2. Prof. Ian Giddy New York University Capital Structure Planning SIM/NYU The Job of the CFO

3. Copyright ©2001 Ian H. Giddy Capital Structure 3 giddy.org Why Financial Restructuring? l The Asian Bet l The Solution, Part I: Recapitalization l The Solution, Part II: Financial Restructuring l The Solution, Part III: Corporate Restructuring

4. Copyright ©2001 Ian H. Giddy Capital Structure 4 giddy.org The Asian Bet l High growth disguised speculative financing structures l Governments shielded companies and banks from capital market discipline l Too much debt l Too much foreign-currency debt l Closely held ownership relying on reinvested earnings

5. Copyright ©2001 Ian H. Giddy Capital Structure 5 giddy.org The Asian Bet l High growth disguised speculative financing structures l Governments shielded companies and banks from capital market discipline l Too much debt l Too much foreign-currency debt l Closely held ownership relying on reinvested earnings The three excesses n Too much debt n Too much labor n Too much capacity The three excesses n Too much debt n Too much labor n Too much capacity Example: Hyundai Group

6. Copyright ©2001 Ian H. Giddy Capital Structure 6 giddy.org How the Bet was Lost l Vulnerable economies, newly liberalized, succumbed to currency crises l Economic downturns followed l Companies were unable to service even domestic debt, never mind foreign currency debt l Still unreformed, many Asian companies remain misfinanced Example: Hyundai Group

7. Copyright ©2001 Ian H. Giddy Capital Structure 7 giddy.org What is Corporate Restructuring? l Any substantial change in a company’s financial structure, or ownership or control, or business portfolio. l Designed to increase the value of the firm Restructuring Improve capitalization Change ownership and control Improve debt composition

8. Copyright ©2001 Ian H. Giddy Capital Structure 8 giddy.org It’s All About Value l How can corporate and financial restructuring create value? Operating Cash Flows Debt Equity AssetsLiabilities Fix the business Or fix the financing

9. Copyright ©2001 Ian H. Giddy Capital Structure 9 giddy.org Restructuring Figure out what the business is worth now Use valuation model – present value of free cash flows Fix the business mix – divestituresValue assets to be sold Fix the business – strategic partner or merger Value the merged firm with synergies Fix the financing – improve D/E structure Revalue firm under different leverage assumptions – lowest WACC Fix the kind of equityWhat can be done to make the equity more valuable to investors? Fix the kind of debt or hybrid financing What mix of debt is best suited to this business? Fix management or controlValue the changes new control would produce

10. Copyright ©2001 Ian H. Giddy Capital Structure 10 giddy.org Getting the Financing Right Step 1: The Proportion of Equity & Debt Debt Equity n Achieve lowest weighted average cost of capital n May also affect the business side

11. Copyright ©2001 Ian H. Giddy Capital Structure 11 giddy.org Getting the Financing Right Step 2: The Kind of Equity & Debt Debt Equity n Short term? Long term? n Baht? Dollar? Yen? n Short term? Long term? n Baht? Dollar? Yen? n Bonds? Asset-backed? n Convertibles? Hybrids? n Bonds? Asset-backed? n Convertibles? Hybrids? n Debt/Equity Swaps? n Private? Public? n Strategic partner? n Domestic? ADRs? n Debt/Equity Swaps? n Private? Public? n Strategic partner? n Domestic? ADRs? n Ownership & control?

12. Copyright ©2001 Ian H. Giddy Capital Structure 12 giddy.org Does Capital Structure Matter? Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E You cannot change the value of the real business just by shuffling paper - Modigliani-Miller

13. Copyright ©2001 Ian H. Giddy Capital Structure 13 giddy.org Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E COST OF CAPITAL DEBT RATIO Optimal debt ratio?

14. Copyright ©2001 Ian H. Giddy Capital Structure 14 giddy.org Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E VALUE OFTHE FIRM DEBT RATIO Optimal debt ratio?

15. Copyright ©2001 Ian H. Giddy Capital Structure 15 giddy.org Does Capital Structure Matter? Yes! Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) Debt Equity Value of the firm = D + E Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs

16. Copyright ©2001 Ian H. Giddy Capital Structure 16 giddy.org Managing the capital base l Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000 l Flexibility to redeem non-voting shares and buy back ordinary shares l Flexibility to dispose remaining non-core assets l Utilizing excess capital for organic growth and acquisitions

17. Copyright ©2001 Ian H. Giddy Capital Structure 17 giddy.org Changing Financial Mix l Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. l 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). l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.

18. Copyright ©2001 Ian H. Giddy Capital Structure 18 giddy.org Debt: Pros and Cons Advantages of BorrowingDisadvantages of Borrowing 1. Tax Benefit: Higher tax rates --> Higher tax benefit 1. Bankruptcy Cost: Higher business risk --> Higher Cost 2. Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit 2. Agency Cost: Greater the separation between stock- holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost

19. Copyright ©2001 Ian H. Giddy Capital Structure 19 giddy.org See Saw Business Uncertainty Financial Risk Operating Leverage Financial Leverage

20. Copyright ©2001 Ian H. Giddy Capital Structure 20 giddy.org Young and Old Operating Leverage Financial Leverage Operating Leverage Financial Leverage Size Maturity

21. Copyright ©2001 Ian H. Giddy Capital Structure 21 giddy.org Disney 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% 0 10% 20%30%40%50%60%70% 80% 90% 100%

22. Copyright ©2001 Ian H. Giddy Capital Structure 22 giddy.org Siderar: Steel Company in Argentina

23. Copyright ©2001 Ian H. Giddy Capital Structure 23 giddy.org Capital Structure: East vs West VALUE OFTHE FIRM DEBT RATIO Optimal debt ratio? IntelTPI

24. Copyright ©2001 Ian H. Giddy Capital Structure 24 giddy.org Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas

25. Copyright ©2001 Ian H. Giddy Capital Structure 25 giddy.org Perceived Benefits to Sammi From Acquisition of Atlas Steel l Achieve $280mm savings by acquiring Atlas Steel and related companies  Cost of setting up own production facility would have been $500 mm  Savings were channeled into restructuring production facilities at existing plants l Sammi’s share price rose 9% on news of strategic acquisitions

26. Copyright ©2001 Ian H. Giddy Capital Structure 26 giddy.org How Should the Acquisition Have Been Financed? Assets added: $210 million Assets added: $210 million Debt added: $210 million (C$250m) Debt added: $210 million (C$250m)

27. Copyright ©2001 Ian H. Giddy Capital Structure 27 giddy.org How Should the Acquisition Have Been Financed? Assets added: $210 million Assets added: $210 million Debt added: $210 million (C$250m) Loan: C$180m Ret earn: C$70m Plus w.cap.: Eurobond with warrants US$50m Debt added: $210 million (C$250m) Loan: C$180m Ret earn: C$70m Plus w.cap.: Eurobond with warrants US$50m

28. Copyright ©2001 Ian H. Giddy Capital Structure 28 giddy.org Problems faced by Sammi from the Acquisition l Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages l Future refinancing of debt caused earnings after interest costs to fall 17% l Purchase price of $210.6 mm found to have been excessive l The acquisition was ill-timed l Existing and new plants suffered from low capacity utilization of around 65%

29. Copyright ©2001 Ian H. Giddy Capital Structure 29 giddy.org Sammi Steel in 1995 l Sammi Atlas pushed to raise productivity by 15% l A leaner organization: Work force had shrunk by 19.4% since 1988 l 4 year freezes on salaries to limit labor costs l Unrelated and unprofitable businesses have been sold off l New export zones identified in China and South- East Asia l Conversion of debt into equity to reduce interest costs by 6%; l Result: dilution in EPS, unless offset by increased volume of sales

30. Copyright ©2001 Ian H. Giddy Capital Structure 30 giddy.org Analysis of Change in Value of Sammi Steel

31. Copyright ©2001 Ian H. Giddy Capital Structure 31 giddy.org March 1997 Sammi Steel is bankrupt!

32. Copyright ©2001 Ian H. Giddy Capital Structure 32 giddy.org March 1997 Sammi Steel is bankrupt! Dr F R Structuring n Diagnosis n Prevention n and Cure Dr F R Structuring n Diagnosis n Prevention n and Cure

33. Copyright ©2001 Ian H. Giddy Capital Structure 33 giddy.org Financing Choices Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) From How much debt? to What kind of debt? and What kind of equity? You can make a difference - Pepper-Giddy

34. Copyright ©2001 Ian H. Giddy Capital Structure 34 giddy.org Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT Case Study: “Intralinks”

35. Prof. Ian Giddy New York University Financing Growth Companies

36. Copyright ©2001 Ian H. Giddy Capital Structure 36 giddy.org Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

37. Copyright ©2001 Ian H. Giddy Capital Structure 37 giddy.org The CFO Questions l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public? l How much (cheap) debt should we have? l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? l How should we manage our financial risks?

38. Copyright ©2001 Ian H. Giddy Capital Structure 38 giddy.org Financing X Inc

39. Copyright ©2001 Ian H. Giddy Capital Structure 39 giddy.org Financing X Inc

40. Copyright ©2001 Ian H. Giddy Capital Structure 40 giddy.org Financing X Inc

41. Copyright ©2001 Ian H. Giddy Capital Structure 41 giddy.org Corporate Financing Life-Cycle Growth companies Mature companies Leverage

42. Copyright ©2001 Ian H. Giddy Capital Structure 42 giddy.org Firm Characteristics as Growth Changes VariableHigh Growth Firms tend to Stable Growth Firms tend to Riskbe above-average riskbe average risk Dividend Payoutpay little or no dividendspay high dividends Net Cap Exhave high net cap exhave low net cap ex Return on Capitalearn high ROC (excess return)earn ROC closer to WACC Leveragehave little or no debthigher leverage Earnings Gearing (Leverage) 0

43. Copyright ©2001 Ian H. Giddy Capital Structure 43 giddy.org Financing Growth Companies: The Agenda l Where can we get the initial equity financing we need to grow? l Do we want money, management, or more? l When do we want to sell out, and how? l When is the right time for debt for a growth company? What kind?

44. Copyright ©2001 Ian H. Giddy Capital Structure 44 giddy.org What Kind of Equity? l Sources of Equity  Private investors  Strategic investors  Interventionist investors  Public market l And Kinds  Common stock  Stock with restricted voting rights  Hybrids, including convertibles

45. Copyright ©2001 Ian H. Giddy Capital Structure 45 giddy.org.comfax (now Messageclick) l Started in September 1997,.comfax enables users to send faxes and receive faxes over the internet at a low cost. l By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day. l Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money. l What form of equity financing would be appropriate for.comfax?

46. Copyright ©2001 Ian H. Giddy Capital Structure 46 giddy.org Pre-IPO Equity Financing l Friends and family l Angel l Venture capital l Strategic partners

47. Copyright ©2001 Ian H. Giddy Capital Structure 47 giddy.org Pre-IPO Equity Financing l Friends and family l Angel l Venture capital l Strategic partners asiajack.com

48. Copyright ©2001 Ian H. Giddy Capital Structure 48 giddy.org Private Equity Funds l Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring. l The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.

49. Copyright ©2001 Ian H. Giddy Capital Structure 49 giddy.org Silipos Inc

50. Copyright ©2001 Ian H. Giddy Capital Structure 50 giddy.org Silipos Inc, 1999 Where do you want to go? Debt? Acquisition? IPO? Sell?

51. Copyright ©2001 Ian H. Giddy Capital Structure 51 giddy.org IntraLinks

52. Copyright ©2001 Ian H. Giddy Capital Structure 52 giddy.org IntraLinks’ Choices  Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.  Seek out one or more private equity investors, ones who believed in the company’s product and its management.  Do an initial public offering (IPO).  Find another corporation who would be willing to acquire IntraLinks.

53. Copyright ©2001 Ian H. Giddy Capital Structure 53 giddy.org Why Venture Capitalists Prefer Preferred l Senior status in bankruptcy l Does not put a value on the shares l Is convertible into common stock before the IPO l Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero)

54. Copyright ©2001 Ian H. Giddy Capital Structure 54 giddy.org Case Study: Photronics

55. Copyright ©2001 Ian H. Giddy Capital Structure 55 giddy.org Case Study: Photronics Photronics is the world's leading and fastest growing manufacturer of photomasks. Photomasks are high precision quartz plates that contain microscopic images of electronic circuits. A key element and enabling technology in the manufacture of semiconductors, photomasks are used to transfer circuit patterns onto semiconductor wafers during the fabrication of integrated circuits. They are produced in accordance with circuit designs provided by customers at strategically located manufacturing facilities in North America, Europe and Asia.

56. Copyright ©2001 Ian H. Giddy Capital Structure 56 giddy.org Case Study: Photronics Sales, 1994-99

57. Copyright ©2001 Ian H. Giddy Capital Structure 57 giddy.org The Company’s Debt

58. Copyright ©2001 Ian H. Giddy Capital Structure 58 giddy.org Should Photronics Have More Debt? l Benefits of Debt  Tax Benefits  Adds discipline to management l Costs of Debt  Bankruptcy Costs  Agency Costs  Loss of Future Flexibility

59. Copyright ©2001 Ian H. Giddy Capital Structure 59 giddy.org The CFO Questions l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public? l How much (cheap) debt should we have? l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? l How should we manage our financial risks?

60. Copyright ©2001 Ian H. Giddy Capital Structure 60 giddy.org Some Useful Websites l giddy.org/jcfo.htm l giddy.org l giddyonline.com l shareinvestor.com l dialpad.com l onebox.com

61. Copyright ©2001 Ian H. Giddy Capital Structure 61 giddy.org Measuring the Cost of Capital l Cost of funding equal return that investors expect l Expected returns depend on the risks investors face (risk must be taken in context) l Cost of capital  Cost of equity  Cost of debt  Weighted average (WACC)

62. Copyright ©2001 Ian H. Giddy Capital Structure 62 giddy.org A $1 Investment in Different Types of Portfolios: 1926-1996 Index ($) $4,495.99 $33.73 $13.54 $8.85 $1,370.95 Small Company Stocks Large Company Stocks Long-Term Government Bonds Treasury Bills Inflation Year-End

63. Copyright ©2001 Ian H. Giddy Capital Structure 63 giddy.org Equity Risk l 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. l 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

64. Copyright ©2001 Ian H. Giddy Capital Structure 64 giddy.org Equity versus Bond Risk Uncertain value of future cash flows Uncertain value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity

65. Copyright ©2001 Ian H. Giddy Capital Structure 65 giddy.org Corporate Cash Flow Valuation: The Steps l 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. l Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm) l Estimate the future earnings and cash flows on the asset being valued, generally by estimating an expected growth rate in earnings. l Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does. l Choose the right DCF model for this asset and value it.

66. Copyright ©2001 Ian H. Giddy Capital Structure 66 giddy.org

67. Copyright ©2001 Ian H. Giddy Capital Structure 67 giddy.org Let’s Start With the Cost of Debt l 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

68. Copyright ©2001 Ian H. Giddy Capital Structure 68 giddy.org What the Cost of Debt Is and Is Not… The cost of debt is  the rate at which the company can borrow at today  corrected for the tax benefit it gets for interest payments. Cost of debt = k d = 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.

69. Copyright ©2001 Ian H. Giddy Capital Structure 69 giddy.org Estimating the Cost of Debt l 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. l If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. l 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 l The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

70. Copyright ©2001 Ian H. Giddy Capital Structure 70 giddy.org Estimating Synthetic Ratings l 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 l 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%

71. Copyright ©2001 Ian H. Giddy Capital Structure 71 giddy.org Interest Coverage Ratios, Ratings and Default Spreads If Interest Coverage Ratio isEstimated Bond RatingDefault Spread > 8.50AAA0.20% 6.50 - 8.50AA0.50% 5.50 - 6.50A+0.80% 4.25 - 5.50A1.00% 3.00 - 4.25A–1.25% 2.50 - 3.00BBB1.50% 2.00 - 2.50BB2.00% 1.75 - 2.00B+2.50% 1.50 - 1.75B3.25% 1.25 - 1.50B –4.25% 0.80 - 1.25CCC5.00% 0.65 - 0.80CC6.00% 0.20 - 0.65C7.50% < 0.20D10.00%

72. Copyright ©2001 Ian H. Giddy Capital Structure 72 giddy.org Other Factors Affecting Ratios Medians of Key Ratios : 1993-1995

73. Copyright ©2001 Ian H. Giddy Capital Structure 73 giddy.org Estimating Siderar’s Cost of Debt (in $) l Riskfree Rate = 6% l Country default spread = 5.25% (Argentine default spread)  I am assuming that all Argentine companies have to pay at least this spread. l Rating for Siderar = A- l Default spread = 1.25% l Pre-tax cost of borrowing for first 5 years= 6% + 5.25% + 1.25% = 12.50%

74. Copyright ©2001 Ian H. Giddy Capital Structure 74 giddy.org The Cost of Equity Equity is not free! Expected return = Risk-free rate + Risk Premium E(R Risky ) = R Risk-free -+ Risk Premium

75. Copyright ©2001 Ian H. Giddy Capital Structure 75 giddy.org The Cost of Equity l Consider the standard approach to estimating cost of equity: Cost of Equity = R f + Equity Beta * (E(R m ) - R f ) where, R f = Riskfree rate E(R m ) = Expected Return on the Market Index (Diversified Portfolio) l 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

76. Copyright ©2001 Ian H. Giddy Capital Structure 76 giddy.org

77. Copyright ©2001 Ian H. Giddy Capital Structure 77 giddy.org Estimating Beta l The standard procedure for estimating betas is to regress stock returns (R j ) against market returns (R m ) - R j = a + b R m  where a is the intercept and b is the slope of the regression. l The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. l 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.

78. Copyright ©2001 Ian H. Giddy Capital Structure 78 giddy.org Beta Estimation: The Old Fashioned Way

79. Copyright ©2001 Ian H. Giddy Capital Structure 79 giddy.org Determinants of Betas l 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 l 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. l 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.

80. Copyright ©2001 Ian H. Giddy Capital Structure 80 giddy.org The Cost of Capital ChoiceCost 1. EquityCost 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. DebtCost 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 Capitalcost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]

81. Copyright ©2001 Ian H. Giddy Capital Structure 81 giddy.org Estimating Cost of Capital: Siderar l Equity  Cost of Equity = 6.00% + 0.71 (16.03%) = 17.38%  Market Value of Equity = 3.20* 310.89 = 995 million (94.37%) l Debt  Cost of debt = 6.00% + 5.25% + 1.25% (default spread) = 12.5%  Market Value of Debt = 59 Mil (5.63%) l Cost of Capital Cost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563)) = 17.38%(.9437) + 8.32%(.0563) = 16.87%

82. Copyright ©2001 Ian H. Giddy Capital Structure 82 giddy.org Next, Minimize the Cost of Capital by Changing the Financial Mix l The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm. l Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt. l 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). l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.

83. Copyright ©2001 Ian H. Giddy Capital Structure 83 giddy.org This is What We’re Trying to Do

84. Copyright ©2001 Ian H. Giddy Capital Structure 84 giddy.org Cost of Capital and Leverage: Method Estimated Beta With current leverage From regression Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Cost of equity With different leverage E(R)=Rf+Bl(Rm-Rf) Equity Leverage, EBITDA And interest cost Interest Coverage EBITDA/Interest Rating (other factors too!) Cost of debt With different leverage Rate=Rf+Spread+? Debt

85. Copyright ©2001 Ian H. Giddy Capital Structure 85 giddy.org Siderar: Optimal Debt Ratio Question: If Siderar’s current debt ratio is 60%, what do you recommend?

86. Copyright ©2001 Ian H. Giddy Capital Structure 86 giddy.org Siderar: Optimal Debt Ratio

87. Copyright ©2001 Ian H. Giddy Capital Structure 87 giddy.org A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat?Is the firm a takeover target? YesNo Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with new equity or with retained earnings. No 1. Pay off debt with retained earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt. Yes No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends No Buy back stock Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares.

89. n giddyonline.com

90. www.giddy.org

92. Copyright ©2001 Ian H. Giddy Capital Structure 92 giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332 Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org