cash flows on the asset being valued, generally by estimating an expected growth rate in earnings.
Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does.
Choose the right DCF model for this asset and value it.

10. Let’s Start With the Cost of Debt
The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components-
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate

11. What the Cost of Debt Is and Is Not…
the rate at which the company can borrow at today
corrected for the tax benefit it gets for interest payments.
Cost of debt =
kd = LT Borrowing Rate(1 - Tax rate)
The cost of debt is not
the interest rate at which the company obtained the debt it has on its books.
We attach the long term cost of borrowing to all debt (whether short or long term), because we assume that the long term rolled-over cost of borrowing short term will be equal to the long term rate.You also do not want to make it appear to firms that they can lower their cost of capital by simply substituting short term for long term debt.
Whether you give debt the tax benefit will depend upon whether you have taxable income in the first place. If you are losing money or have huge net operating losses carried forward, there will be no tax advantage associated with debt.
The historical cost of borrowing should never be used as the cost of debt because it is backward looking.

12. Estimating the Cost of Debt
If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate.
If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.
If the firm is not rated,
and it has recently borrowed long term from a bank, use the interest rate on the borrowing or
estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt
The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

13. Estimating Synthetic Ratings
The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT/Interest Expenses
For Siderar, for instance
Interest Coverage Ratio = 161/48 = 3.33
Based upon the relationship between interest coverage ratios and ratings, we would estimate a rating of A- for Siderar.
Given the rating of A-, default spread is 1.25%

14. Interest Coverage Ratios, Ratings and Default Spreads
If Interest Coverage Ratio is Estimated Bond Rating Default Spread
> 8.50 AAA 0.20%
AA 0.50%
A+ 0.80%
A 1.00%
A– 1.25%
BBB 1.50%
BB 2.00%
B+ 2.50%
B 3.25%
B – 4.25%
CCC 5.00%
CC 6.00%
C 7.50%
< 0.20 D 10.00%

15. Other Factors Affecting Ratios Medians of Key Ratios : 1993-1995

16. Estimating Siderar’s Cost of Debt (in $)
Riskfree Rate = 6%
Country default spread = 5.25% (Argentine default spread)
I am assuming that all Argentine companies have to pay at least this spread.
Rating for Siderar = A-
Default spread = 1.25%
Pre-tax cost of borrowing for first 5 years= 6% % % = 12.50%
Pre-tax cost of borrowing after 5 years = 6% + 2.5% % = 9.75%

17. E(RRisky) = RRisk-free -+ Risk Premium
The Cost of Equity
Equity is not free!
Expected return = Risk-free rate + Risk Premium
E(RRisky) = RRisk-free -+ Risk Premium

18. The Cost of Equity
Consider the standard approach to estimating cost of equity:
Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,
Rf = Riskfree rate
E(Rm) = Expected Return on the Market Index (Diversified Portfolio)
In practice,
Short term government security rates are used as risk free rates
Historical risk premiums are used for the risk premium
Betas are estimated by regressing stock returns against market returns

20. Short Term Governments are Not Risk Free
On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return.
For an investment to be riskfree, then, it has to have
No default risk
No reinvestment risk
Match the duration of the analysis (generally long term) to the duration of the riskfree rate (also long term)
In emerging markets, there are two problems:
The government might not be viewed as riskfree (Brazil, Indonesia)
There might be no market-based long term government rate (China)

21. Estimating a Riskfree Rate
Estimate a range for the riskfree rate in local terms:
Upper limit: Obtain the rate at which the largest, safest firms in the country borrow at and use as the riskfree rate.
Lower limit: Use a local bank deposit rate as the riskfree rate
Do the analysis in real terms (rather than nominal terms) using a real riskfree rate, which can be obtained in one of two ways –
from an inflation-indexed government bond, if one exists
set equal, approximately, to the long term real growth rate of the economy in which the valuation is being done.
Do the analysis in another more stable currency, say US dollars.

22. Everyone uses historical premiums, but..
The historical premium is the premium that stocks have historically earned over riskless securities.
Practitioners never seem to agree on the premium; it is sensitive to
How far back you go in history…
Whether you use T.bill rates or T.Bond rates
Whether you use geometric or arithmetic averages.
For instance, looking at the US:
Historical period Stocks - T.Bills Stocks - T.Bonds
Arith Geom Arith Geom
% 6.95% 7.57% 5.91%
% 4.63% 5.16% 4.46%
% 9.72% 9.22% 8.02%

23. If you choose to use historical premiums….
Go back as far as you can. A risk premium comes with a standard error. Given the annual standard deviation in stock prices is about 25%, the standard error in a historical premium estimated over 25 years is roughly:
Standard Error in Premium = 25%/√25 = 25%/5 = 5%
Be consistent in your use of the riskfree rate. Since we argued for long term bond rates, the premium should be the one over TreasuryBonds
Use the geometric risk premium. It is closer to how investors think about risk premiums over long periods.
Never use historical risk premiums estimated over short periods.
For emerging markets, start with the base historical premium in the US and add a country spread, based upon the country rating and the relative equity market volatility.

24. Assessing Country Risk Using Currency Ratings: Latin America
Country Rating Default Spread over US T.Bond
Argentina Ba3 525
Bolivia B1 600
Brazil B2 750
Chile Baa1 150
Colombia Baa3 200
Ecuador B3 850
Paraguay B2 750
Peru Ba3 525
Uruguay Baa3 200
Venezuela B2 750

25. Using Country Ratings to Estimate Equity Spreads
Country ratings measure default risk. While default risk premiums and equity risk premiums are highly correlated, one would expect equity spreads to be higher than debt spreads.
One way to adjust the country spread upwards is to use information from the US market. In the US, the equity risk premium has been roughly twice the default spread on junk bonds.
Another is to multiply the bond spread by the relative volatility of stock and bond prices in that market. For example,
Standard Deviation in Merval (Equity) = 42.87%
Standard Deviation in Argentine Long Bond = 21.37%
Adjusted Equity Spread = 5.25% (42.87/21.37) = %
Ratings agencies make mistakes. They are often late in recognizing and building in risk.

26. Ratings Errors: Ratings for Asia
Country July 1997 Rating January 1998 Ratings
China BBB+ BBB+
Indonesia BBB CCC+
India BB+ BB+
Japan AAA AAA
South Korea AA- BB+
Malaysia A+ A-
Pakistan B+ B-
Philippines BB+ BB+
Singapore AAA AAA
Taiwan AA+ AA+
Thailand A BBB-

27. From Country Spreads to Risk Premiums
Approach 1: Assume that every company in the country is equally exposed to country risk. In this case,
E(Return) = Riskfree Rate + Country Spread + Beta (US premium)
Implicitly, this is what you are assuming when you use the local Government’s dollar borrowing rate as your riskfree rate.
Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk.
E(Return) = Riskfree Rate + Beta (US premium + Country Spread)
Approach 3: Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales)
E(Return)=Riskfree Rate+ b (US premium) + l (Country Spread)

28. Estimating Exposure to Country Risk
Different companies should be exposed to different degrees to country risk. For instance, an Argentinan firm that generates the bulk of its revenues in North America should be less exposed to country risk in Argentina than one that generates all its business within Argentina.
The factor “l” measures the relative exposure of a firm to country risk. One simplistic solution would be to do the following:
l = % of revenues domesticallyfirm/ % of revenues domesticallyavg firm
For instance, if a firm gets 35% of its revenues domestically while the average firm in that market gets 70% of its revenues domestically
l = 35%/ 70 % = 0.5
There are two implications
A company’s risk exposure is determined by where it does business and not by where it is located
Firms might be able to actively manage their country risk exposures

29. Estimating E(Return) for Siderar
Assume that the beta for Siderar is 0.71, and that the riskfree rate used is 6.00%. (US Long Term Bond rate)
Approach 1: Assume that every company in the country is equally exposed to country risk. In this case,
E(Return) = 6.00% % (5.5%) = 20.44%
Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk.
E(Return) = 6.00% (5.5% %) = 17.38%
Approach 3: Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales)
E(Return)=6.00% (5.5%) (10.53%) = 21.49%
In 1998, Siderar got 76.3% of its revenues from Argentina. The average across all Argentinan firms is closer to 70%.

30. Estimating Beta
The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
This beta has three problems:
It has high standard error
It reflects the firm’s business mix over the period of the regression, not the current mix
It reflects the firm’s average financial leverage over the period rather than the current leverage.

31. Beta Estimation: The Old Fashioned Way

32. Determinants of Betas
Product or Service: The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market.
Cyclical companies have higher betas than non-cyclical firms
Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products
Operating Leverage: The greater the proportion of fixed costs in the cost structure of a business, the higher the beta will be of that business. This is because higher fixed costs increase your exposure to all risk, including market risk.
Financial Leverage: The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risk.

33. Business Risk
Consider an investment in Tiffany’s. What kind of beta do you think this investment will have?
Much higher than one
Close to one
Much lower than one
Much Higher than one. Most of the products sold by Tiffany’s are discretionary.

34. Measures of Operating Leverage
Fixed Costs Measure = Fixed Costs / Variable Costs
This measures the relationship between fixed and variable costs. The higher the proportion, the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues
This measures how quickly the earnings before interest and taxes changes as revenue changes. The higher this number, the greater the operating leverage.
The direct measures of fixed costs and variable costs are difficult to obtain. Hence we use the second.

35. Equity Betas and Leverage
The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio
L = u (1+ ((1-t)D/E)
where
L = Levered or Equity Beta
u = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
While this beta is estimated on the assumption that debt carries no market risk (and has a beta of zero), you can have a modified version:
L = u (1+ ((1-t)D/E) - debt (1-t) D/(D+E)

36. Solutions to the Regression Beta Problem
Modify the regression beta by
changing the index used to estimate the beta
adjusting the regression beta estimate, by bringing in information about the fundamentals of the company
Estimate the beta for the firm using
the standard deviation in stock prices instead of a regression against an index.
accounting earnings or revenues, which are less noisy than market prices.
Estimate the beta for the firm from the bottom up without employing the regression technique. This will require
understanding the business mix of the firm
estimating the financial leverage of the firm
Use an alternative measure of market risk that does not need a regression.

37. The Solution: Bottom-up Betas
The bottom up beta can be estimated by :
Taking a weighted (by sales or operating income) average of the unlevered betas of the different businesses a firm is in.
(The unlevered beta of a business can be estimated by looking at other firms in the same business)
Lever up using the firm’s debt/equity ratio
The bottom up beta will give you a better estimate of the true beta when
It has lower standard error (SEaverage = SEfirm / √n (n = number of firms)
It reflects the firm’s current business mix and financial leverage
It can be estimated for divisions and private firms.

38. Siderar’s Bottom-up Beta
Business Unlevered D/E Ratio Levered Riskfree Risk Cost of
Beta Beta Rate Premium Equity
Steel % % 16.03% 17.38%
Proportion of operating income from steel = 100%
Levered Beta for Siderar= 0.71
Assume now that Siderar decides to go into the retailing business, and that the unlevered beta for that business is Assuming that 25% of Siderar’s business looking forward will come from this business, what will the firm’s beta be?

39. The Weighted Average Cost of Capital
The weights used to compute the cost of capital should be the market value weights for debt and equity.
There is an element of circularity that is introduced into every valuation by doing this, since the values that we attach to the firm and equity at the end of the analysis are different from the values we gave them at the beginning.
As a general rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.

40. The Cost of Capital Choice Cost
1. Equity Cost of equity
- Retained earnings - depends upon riskiness of the stock
- New stock issues - will be affected by level of interest rates
- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt
- Bank borrowing - depends upon default risk of the firm
- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity and
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

41. Estimating Cost of Capital: Siderar
Equity
Cost of Equity = 6.00% (16.03%) = 17.38%
Market Value of Equity = 3.20* = 995 million (94.37%)
Debt
Cost of debt = 6.00% % % (default spread) = 12.5%
Market Value of Debt = 59 Mil (5.63%)
Cost of Capital
Cost of Capital = 17.38%(.9437) %( )(.0563))
= 17.38%(.9437) %(.0563) = 16.87%

42. Next, Minimize the Cost of Capital by Changing the Financial Mix
The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm.
Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt.
But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.

43. This is What We’re Trying to Do
This is a simple example, where both the costs of debt and equity are given. Note that both increase as the debt ratio goes up, but the cost of capital becomes lower at least initially as you take on more debt ( because you are substituting in cheaper debt for more expensive equity)
At 40%, the cost of capital is minimized. It is the optimal debt ratio.

44. Cost of Capital and Leverage: Method
Equity
Debt
Estimated Beta
With current leverage
From regression
Leverage, EBITDA
And interest cost
Unlevered Beta
With no leverage
Bu=Bl/(1+D/E(1-T))
Interest Coverage
EBITDA/Interest
Levered Beta
With different leverage
Bl=Bu(1+D/E(1-T))
Rating
(other factors too!)
Cost of equity
With different leverage
E(R)=Rf+Bl(Rm-Rf)
Cost of debt
With different leverage
Rate=Rf+Spread+?

45. Siderar: Optimal Debt Ratio
Question: If Siderar’s current debt ratio is 60%, what do you recommend?

46. Siderar: Optimal Debt Ratio

47. Case Study: Nokia 2000

48. A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal
Actual < Optimal
Overlevered
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes No
Yes No
Reduce Debt quickly
Increase leverage
Does the firm have good
1. Equity for Debt swap
quickly
Does the firm have good
2. Sell Assets; use cash
projects?
1. Debt/Equity swaps
projects?
to pay off debt
ROE > Cost of Equity
2. Borrow money&
ROE > Cost of Equity
ROC > Cost of Capital
3. Renegotiate with lenders
buy shares.
ROC > Cost of Capital
Studies that have looked at the likelihood of a firm being taken over (in a hostile takeover) have concluded that
Small firms are more likely to be taken over than larger firms
Closely held firms are less likely to be taken over than widely held firms
Firms with anti-takeover restrictions in the corporate charter (or from the state) are less likely to be taken over than firms without these restrictions
Firms which have done well for their stockholders (positive Jensen’s alpha, Positive EVA) are less likely to be taken over than firms which have done badly.
Whether a firm is under bankruptcy threat can be assessed by looking at its rating. If its rating is B or less, you can argue that the bankruptcy threat is real.
Looking at historical ROE or ROC, relative to the cost of equity and capital, does assume that the future will look like the past.
Yes No
Yes No
Take good projects with
1. Pay off debt with retained
new equity or with retained
earnings.
Take good projects with
earnings.
2. Reduce or eliminate dividends.
debt.
Do your stockholders like
3. Issue new equity and pay off
dividends?
debt.
Yes No
Pay Dividends
Buy back stock

52. Appendix Minimizing the Cost of Capital: Example
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
WACC
9.40%
9.60%
9.80%
10.00%
10.20%
10.40%
10.60%
10.80%
11.00%
11.20%
11.40%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%

53. Optimum Capital Structure and Cost of Capital
If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
If the cash flows are the same, and the discount rate is lowered, the present value has to go up. (The key is that cash flows have to remain the same. If this is not true, then minimizing cost of capital may not maximize firm value)

54. Applying Approach: The Textbook Example
This is a simple example, where both the costs of debt and equity are given. Note that both increase as the debt ratio goes up, but the cost of capital becomes lower at least initially as you take on more debt ( because you are substituting in cheaper debt for more expensive equity)
At 40%, the cost of capital is minimized. It is the optimal debt ratio.

55. WACC and Debt Ratios Weighted Average Cost of Capital and Debt Ratios
9.40%
9.60%
9.80%
10.00%
10.20%
10.40%
10.60%
10.80%
11.00%
11.20%
11.40%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%

56. Current Cost of Capital: Disney
Equity
Cost of Equity = %
Market Value of Equity = $50.88 Billion
Equity/(Debt+Equity ) = 82%
Debt
After-tax Cost of debt = 7.50% (1-.36) = 4.80%
Market Value of Debt = $ Billion
Debt/(Debt +Equity) = 18%
Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%
This reproduces the current cost of capital computation for Disney, using market value weights for both debt and equity, the cost of equity (based upon the bottom-up beta) and the cost of debt (based upon the bond rating)
The market value of debt is estimated by estimating the present value of total interest payments and face value at the current cost of debt.
One way to frame the capital structure question: Is there a mix of debt and equity at which Disney’s cost of capital will be lower than 12.22%?

57. Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase.
To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.
The basic inputs for computing cost of capital are cost of equity and cost of debt. This summarizes the basic approach we will use to estimate each.

58. Medians of Key Ratios : 1993-1995

59. Process of Ratings and Rate Estimation
We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class.
We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place.
The interest coverage ratios in the previous table are medians. We use the ratios for large manufacturing firms to develop the table on the next page.
We also estimate a spread over the long term government bond rate at each rating, using the average yield to maturity on 5 long-term straight bonds within each ratings class and comparing to the treasury bond rate.

60. Interest Coverage Ratios and Bond Ratings
If Interest Coverage Ratio is Estimated Bond Rating
> 8.50 AAA AA A+ A A–
BBB BB B+ B
B –
CCC CC C
< 0.20 D
These are interest coverage ratio/ratings classes for large manufacturing firms.
The ratios need to be much higher for smaller firms to get similar ratings. (See ratings.xls spreadsheet)

61. Spreads Over Long Bond Rate for Ratings Classes

62. Current Income Statement for Disney: 1996
Revenues 18,739
-Operating Expenses 12,046
EBITDA ,693
-Depreciation 1,134
EBIT ,559
-Interest Expense
Income before taxes 5,080
-Taxes
Income after taxes ,233
Interest coverage ratio= 5,559/479 = 11.61
(Amortization from Capital Cities acquisition not considered)
This is the current interest coverage ratio at Disney. Note that it is high enough for Disney to command a AAA rating, but Disney’s actual rating is AA. This is because the interest expenses of $ 479 million do not reflect adequately the amount of debt that Disney had on its balance sheet at then end of 1996 ($ 12.2 billion in book value terms). Some of the debt was taken during the course of the year, and the interest expenses are for only a portion of the year.

63. Estimating Cost of Equity
Current Beta = 1.25 Unlevered Beta = 1.09
Market premium = 5.5% T.Bond Rate = 7.00% t=36%
Debt Ratio D/E Ratio Beta Cost of Equity
0% 0% %
10% 11% %
20% 25% %
30% 43% %
40% 67% %
50% 100% %
60% 150% %
70% 233% %
80% 400% %
90% 900% %
This reproduces the levered beta, using the formula developed during the risk and return section. The unlevered beta of 1.09 is the bottom-up unlevered beta.
BetaLevered = Unlevered Beta (1 + (1-t) (Debt/Equity Ratio))

64. Disney: Beta, Cost of Equity and D/E Ratio

65. Estimating Cost of Debt
D/(D+E) 0.00% 10.00% Calculation Details Step
D/E % 11.11% = [D/(D+E)]/( 1 -[D/(D+E)])
$ Debt $0 $6,207 = [D/(D+E)]* Firm Value 1
EBITDA $6,693 $6,693 Kept constant as debt changes.
Depreciation $1,134 $1,134 "
EBIT $5,559 $5,559
Interest $0 $447 = Interest Rate * $ Debt 2
Taxable Income $5,559 $5,112 = OI - Depreciation - Interest
Tax $2,001 $1,840 = Tax Rate * Taxable Income
Net Income $3,558 $3,272 = Taxable Income - Tax
Pre-tax Int. cov ∞ = (OI - Deprec'n)/Int. Exp 3
Likely Rating AAA AAA Based upon interest coverage 4
Interest Rate 7.20% 7.20% Interest rate for given rating 5
Eff. Tax Rate 36.00% 36.00% See notes on effective tax rate
After-tax kd 4.61% 4.61% =Interest Rate * (1 - Tax Rate)
Firm Value = 50,888+11,180= $62,068
This is a manual computation of the cost of debt. Note the circularity in the argument, since the interest expense is needed to compute the rating, and the rating is needed to compute the cost of debt.
To get around the circularity, I start the 10% debt ratio calculation assuming that my cost of debt is the same as it was at 0% (which is 7.20%). I could have even started with the long term treasury bond rate, but I would have had to do one additional iteration to get the costs of debt consistent.

66. The Ratings Table If Interest Coverage Ratio is Estimated Bond Rating
> 8.50 AAA AA A+ A A–
BBB BB B+ B
B –
CCC CC C
< 0.20 D
This is the look-up table that I used to determine what my rating and cost of debt would be at a interest coverage ratio.

67. Bond Ratings, Cost of Debt and Debt Ratios

68. Stated versus Effective Tax Rates
You need taxable income for interest to provide a tax savings
In the Disney case, consider the interest expense at 70% and 80%
70% Debt Ratio 80% Debt Ratio
EBIT $ 5,559 m $ 5,559 m
Interest Expense $ 5,214 m $ 5,959 m
Tax Savings $ 1,866 m $ 2,001m
Effective Tax Rate % 2001/5959 = 33.59%
Pre-tax interest rate 12.00% %
After-tax Interest Rate 7.68% 7.97%
You can deduct only $5,559million of the $5,959 million of the interest expense at 80%. Therefore, only 36% of $ 5,559 is considered as the tax savings.
We are being conservative. The interest that is not tax deductible can be carried forward and will probably earn some tax benefit in future periods.
Given that this is a permanent change in capital structure, however, it seems to be more conservative to just look at the interest expenses that provide a tax benefit in the current period.

69. Cost of Debt

70. Disney’s Cost of Capital Schedule
Debt Ratio Cost of Equity AT Cost of Debt Cost of Capital
0.00% 13.00% 4.61% 13.00%
10.00% 13.43% 4.61% 12.55%
20.00% 13.96% 4.99% 12.17%
30.00% 14.65% 5.28% 11.84%
40.00% 15.56% 5.76% 11.64%
50.00% 16.85% 6.56% 11.70%
60.00% 18.77% 7.68% 12.11%
70.00% 21.97% 7.68% 11.97%
80.00% 28.95% 7.97% 12.17%
90.00% 52.14% 9.42% 13.69%
Summarizes the cost of equity and debt from prior pages, as well as the cost of capital at different debt ratios.
If the objective is to minimize cost of capital, it occurs at 40% debt.
This will maximize firm value, if operating earnings (EBITDA) is unaffected by changes in leverage and the consequent changes in ratings.

71. Disney: Cost of Capital Chart

72. Effect on Firm Value
Firm Value before the change = 50,888+11,180= $ 62,068
WACCb = 12.22% Annual Cost = $62,068 *12.22%= $7,583 million
WACCa = 11.64% Annual Cost = $62,068 *11.64% = $7,226 million
WACC = 0.58% Change in Annual Cost = $ 357 million
If there is no growth in the firm value, (Conservative Estimate)
Increase in firm value = $357 / = $3,065 million
Change in Stock Price = $3,065/675.13= $4.54 per share
If there is growth (of 7.13%) in firm value over time,
Increase in firm value = $357 * /( ) = $ 8,474
Change in Stock Price = $8,474/ = $12.55 per share
Implied Growth Rate obtained by
Firm value Today =FCFF(1+g)/(WACC-g): Perpetual growth formula
$62,068 = $3,222(1+g)/(.1222-g): Solve for g
The reduction in the cost of capital translates into annual savings. Most of these savings are implicit, being savings in the cost of equity. Thus, the firm’s accounting earnings will not reflect these savings directly.
These savings can be converted into a present value by discounting back at the new cost of capital.
It is more realistic to assume growth in firm value. A simple way to estimate what the current growth attributed to the firm by the market is to estimate it using the firm value today, the free cash flow to the firm and the current cost of capital.
FCFF = 5,559 (1-.36) - ( ) = $3,222 (Ignored working capital)
Current firm value = $ 50,888 + $ 11,180 = $ 62,068 million
Note that the simple valuation formula used above assumes stable growth forever. For high growth firms, this formula will yield an implied growth rate that is too high (It will be very close to the cost of capital). In those cases, it is better to put a cap on the growth rate of around 6% (the nominal growth rate of the US economy).
In this case, maximizing firm value also maximizes stock price, because we assume that
Debt is refinanced at current market rates, thus protecting bondholders
Markets are rational and efficient.

73. www.giddy.org Ian Giddy NYU Stern School of Business
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