BUSFIN 4211: 5.1 and 5.2 PP

5.1 PP

0

Capital Structure

• the mix of financing that a firm uses to fund its operations

• How optimal it is depends on the benefits and costs of using debt (leverage) versus equity financing.

Modiglani Miller MM Proposition I:

• All else equal, value of levered (𝑉𝐿) (Equity and Debt) and unlevered (𝑉𝑈) (Equity) firm is the same

• MM relies on strong assumptions

• The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus

a premium that is proportional to the debt-equity ratio (measured using market values)

Prop 1 MORE

• In a perfect capital market, the total value of a firm is equal to the market

value of the free cash flows generated by the firm’s assets and is not affected by its choice of

capital structure:

• Under some assumptions, the total value of the firm is the same with or without leverage

• Therefore, the firm should be indifferent about its capital structure choice

MM Proposition II:

Increasing leverage increases the riskiness of existing equity

A firm’s cost of equity increases with its debt-equity ratio (leverage)

MM relies on strong assumptions

The weighted average cost of capital (WACC) is

unaffected by the amount of leverage

Order

• Debt is a senior claimant

• Equity-holders get the rest

debt is

“cheaper” than equity.

The fraction of debt vs equity on a firm’s liability side (that is, how the pie is split)

• does not affect the firm’s value (that is, the size of the pie)

• the stocks, bonds, warrants, etc., issued don’t affect the

  aggregate value of the firm. They just slice up the underlying earnings in different ways

Pie Split, Size of Pie: This is true if financial markets are perfect. The assumptions are:

• Securities are fairly priced

• No tax consequences or transactions costs

• Investment cash flows are independent of financing choices

“unlevered equity”

there is no leverage, i.e., no debt

“levered equity”

the firm will have outstanding debt

Levered equity returns are

more volatile than unlevered returns: Expected return on equity is higher with leverage because the risk is higher

Returns are

“split” between risk-free debt and high-risk levered equity

Leverage increases

equity risk even when there is no risk that the firm will default

The total cash flow of the firm (and its risk) is the

same regardless of the financing decision MM Prop 1

• Thus, it seems intuitive that the total firm value (discounted CF) should be the same

in the real world, firms are

not indifferent about its capital structure choices

• MM is not a literal statement about the real world. It leaves important things out. It is a benchmark for how to think about capital structure, which gets you to ask the right question:

MM’s most basic message:

• Value is created only by operating assets, i.e., on the left-hand side of the balance sheets

• A firm’s financial policy should be a means to support the operating policy, not an end in itself

5.2 PP

0

the value of a firm is equal to

the value of its debt plus its equity (These two are liabilities)

Steps: How do we value a firm?

• Find the set of cashflows (CF) that we want to value: See capital budgeting lectures?

• Discount the cashflows back using the cost of capital to the cash flow recipient?

• This is how we account for the risk and opportunity cost

“weighted average cost of capital”

a firm’s overall cost of capital should be a blend of the costs of its different

sources of capital.

How do we calculate the blend/weights of different sources of capital (debt vs. equity)?

• Use the market value of outstanding securities to determine weights

• Be careful – don’t use book values from the balance sheet!

Market Value of Equity =

Price per Share x # Shares Outstanding

Market Value of Debt

can be approximated with the Book Value of Debt. It’s OK to use Book

Value of Debt because Market Value is often unavailable, due to lack of debt pricing data

Book Value: the value of a company’s assets after deducting its liabilities. INVESTOPEDIA

Unlevered Firm: We can estimate equity cost of capital with the

CAPM

Levered Firm: Expected return on portfolio containing

firm’s equity and debt

In perfect capital markets, firm value and cash flows, and therefore the overall (or

weighted average) cost of capital, are

unaffected by the amount of leverage

Cost of Debt

• Observed by looking at the yield to maturity of publicly traded outstanding debt. NOT the coupon rate!

• If no public debt, then one can look at competitors with similar credit ratings (E.g., Moody’s or S&P bond ratings)

Cost of Equity

• When possible, computed from CAPM

  • Can also be computed from a dividend growth model, which requires some assumptions

In perfect markets, the firm’s weighted average cost of capital is

unaffected by leverage

Suppose you want to calculate a firm’s equity cost of capital using information on the equity beta of another firm in the same industry. Even if the underlying assets of the two firms are exactly the same, if they have different capital structures, then

their equity betas will be different!

The risk of equity (which the equity beta measures)

increases with leverage

Under the assumption of constant leverage underlying the WACC formula, and risk-free debt, we can calculate the firm’s unlevered asset beta by

“unlevering” the equity beta:

Perfect Markets: rwacc is constant because

leverage does not

affect business risk

Perfect Markets: rD is constant

(Except for very high leverage,

when debt becomes risky due to credit risk)

Perfect Markets: rE increases

with leverage (MM2)

When calculating weights, it is standard to use Net Debt instead of Gross Debt

• Net Debt = Debt – Cash and Equivalents

• Cash can be thought of as “negative debt.” Some firms hold a lot of cash

• Weights are then Equity/EV and Net Debt/EV, where EV = Equity + Debt – Cash

Measurement of Risk Free Rate

• CAPM says we should use risk-free rate corresponding to investors’ horizon

• Most financial analysts use long-term Treasury yields (10 to 30 year maturity)

Measurement of Market Risk Premium

• Market risk premium is historically between 5% and 7%, but has been declining

• Average risk premium over 10-year Treasuries has been about 3.8% since 1962

What do we use WACC for?

• Firm valuation (is a given firm overvalued or undervalued?)

• Much of investment banking is valuation

• Project evaluation (is this positive or negative NPV?)

• Capital budgeting — “should I take this project?”

• Performance targets (what level of sales do I need to make my cost of capital?)

• Useful for operations, managerial budgeting, control, and accounting

While WACC is most useful for Discounted Cash Flow analysis, under some assumptions it might also be

used for

capital budgeting, to value individual projects of a firm in which case:

Using WACC to discount project cash flows incorporates

benefits of the financing decision (i.e.,how much debt the project takes on) in addition to project cash flows

𝑟𝑤𝑎𝑐𝑐 is

average return firm must pay to investors on after-tax basis

WACC to Value Projects Assumptions

• Average Risk

• Constant Debt to Equity Ratio

• Limited Leverage Effects

Average Risk

• When using WACC to discount cash flows for a specific project of a firm, the implicit assumption is that the cash flows

of the project have the same average risk as the overall firm

• Example: If DuPont starts an athletic shoe division, the WACC of DuPont is not the right discount rate because

DuPont is a chemical company. The WACC of Nike would be more appropriate

• For firms with multiple business lines, “divisional cost of capital” should be used to evaluate projects

Constant Debt to Equity Ratio

• We assume that the firm adjusts its leverage to maintain a constant debt-equity ratio

• Otherwise WACC changes due to the tax benefit of debt

• This places an implicit restriction on the financing of the project

Limited Leverage Effects

• We assume the interest tax deduction is the only effect of debt on the value of the firm

Use the WACC as the cost of capital to compute

enterprise value of a firm

• Also requires estimates of free cash flows, terminal value, growth rates, etc

Given market values of debt and equity, one can determine the

minimum amount of sales

necessary for a firm to cover its cost of capital

• These can be used to set performance targets for managers