corporate finance review for third quiz - nyu

CORPORATEFINANCEREVIEWFORTHIRDQUIZ

AswathDamodaran

2

BasicSkillsNeeded

¨ Whatisthetradeoffinvolvedinthecapitalstructurechoice?

¨ Canyouestimatetheoptimaldebtratioforafirmusingthecostofcapitalapproach,andcanyouestimatetheeffectonfirmvalueofmovingtotheoptimal?

¨ Basedonthefirm’sfinancialfundamentals,canyoudeterminehowtheyshouldmovetotheiroptimal?

¨ Canyouusethemacroeconomicregressiontoevaluatewhatkindoffinancingyoushouldbeusingasafirm?

3

Debt:TheTradeOff

Advantages of Borrowing Disadvantages 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

4

QualitativeAnalysis:Asimpleexample

¨ Assumethatlegislatorsareconsideringataxreformplanthatwillallowcompaniestodeductdividendsfortaxpurposes?Whateffectwillthishaveonoptimaldebtratios?Why?

¨ Alternatively,assumethatlegislatorsaretalkingaboutputtingacapontheinterestexpensetaxdeduction(i.e.,itcannotexceed50%ofoperatingincome).Whateffectwillthishaveontheoptimaldebtratio?Why?

5

TheCostofCapital:Definition

¨ CostofCapital=ke(E/(D+E))+After-taxkd(D/(D+E))

Weighted average of costs of financing

Riskfree Rate + Beta

(Risk Premium)Beta: is the levered beta based on D/E

ratio

Today’s long term Borrowing rate (1-tax

rate)Borrowing rate = Riskfree

rate + Default spreadDefault spread: based on

rating (actual or synethetic)

Market Value Weight of Equity

Market Value Weight of Debt

6

ComputingMarketValues

¨ Themarketvalueofequityisusuallyfairlysimpletocompute,atleastforapubliclytradedfirm.

¨ Themarketvalueofdebtcanusuallybecomputedbytakingthepresentvalueoftheexpectedpaymentsonthedebtanddiscountingbacktothepresentatthecurrentborrowingrate.

7

ComputingCostofCapital:Example

¨ Youhavebeenasked toassessthecostofcapitalandreturnoncapitalforCVXCorporation. Thefollowing information isprovidedtoyou:¤ Thefirmhas15millionsharesoutstanding,tradingat$10pershare.The

bookvalueofequityis$50million.¤ Thefirmhas$50millionbondofferingoutstanding,withacouponrateof

7%,tradingatpar.Inaddition,thefirmhasanoldbankloanonitsbooks,with5yearslefttomaturity,an8%statedinterestrate,andafacevalueof$50million.

¤ Thefirmalsohadoperatingleaseexpensesof$10millionforthecurrentyear,andhascommitmentstomakethesesameleasepaymentsforthenext7years.

¤ Thefirm’scurrentbetais1.20,thetreasurybondrateis6%andthemarketriskpremiumis5.5%

¤ Thefirmalsoreportedearningsbeforeinterestandtaxesof$40million(afteroperatingleaseexpenses),andhasamarginaltaxrateof40%.

8

EstimatingMarketValueofDebt

¨ Step1:Getacurrentlongtermborrowingrate.Therearetworatesprovidedintheproblem– thecouponrateonthebond(7%)andtheinterestrateonthebankloan(8%).Theyarebothhistoricalratesandcannotbeusedgenerallyascostsofdebt.However,thebondtradesatpar,indicatingthatthecouponrateonthebond=currentmarketinterestrateonthebond=currentcostofdebt

¨ Step2:Computemarketvalueofdebt¤ 5-yearbankloan;Facevalue=$50million;Interestexpense =$4

million(8%)¤ ValueofBankLoan=4(PVA,7%,5)+50/(1.07)5 = $52.05¤ ValueofBondsOutstanding (tradingatpar)= $50.00¤ PVofOperatingLeases=10(PVA,7%,7) = $53.89¤ MarketValueofOutstandingDebt= $155.94

9

EstimatingCostofCapital

¨ Step1:Getthemarketvalueweights¤ MarketValueofEquity=15*10= $150.00¤ DebtRatio=155.94/(150+155.94)= 50.97%

¨ Step2:Computethecostofcapital¤ CostofEquity=6%+1.2(5.5%)= 12.60%¤ CostofCapital=12.60%(.49)+7%(1-.4)(.51)=8.32%

10

EstimatingReturnonCapital

¨ UnadjustedReturnoncapital=40(1-.4)/(50+50+50)=16%¤ BVofequity=50 BVofdebt=100(Bankloan+Bond)

¨ Sinceoperating leases aredebt,youhavetoadjusttheoperatingincome toreflectimputed interestexpensesontheleasedebt.¤ AdjustedEBIT=40+53.89*.07= $43.77¤ AdjustedBVofCapital=50+(50+50+53.89)= 203.89¤ AdjustedReturnonCapital=43.77(1-.4)/203.89=12.88%

¨ TheLongWay¤ AdjustedEBIT=EBIT+OperatingLeaseExp - DepreciationonLeasedAsset

=40+10- 53.89/7=$42.30¨ TheShortCut

¤ AdjustedEBIT=EBIT+ImputedInterestexpenseonLeaseDebt=40+53.89*.07=$43.77

11

OptimalFinancingMixandCostofCapital

¨ Thevalueofafirmisthepresentvalueoftheexpectedcashflowstothefirmdiscountedbackatthecostofcapital.

¨ Whentheoperatingincomeisunaffectedbychangesindefaultrisk(ratings),thevalueofthefirmwillbemaximizedwherecostofcapitalisminimized.Thisistheoptimaldebtratio.

¨ Inthemoregeneralcase,wherebothcashflowsandthecostofcapitalchangeasthefinancingmixchanges,theoptimaldebtratioiswherethefirmvalueismaximized.

12

ComputingCostofCapitalasDebtRatiosChange

¨ CostofEquity¤ Estimate theunlevered betaforthefirm¤ Estimate thebetaateachdebtratio.Asdebtratioschange, thedebt to

equityratiowillalsochange,leadingtoahigherbeta.¤ D/E=DebtRatio/(1 - DebtRatio)¤ Use theleveredbetatoestimate thecostofequityateachdebtratio.

¨ CostofDebt¤ Estimate thetotalvalueofthefirm(ValueofEquity+ValueofDebt)¤ Estimate thedollardebtateachdebtratio¤ Estimate theinterestexpenses ateachdebtratio:Debt*Interest rate¤ Estimate theinterestcoverage ratio¤ Estimate theratingandinterest rate¤ Checktomakesurethatyouhaveconsistency.Ifnot,loopback.

13

EstimatingCostofCapital;Example

DebtRatio 10% 20% ExtraColumn$Debt $1,500 $3,000EBIT $1,000 $1,000InterestExpenses $120 $240 $270InterestCoverageRatio8.33 4.17 3.70BondRating AA BBB BBBInterestRate 8.00% 9.00% 9.00%After-taxCostofDebt 4.80% 5.40%Beta 1.06 1.14CostofEquity 12.83% 13.29%CostofCapital 12.03% 11.71%

14

CoverageRatiosandSpreads

CoverageRatio Rating SpreadoverTreasury>10 AAA 0.30%7-10 AA 1.00%5- 7 A 1.50%3- 5 BBB 2.00%2- 3 BB 2.50%1.25- 2 B 3.00%0.75- 1.25 CCC 5.00%0.50- 0.75 CC 6.50%0.25- 0.50 C 8.00%<0.25 D 10.00%

15

ThePayoffinTermsofFirmValue

¨ When thecostofcapitalchanges,thevalueofthefirmwillalsochange.Thesimplestwaytocompute thechangeistodothefollowing:

¨ 1.Estimatetheannualchangeinfinancingcostsfrommoving fromonecostofcapitaltoanother.¤ ChangeinFinancingCost=(WACCb - WACCa)Current FirmValue¤ Firmvalue=Marketvalueofequity+MarketvalueofDebt

¨ 2.Estimatethepresentvalueofthesavingsinfinancing costs,bya.assumingaperpetuity withnogrowth

ChangeinFirmValue=AnnualChange/WACCab.assumingagrowingperpetuity

ChangeinFirmValue=AnnualChange/(WACCa - g)[gcanbeestimatedfromcurrentmarketvaluebutshouldbe<growthrateineconomy]

16

ComputingPerShareValues&MaximumOfferprices

¨ Ifweassumerationality,whereallinvestorsincludingthosewhosellbacktheirshares tothefirmgetanequalshareofthevalueincrease:¤ ValueIncreaseperShare=TotalIncrease/NumberofShares¤ BuybackPrice=CurrentPrice+ValueIncrease

¨ Ifweassumethatwecanbuybackstockatthecurrentprice,thevalueincrease totheremainingstockholderswillbeevengreater:¤ ValueIncreaseperShare=TotalIncrease/(NumberofShares- Sharesboughtback)¤ Sharesbought back=NewDebttakenon/Currentstockprice

¨ Inthemostgeneralcase,where thesharesareboughtbackat$Px,thedivisionwillbeasfollows($Pistheoriginalprice):¤ SellingShareholders =(PX-P)*Numberofsharesbought back¤ Holding Shareholders =ValueIncrease- (Px-P)*Numberofsharesbought back

¨ Ifwecanlockincurrentdebtatexistingrates,whilemovingtohigherleverageandgreaterdefaultrisk,theincrease invaluewillbeevengreater.

17

ComputingChangeinFirmValue:Example

¨ CSLCorporationisamid-sizedtransportationfirmwith10millionsharesoutstanding,tradingat$25pershareanddebtoutstandingof$50million.¤ Itisestimatedthatthecostofcapital,whichiscurrently11%,willdropto10%,ifthefirmborrows$100millionandbuysbackstock.

¤ Estimatetheexpectedchangeinthestockpriceiftheexpectedgrowthrateinoperatingearningsovertimeis5%.

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Ifinvestorsarerational:ComputingChangeinFirmValueandshareprice

¨ Hereisthefirstwaytodothis¤ Savingseachyear=(250+50)(.11- .10)=3¤ ChangeinFirmValue=3/(.10-.05)=60¤ Changeinstockprice=60/10=$6.00¤ Newstockprice=25+6.00=31.00

¨ Hereisanotherwayofshowingwhathappens:¤ Valueoffirmbeforechangeincapitalstructure=250+50= 300¤ Valueoffirmafterchangeincapitalstructure=300+60= 360¤ Debtoutstandingafterrecapitalization=50+100= 150¤ Valueofequityafter recapitalization= 210¤ Numberofsharesafter recap=10– 100/31.00= 6.774¤ Valuepershare= 210/6.774= $31.00

19

Buybackatthecurrentprice?

¨ Whatwouldthechangeinstockpricebe,ifyouwereabletobuybackstockatthecurrentprice?¤ Numberofsharesboughtback=$100mil/$25=4millionshares¤ Changeinstockprice=60/(10- 4)=$10¤ Newstockprice=$25+$10=35.00

¨ Hereisanotherwayofshowingwhathappens:¤ Valueoffirmbeforechangeincapitalstructure=250+50= 300¤ Valueoffirmafterchangeincapitalstructure=300+60= 360¤ Debtoutstandingafterrecapitalization=50+100= 150¤ Valueofequityafter recapitalization= 210¤ Numberofsharesafter recap= 10– 100/25=

6¤ Valuepershare= 210/6= $35.00

20

Buybackattoohighaprice…

¨ Whatiftheyhadpaid$33.33pershare?¤ Numberofsharesboughtback=$100/$33.33=3millionshares¤ Sellingshareholdersgain=3millionshares*(33.33-25) =$25million¤ Changeinstockprice=(60- 25)/7=35/7=$5.00¤ Newstockprice=$25+$5=$30.00

¨ Hereisanotherwayofshowingwhathappens:¤ Valueoffirmbeforechangeincapitalstructure=250+50= 300¤ Valueoffirmafterchangeincapitalstructure=300+60= 360¤ Debtoutstandingafterrecapitalization=50+100= 150¤ Valueofequityafterrecapitalization= 210¤ Numberofsharesafterrecap=10– 100/33.33= 7million¤ Valuepershare= 210/7 $30.00

21

Lookingatthepremium

¨ Premiumpaidtobuybackstockholders=Numberofsharesboughtback*(Priceonbuyback– Pricepriortorecap)=3*(33.33– 25)=$25million

¨ Premiumleftfornon-tenderingstockholders=Remainingshares*(Priceafterrecap– Pricepriortorecap)=7*(30-25)=$35million

¨ Totalvalueaddedbyrecap=$25million+$35million=$60million

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GettingtotheOptimal

Conditionofthefirm Actiontotake

Underlevered,Targetoftakeover Borrowmoney,buybackstocknow

Underlevered,Nottargetofatakeover,Goodprojects

Borrowmoney,Takeprojects(nowandovertime)

Underlevered,Nottargetofatakeover,Badprojects

Borrowmoney,Buybackstock&paydividends overtime

Overlevered,threatofbankruptcyhigh Issueequitytoretiredebtorequityfordebtswap,Restructure debt

Overlevered,nonear-term threatofbankruptcy,Goodprojects

Useretainedearnings(equity)totakeprojectsovertime

Overlevered,nonear-term threatofbankruptcy,Badprojects

Useretainedearnings(equity)toretiredebtovertime

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TheRightFinancingTypeMacroRegression ImplicationsforDebtDesign

Δ V=a+b(Δ Interestrate) Ifbisnegative:Measures asset durationIfbis0orpositive: Suggestsshortduration(Setdebt duration=asset duration)

Δ V=a+b(Δ GDP) Ifbispositive, firm iscyclicalIfbiszero,firmisnon-cyclicalIfbisnegative, firmiscountercyclical(Becautious inmovingtooptimal)

Δ OI=a+b(Δ Inflationrate)Δ V=a+b(Δ Inflationrate)

Ifbispositive, firm haspricingpowerIfbiszero,firmhasnopricingpowerIfbisnegative, firmhasnopricingpower&hascoststhatarepronetoinflation(Ifpricingpower,usefloatingratedebt)

Δ OI=a+b(ΔWeightedDollar)Δ V=a+b(ΔWeighted Dollar)

Ifbispositive, firm gainsfromstronger$Ifbisnegative, firmlosesfromstronger$(Witheither, youneedforeigncurrencydebt)

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Abalancesheetviewofduration…

Assets LiabilitiesBusiness/ Asset 1 V1 D1Business/ Asset 2 V2 D2Business/ Asset 3 V3 D3

Duration of the firm = Weighted average of the durations of the individual businesses or assets (Weights are value weights)[V1D1+ V2D2 + V3D3]/(V1+ V2+ V3)

Debt 1 B1 D1Debt 2 B2 D2Equity

Duration of the debt is the weighted average of the durations of the individual debt issues (weights are based on amount)[B1D1+ B2D2] /(B1+ B2)

Objective: Duration of the debt = Duration of the assets

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ExampleofDurationUsage

¨ Youhaverunaregression ofchangesinfirmvalueagainstchanges inlongtermbondratesandarrived atthefollowingregression:

ChangeinFirmValue=0.16- 5.00ChangeinLongTermBondRate¨ Thefirmhas$100millioninzero-coupon two-yearnotesoutstanding,

andplanstoborrowanother$150millionusingzero-couponsecurities. Ifyourobjective istomatchthedurationofthefinancingtothoseoftheassets, whatshouldthematurityofthesezero-couponnotesbe?

Step1:Estimate thedurationofyourassetsRegression coefficient=Duration=5years

Step2:Setthedurationofyourdebtequal tothedurationofyourassets(100/250) (2)+(150/250) (X)=5SolveforX, X=7years

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Bottom-upDuration:Amorecomplicatedexample

¨ YouhaverunaregressionoffirmvaluechangesagainstinterestratechangesforSteelProductsInc,anofficesuppliesmanufacturer.¤ ChangeinFirmValue=0.06– 7.5(Change inInterestRates)

¨ Thefirmhastwotypesofdebtoutstanding– aone-year$200millionbondissue(withadurationof1year),andafive-year$100millionbankloan(withadurationof4years),and70millionsharesoutstandingat$10pershare.Itisplanninga$250millionbondissuetofinanceexpansionintotheinternetretailingbusiness.Ifthedurationofassetsoffirmsinthissectorisonly1year,whatshouldthedurationofthebondissuebe?

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TheSolution

¨ Step1:Computethedurationofthefirmafterexpansion¤ Valueoffirmbeforeexpansion=300+70*10=1000¤ Durationofassetsafterexpansion=7.5(1000/1250)+1(250/1250)=6.2¤ WeightedDurationofAssetshastobeequal to6.2years

¨ Step2:Solveforthedurationofyournewdebt¤ (200/550)(1)+(100/550)(4)+(250/550)(X)=6.2

¤ SolveforXX=11.24years