COB 300B Exam 3

Cost of Capital, Capital Structure and Leverage, Capital Budgeting

Debt, Preferred stock, and common equity

What are the 3 sources of capital?

Notes payable and long term debt

What are two common forms of debt?

Retained earnings, new common stock

What are two forms of common equity?

Cost of Capital

The firm’s average cost of funds used to finance its operations and investments, reflecting the required return for equity and debt holders.

rd (or YTM)

Before tax cost of debt, the return investors require to purchase the firm’s bonds

rd(1-Tc)

After tax cost of debt

rps

Cost of preferred stock

rs

cost of equity

WACC

Weighted average cost of capital

Capital structure

The combination of different types of capital used by a firm

1. Estimate the weights- estimate the market values of each source of capital and calculate the proportion of each source in the company’s invested capital

2. Estimate the costs- Estimate the marginal cost of each source of capital (after tax)

3. Assemble the pieces- Calculate the WACC of each source using the weights and estimated marginal costs

Steps in Calculating the WACC

Optimal Capital Structure

The ideal mix of debt and equity financing that minimizes the company's overall cost of capital while maximizing its value.

1. Optimizes financial leverage

2. Combination of calculation and strategy

3. Key in determining a firm’s WACC

Other characteristics of Optimal Capital Structure

• Use Capital Structure/optimal structure if available

• Use Present Capital Structure as an estimate

• Use market values NOT book values

Which weights are used to determine the relative proportions of debt and equity in the capital structure?

Weights of debt, weights of PS, weights of equity

What do you need to compute WACC?

Debt’s market value

The number of outstanding bonds times the market price of one bond

Equity’s Market Value

The number of shares of outstanding common stock times the market price of one share of common stock

A firm’s market value

________ is calculated as the sum of the market values of its debt, preferred stock, and equity.

V= D + E

The percent of value financed with debt

Wd= D/V

where D is the market value of debt and V is the total market value of the firm.

The percent of value financed with Equity

We= E/V

Where E is the market value of equity and V is the total market value of the firm

100%

What must capital structure weights add up to?

WACC weights formula

WACC= Wd + We + Wps = 100%

WACC Formula

Wd*rd(1-T) + Wsrs

Marginal Cost of Capital (MCC)

The cost of obtaining another dollar of new capital

Cost of preferred stock

The preferred dividend divided by the net issuing price

Rps= D/P

Cost of equity

The return required by equity investors given the risk of the cash flows from the firm

Can be both business risk and financial risk

1. CAPM

2. Discounted Cash flow (DCF)

3. Bond yield plus risk premium

What are the approaches to calculate the cost of equity?

Capital Asset Pricing Model (CAPM) Approach

Widely used financial model that helps determine the cost of equity.

rS = rRF + βS (rM – rRF)

rRF

Risk free rate of return

rM

Market return

βs

Beta coefficient for stock S

(rM – rRF)

Risk premium for Stock S

1. Explicitly adjusts for systematic risk

2. Applicable to all companies, as long as we can estimate the beta coefficient

What are the pros of the CAPM Approach?

1. You have to estimate the expected market risk premium, which is known to vary over time

2. You have to estimate Beta, which varies over time

3. We are using the past to estimate the future (not always reliable)

What are some cons to the CAPM approach?

Discounted Cash Flow (DCF) Approach

A method used to estimate the value of an investment based on expected future cash flows. This model assumes constant growth.

Rs= D0(1+g) / P0 + g=D1/P0 + g

Easy to understand and use

What are the pros of using DCF approach?

1. Only applicable to companies currently paying dividends

2. Not applicable if dividends are not growing at a constant rate

3. Extremely sensitive to the estimated growth rate

4. Does not consider risk

What are some cons of using the DCF approach?

The Bond-Yield-Plus-Premium Approach

A method used to estimate the cost of equity by adding a risk premium to the yield of a firm’s long-term debt

rs= rd + risk premium

1. It can be used if the firm has no publicly traded stock

2. Easy to calculate

What are some pros of the Bond-Yield-Plus-Premium Approach ?

1. Very subjective

2. The Bond risk premium is just an estimate

3. It is subject to significant errorWh

What are some cons of the Bond-Yield-Plus-Premium Approach?

1. It shows the required rate of return for the entire company

2. The financial health of firm

3. Capital Structure- what are we financing with?

4. Project analysis

5. It is the basis for determining how a firm can finance growth

Why is WACC important?

Flotation costs

The costs associated with the issuance of new financial assets. These include any fees paid to the investment dealer or any discounts provided to investors to entice them to purchase securities.

The cost of issuing new securities will be higher than the return required by investors

What is the result of flotation costs?

Capital Structure

The mix of debt and equity that is used to finance a firm’s asset

1. Ratios- total debt ratio, debt/equity, debt/invested capital

2. Market value vs. book value

3. WACC

4. Industry Comparisons

What do we use to measure capital structure?

Business risk

Potential threats or uncertainties a company faces that could impact its ability to achieve its financial goals and objectives

Inherent risk that includes sales and operating risk.

Sales Risk

Risk where sales volume or price will impact earnings

Operating risk

Risk use of fixed operating costs relative to total operating costs will be inappropriate

Taking the standard deviation of ROIC

How do we measure Uncertainty to earnings (sales/operating risk)?

ROIC= EBIT(1-T) / Total invested capital

ROIC Formula

1. Competition

2. Uncertainty about demand (affects sales)

3. Uncertainty about output prices

4. Uncertainty about costs

5. Product obsolescence

6. Foreign risk exposure

7. Regulatory risk and legal exposure

8. Operating leverage

Drivers of business risk

Degree of operating leverage (DOL)

The relationship between operating earnings and fixed costs

Formula: DOL= Q(P-V) / Q(P-V) -F

Contribution margin

Difference between the sales price and variable operating costs

P-V

Break-Even Point

The units produced and sold at which the operating profit is zero

QB-E = FC / (P – V)

Sales risk

Volume based pricing introduces variability in the profit margin, creating _____________

Financial Risk

Risk to shareholders over and above firm’s business risk, resulting from the use of financial leverage

Higher cost of debt

Higher debt leads to ___________

Solvency

A company’s ability to meet its long-term financial obligations and sustain operations over time.

Can we pay off our debts as they are due?

Degree of Financial Leverage (DFL)

Measures the sensitivity of earnings to a change in cash flows

Formula: DFL= [Q(P-V)] - F / [Q(P-V]-F-1

• When we increase the amount of debt financing, we increase the fixed interest expense

• If we have a really good year, then we pay our fixed cost and have more left over to our stockholders

• If we have a really bad year, we still have to pay our fixed costs and have less left over for our stockholders

What are some effects of Financial Leverage?

Leverage

____________ amplifies the variation in both EPS and ROE. A small change in leverage generates a large change in profits.

Financial Break-Even Point

Return on investment or quantity produced/sold at which a company’s ROE is zero

Formula: Qfbe= F+I / (P-V)

Indifference point

The quantity produced and sold or return on investment at which two financing strategies provide the same return on equity.

Degree of Total Leverage

Captures the leveraging effects of both the operating risk and the financial risk, using the sum total of the fixed operating costs and the fixed financing costs as the fulcrum

DTL= DOL * DFL

or [Q(P-V)] / [Q(P-V)] -F - I

1. Managing risk by predicting extreme events

2. Using the past to manage risk

3. Not considering advice intended to instruct what not to do

4. Measuring risk by standard deviation

5. Not factoring in human error

6. Seeking optimization, without considering vulnerability

Common risk management mistakes

• The firm’s risk increases

• Cost of debt increases

• WACC increases

  These altogether lead to the eventual increase in cost of equity (rs)

How does increase in debt affect the cost of equity?

The Hamada Equation

This equation attempts to quantify the increased cost of equity due to financial leverage using the firm’s unlevered beta

Formula: bL = bU[1 + (1 – T)(D/E)]

Unlevered Beta Coefficient

The firm’s business risk as if it had no debt

1. Minimize WACC

2. Maximize Stock price

   Note: These yield the same results

How to determine the firm’s optimal capital structure?

1. Sales stability

2. High operating leverage

3. Debt ratio and debt/equity ratio

4. The corporate tax rate

5. Bankruptcy costs

6. Financial flexibility

7. Firm’s Growth Rate

Factors affecting the target capital structure:

Static Theory

The point where tax benefits from debt maximize value while minimizing WACC

• Just shy of feeling the effects of financial distress

Bankruptcy

A legal status of a company that permits the company to deal with debt problems

1. The company commits an act of default, so creditors enforce their legal rights

   -Ex: Not paying interest

2. The company voluntarily declares bankruptcy

How does bankruptcy occur?

Financial distress

Significant problems in meeting debt obligations

• Does not mean bankruptcy

1. Legal and administrative costs

2. Causing bondholders to incur losses

3. Disincentive to debt financing

What are some direct costs of bankruptcy?

• Larger than direct costs, but more difficult to measure and
  estimate

• Stockholders want to avoid a formal bankruptcy filing

• Bondholders want to keep existing assets intact so they can
  at least receive that money

• Assets lose value as management spends time worrying
  about avoiding bankruptcy instead of running the business

• The firm may also lose sales, experience interrupted
  operations and lose valuable employees
  

What are some indirect bankruptcy costs?

Modigliani-Miller Irrelevance Theory

Also known as trade off theory, states that in a perfect market the value of a firm is unaffected by its capital structure and that the cost of equity increases linearly with the fir’s debt/equity ratio.

Signaling Theory

Explains how individuals/organizations convey credible information about themselves to others. One party may have better information than the other (asymmetric information)

Financial Slack

The excess resources a company has beyond what is needed for its immediate operational requirements

Pecking order Theory

Theory that states that companies prioritize their sources of financing based on the principle of least effort or cost

• This theory includes a hierarchy of how companies choose to finance investments

1. Debt is used more frequently than equity

   • Benefits: Tax deductible interest, financial leverage, increased EPS and ROE for shareholders

   • Detriments: you have to pay it back, can lead to distress, cash flows must cover payments

Capital Structure In Practice:

Financial Leverage Ratios

1. Debt ratio: Debt/Total assets

2. Debt-equity ratio: debt/equity

3. Equity Multiplier: Total assets/equity

4. TIE: EBIT/Interest

5. Cash flow to debt ratio: Cash flow from operations/debt

Altman’s Z-Score

a financial model used to predict the likelihood of a company going bankrupt

Formula: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

where

• x1 is working capital divided by assets

• x2 is retained earnings divided by assets

• x3 is EBIT divided by assets

• X4 is market values of equity divided by nonequity book liabilities

• X5 is sales divided by assets

Zones of Discrimination:

Z> 2.99 is safe

1.81< Z < 2.99 is gray

Z<1.81 is distress, soon to be bankrupt

Capital Expenditure

A firm’s investment in long-lived assets (tangible or intangible)

Capital Budgeting

Long term investment decisions; what projects do we want to put our money towards?

1. Identify alternatives

2. Evaluate alternatives

3. Implement decisions

4. Monitor and evaluate implemented decisions

The capital budgeting process:

1. Maintenance or obsolescence

2. Expanding a current product/service

3. New product/services

4. Cost reduction

What is capital budgeting used for?

To increase firm value

What is the primary role of financial manger?

Comparative Advantage

The ability of a company to produce a product at a lower cost than its competitors

Competitive advantage

Any strategy or company action that reduces the competition that the company experiences

Bottom up analysis

The idea that a company is simply a set or portfolio of capital investment decisions

Top-Down analysis

Focuses on the strategic decisions about which industries or products the company should be involved in

1. Percent of Sales Technique

2. Delphi Method

3. Casual Models

4. Regression and Time Series

Forecasting models

Projected (Pro Forma) Financial Statements

Projection into the future using defined assumptions

Horizon

Projecting the asset requirements for the planning period

Operations

Projecting the funds that will be generated under normal conditions

Additional Funds needed to support operations

Calculated by subtracting the projected liabilities and equity from the required assets

1. Forecast the income statement

2. Forecast the Balance sheet

3. Raise additional funds needed

Process of Pro-Forma Statements

Income statement assumptions

• Sales forecasted to grow 10% for next year

• Costs vary directly with sales (constant PM)

• Depreciation and interest may not vary directly with sales (nonconstant PM)

• Dividends are a management decision and do not vary with sales