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Prof. Ian GiddyNew York University
Capital Structure Planning
SIM/NYUThe Job of the CFO
Copyright ©2001 Ian H. Giddy Capital Structure 3giddy.org
Why Financial Restructuring?
The Asian Bet The Solution, Part I: Recapitalization The Solution, Part II: Financial
Restructuring The Solution, Part III: Corporate
Restructuring
Copyright ©2001 Ian H. Giddy Capital Structure 4giddy.org
The Asian Bet
High growth disguised speculative financing structures
Governments shielded companies and banks from capital market discipline
Too much debt Too much foreign-currency debt Closely held ownership relying on
reinvested earnings
Copyright ©2001 Ian H. Giddy Capital Structure 5giddy.org
The Asian Bet
High growth disguised speculative financing structures
Governments shielded companies and banks from capital market discipline
Too much debt Too much foreign-currency debt Closely held ownership relying on
reinvested earnings
The three excesses Too much debt Too much labor Too much capacity
The three excesses Too much debt Too much labor Too much capacity
Example: Hyundai G
roup
Copyright ©2001 Ian H. Giddy Capital Structure 6giddy.org
How the Bet was Lost
Vulnerable economies, newly liberalized, succumbed to currency crises
Economic downturns followed Companies were unable to service even
domestic debt, never mind foreign currency debt
Still unreformed, many Asian companies remain misfinanced
Example: Hyundai G
roup
Copyright ©2001 Ian H. Giddy Capital Structure 7giddy.org
What is Corporate Restructuring?
Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.
Designed to increase the value of the firm Restructuring
Improve
capitalization
Change ownership
and control
Improve
debt composition
Copyright ©2001 Ian H. Giddy Capital Structure 8giddy.org
It’s All About Value
How can corporate and financial restructuring create value?
Operating
Cash
Flows
Debt
Equity
Assets Liabilities
Fix the business
Or fix the financing
Copyright ©2001 Ian H. Giddy Capital Structure 9giddy.org
Restructuring
Figure out what the business is worth now
Use valuation model – present value of free cash flows
Fix the business mix – divestitures Value 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 equity What 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 control Value the changes new control would produce
Copyright ©2001 Ian H. Giddy Capital Structure 10giddy.org
Getting the Financing RightStep 1: The Proportion of Equity & Debt
Debt
Equity
Achieve lowest weighted average cost of capital
May also affect the business side
Copyright ©2001 Ian H. Giddy Capital Structure 11giddy.org
Getting the Financing RightStep 2: The Kind of Equity & Debt
Debt
Equity
Short term? Long term? Baht? Dollar? Yen?
Short term? Long term? Baht? Dollar? Yen?
Bonds? Asset-backed? Convertibles? Hybrids?
Bonds? Asset-backed? Convertibles? Hybrids?
Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?
Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs?
Ownership & control? Ownership & control?
Copyright ©2001 Ian H. Giddy Capital Structure 12giddy.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
Copyright ©2001 Ian H. Giddy Capital Structure 13giddy.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?
Copyright ©2001 Ian H. Giddy Capital Structure 14giddy.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?
Copyright ©2001 Ian H. Giddy Capital Structure 15giddy.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
Copyright ©2001 Ian H. Giddy Capital Structure 16giddy.org
Managing the capital base
Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000
Flexibility to redeem non-voting shares and buy back ordinary shares
Flexibility to dispose remaining non-core assets
Utilizing excess capital for organic growth and acquisitions
Copyright ©2001 Ian H. Giddy Capital Structure 17giddy.org
Changing Financial Mix
Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt.
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 debt.
Copyright ©2001 Ian H. Giddy Capital Structure 18giddy.org
Debt: Pros and Cons
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
Copyright ©2001 Ian H. Giddy Capital Structure 19giddy.org
See Saw
Business Uncertainty
Financial Risk
Operating Leverage
Financial Leverage
Copyright ©2001 Ian H. Giddy Capital Structure 20giddy.org
Young and Old
Operating Leverage
Financial Leverage
Operating Leverage
Financial LeverageSize
Maturity
Copyright ©2001 Ian H. Giddy Capital Structure 21giddy.org
Disney
Weighted Average Cost of Capital and Debt Ratios
Debt Ratio
WA
CC
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%
Copyright ©2001 Ian H. Giddy Capital Structure 22giddy.org
Siderar: Steel Company in Argentina
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
0
200
400
600
800
1000
1200
0% 20% 40% 60% 80% 100%
Debt Percentage
Va
lue
($
mil
lio
ns
)
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
0% 20% 40% 60% 80% 100%
Debt Percentage
Co
st
of
Ca
pit
al
Copyright ©2001 Ian H. Giddy Capital Structure 23giddy.org
Capital Structure: East vs West
VALUE OFTHE
FIRM
DEBT
RATIO
Optimal debt ratio?
Intel TPI
Copyright ©2001 Ian H. Giddy Capital Structure 24giddy.org
Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas
Copyright ©2001 Ian H. Giddy Capital Structure 25giddy.org
Perceived Benefits to Sammi From Acquisition of Atlas Steel
Achieve $280mm savings by acquiring Atlas Steel and related companiesCost of setting up own production facility
would have been $500 mmSavings were channeled into restructuring
production facilities at existing plants Sammi’s share price rose 9% on news
of strategic acquisitions
Copyright ©2001 Ian H. Giddy Capital Structure 26giddy.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)
Copyright ©2001 Ian H. Giddy Capital Structure 27giddy.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
Copyright ©2001 Ian H. Giddy Capital Structure 28giddy.org
Problems faced by Sammi from the Acquisition
Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages
Future refinancing of debt caused earnings after interest costs to fall 17%
Purchase price of $210.6 mm found to have been excessive
The acquisition was ill-timed Existing and new plants suffered from low
capacity utilization of around 65%
Copyright ©2001 Ian H. Giddy Capital Structure 29giddy.org
Sammi Steel in 1995
Sammi Atlas pushed to raise productivity by 15% A leaner organization: Work force had shrunk by
19.4% since 1988 4 year freezes on salaries to limit labor costs Unrelated and unprofitable businesses have
been sold off New export zones identified in China and South-
East Asia Conversion of debt into equity to reduce interest
costs by 6%; Result: dilution in EPS, unless offset by
increased volume of sales
Copyright ©2001 Ian H. Giddy Capital Structure 30giddy.org
Analysis of Change in Value of Sammi Steel
( Billions of Korean Won) 1989 1994
Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027
( Billions of Korean Won) 1989 1994
Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027
Copyright ©2001 Ian H. Giddy Capital Structure 31giddy.org
March 1997
Sammi Steel is bankrupt!
ALTO
Copyright ©2001 Ian H. Giddy Capital Structure 32giddy.org
March 1997
Sammi Steel is bankrupt!
ALTODr F R
Structuring Diagnosis Prevention and Cure
Dr F R Structuring
Diagnosis Prevention and Cure
Copyright ©2001 Ian H. Giddy Capital Structure 33giddy.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
Copyright ©2001 Ian H. Giddy Capital Structure 34giddy.org
Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Case Study: “Intralinks”Case Study: “Intralinks”
Prof. Ian GiddyNew York University
Financing Growth Companies
Copyright ©2001 Ian H. Giddy Capital Structure 36giddy.org
Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©2001 Ian H. Giddy Capital Structure 37giddy.org
The CFO Questions
How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
How much (cheap) debt should we have? What kind of debt should we have? Maturity?
Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
How should we manage our financial risks?
Copyright ©2001 Ian H. Giddy Capital Structure 38giddy.org
Financing X Inc
Copyright ©2001 Ian H. Giddy Capital Structure 39giddy.org
Financing X Inc
Copyright ©2001 Ian H. Giddy Capital Structure 40giddy.org
Financing X Inc
Copyright ©2001 Ian H. Giddy Capital Structure 41giddy.org
Corporate Financing Life-Cycle
Growth companies Mature companies
Leverage
Copyright ©2001 Ian H. Giddy Capital Structure 42giddy.org
Firm Characteristics as Growth Changes
Variable High Growth Firms tend to Stable Growth Firms tend to
Risk be above-average risk be average risk
Dividend Payout pay little or no dividends pay high dividends
Net Cap Ex have high net cap ex have low net cap ex
Return on Capital earn high ROC (excess return) earn ROC closer to WACC
Leverage have little or no debt higher leverage
Earnings
Gearing
(Leverage)
0
Copyright ©2001 Ian H. Giddy Capital Structure 43giddy.org
Financing Growth Companies:The Agenda
Where can we get the initial equity financing we need to grow?
Do we want money, management, or more?
When do we want to sell out, and how? When is the right time for debt for a
growth company? What kind?
Copyright ©2001 Ian H. Giddy Capital Structure 44giddy.org
What Kind of Equity?
Sources of EquityPrivate investorsStrategic investorsInterventionist investorsPublic market
And KindsCommon stockStock with restricted voting rightsHybrids, including convertibles
Copyright ©2001 Ian H. Giddy Capital Structure 45giddy.org
.comfax (now Messageclick)
Started in September 1997, .comfax enables users to send faxes and receive faxes over the internet at a low cost.
By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day.
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.
What form of equity financing would be appropriate for .comfax?
Copyright ©2001 Ian H. Giddy Capital Structure 46giddy.org
Pre-IPO Equity Financing
Friends and family Angel Venture capital Strategic partners
Copyright ©2001 Ian H. Giddy Capital Structure 47giddy.org
Pre-IPO Equity Financing
Friends and family Angel Venture capital Strategic partners
asiajack.com
Copyright ©2001 Ian H. Giddy Capital Structure 48giddy.org
Private Equity Funds
Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring.
The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.
Copyright ©2001 Ian H. Giddy Capital Structure 49giddy.org
Silipos Inc
Copyright ©2001 Ian H. Giddy Capital Structure 50giddy.org
Silipos Inc, 1999
Where do you want
to go?
Debt?Debt?
Acquisition?Acquisition?
IPO?IPO?
Sell?Sell?
Copyright ©2001 Ian H. Giddy Capital Structure 51giddy.org
IntraLinks
Copyright ©2001 Ian H. Giddy Capital Structure 52giddy.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.
Copyright ©2001 Ian H. Giddy Capital Structure 53giddy.org
Why Venture Capitalists Prefer Preferred
Senior status in bankruptcy Does not put a value on the shares Is convertible into common stock before
the IPO Conversion price is set such that if there
is a liquidation all the money goes to the preferred shareholders (equity is worth zero)
Copyright ©2001 Ian H. Giddy Capital Structure 54giddy.org
Case Study: Photronics
Copyright ©2001 Ian H. Giddy Capital Structure 55giddy.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.
Copyright ©2001 Ian H. Giddy Capital Structure 56giddy.org
Case Study: Photronics
Sales, 1994-99
Balance Sheet, end-1999USD millionsAssets Liabilities & EquityCash 7.6 Current liabilities 50.2Other current assets 59.9 Long term liabilities 132.7Long term assets 319.6 Shareholder's equity 204.2Total 387.1 Total 387.1
Market capitalization 720 P/E 26xEBIT/Int cost 5.77
Book MarketD/E 0.90 0.25D/(D+E) 0.47 0.20
Copyright ©2001 Ian H. Giddy Capital Structure 57giddy.org
The Company’s Debt
Copyright ©2001 Ian H. Giddy Capital Structure 58giddy.org
Should Photronics Have More Debt?
Benefits of DebtTax BenefitsAdds discipline to management
Costs of DebtBankruptcy CostsAgency CostsLoss of Future Flexibility
Copyright ©2001 Ian H. Giddy Capital Structure 59giddy.org
The CFO Questions
How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
How much (cheap) debt should we have? What kind of debt should we have? Maturity?
Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
How should we manage our financial risks?
Copyright ©2001 Ian H. Giddy Capital Structure 60giddy.org
Some Useful Websites
giddy.org/jcfo.htm giddy.org giddyonline.com
shareinvestor.com dialpad.com onebox.com
Copyright ©2001 Ian H. Giddy Capital Structure 61giddy.org
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 capitalCost of equityCost of debtWeighted average (WACC)
Copyright ©2001 Ian H. Giddy Capital Structure 62giddy.org
A $1 Investment in Different Types of Portfolios: 1926-1996
0.1
1
10
100
1000
10000
1925 1935 1945 1955 1965 1975 1985 1995
Index ($)
$4,495.99
$33.73
$13.54$8.85
$1,370.95
Small Company Stocks
Large Company Stocks
Long-Term Government Bonds
Treasury BillsInflation Year-End
Copyright ©2001 Ian H. Giddy Capital Structure 66giddy.org
Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF
Expected GrowthReinvestment Rate* Return on Capital
FCFF1 FCFF2 FCFF3 FCFF4 FCFF5
Forever
Firm is in stable growth:Grows at constant rateforever
Terminal Value= FCFF n+1/(r-gn)
FCFFn.........
Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)
WeightsBased on Market Value
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity
Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows
+Beta- Measures market risk X
Risk Premium- Premium for averagerisk investment
Type of Business
Operating Leverage
FinancialLeverage
Base EquityPremium
Country RiskPremium
DISCOUNTED CASHFLOW VALUATION
Copyright ©2001 Ian H. Giddy Capital Structure 67giddy.org
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
Copyright ©2001 Ian H. Giddy Capital Structure 71giddy.org
Interest Coverage Ratios, Ratings and Default Spreads
If Interest Coverage Ratio is Estimated Bond Rating Default Spread
> 8.50 AAA 0.20%6.50 - 8.50 AA 0.50%5.50 - 6.50 A+ 0.80%4.25 - 5.50 A 1.00%3.00 - 4.25 A– 1.25%2.50 - 3.00 BBB 1.50%2.00 - 2.50 BB 2.00%1.75 - 2.00 B+ 2.50%1.50 - 1.75 B 3.25%1.25 - 1.50 B – 4.25%0.80 - 1.25 CCC 5.00%0.65 - 0.80 CC 6.00%0.20 - 0.65 C 7.50%< 0.20 D 10.00%
Copyright ©2001 Ian H. Giddy Capital Structure 72giddy.org
Other Factors Affecting RatiosMedians of Key Ratios : 1993-1995
AAA AA A BBB BB B CCCPretax Interest Coverage 13.50 9.67 5.76 3.94 2.14 1.51 0.96
EBITDA Interest Coverage 17.08 12.80 8.18 6.00 3.49 2.45 1.51Funds from Operations / Total Debt
(%) 98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%
Free Operating Cashflow/ TotalDebt (%) 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%
Pretax Return on Permanent Capital(%) 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%
Operating Income/Sales (%) 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%Long Term Debt/ Capital 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%
AAA AA A BBB BB B CCCPretax Interest Coverage 13.50 9.67 5.76 3.94 2.14 1.51 0.96
EBITDA Interest Coverage 17.08 12.80 8.18 6.00 3.49 2.45 1.51Funds from Operations / Total Debt
(%) 98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%
Free Operating Cashflow/ TotalDebt (%) 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%
Pretax Return on Permanent Capital(%) 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%
Operating Income/Sales (%) 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%Long Term Debt/ Capital 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%
Copyright ©2001 Ian H. Giddy Capital Structure 73giddy.org
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% + 5.25% + 1.25% = 12.50%
Copyright ©2001 Ian H. Giddy Capital Structure 74giddy.org
The Cost of Equity
Equity is not free!
Expected return = Risk-free rate + Risk Premium
E(RRisky) = RRisk-free -+ Risk Premium
Copyright ©2001 Ian H. Giddy Capital Structure 75giddy.org
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
Copyright ©2001 Ian H. Giddy Capital Structure 76giddy.org
Private Business: Owner hasall his wealth invested in thebusiness
Venture Capitalist: Haswealth invested in a numberof companies in one sector
Publicly traded companywith investors who are diversified domesticallyorIPO to investors who aredomestically diversified
Publicly traded companywith investors who are diverisified globallyorIPO to global investors
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
Market Risk
Int’nl Risk
Sector Risk
Competitive Risk
Project Risk
TotalRisk
Risk added to sectorportfolio
Risk added to domestic portfolio
Risk added to global portfolio
StandardDeviation
Beta relative to sector
Beta relative to local index
Beta relative to global index
40%
25%
15%
10%
100/.4=250
100/.25=400
100/.15=667
100/.10=1000
Investor Type Cares about Risk Measure Cost ofEquity
Firm Value
Valuing a Firm from Different Risk PerspectivesFirm is assumed to have a cash flow of 100 each year forever.
Copyright ©2001 Ian H. Giddy Capital Structure 80giddy.org
The Cost of Capital
Choice Cost1. 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)]
Copyright ©2001 Ian H. Giddy Capital Structure 81giddy.org
Estimating Cost of Capital: Siderar
EquityCost of Equity = 6.00% + 0.71 (16.03%) = 17.38%Market Value of Equity = 3.20* 310.89 = 995 million
(94.37%) Debt
Cost of debt = 6.00% + 5.25% + 1.25% (default spread) = 12.5%
Market Value of Debt = 59 Mil (5.63%) Cost of CapitalCost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563))
= 17.38%(.9437) + 8.32%(.0563) = 16.87%
Copyright ©2001 Ian H. Giddy Capital Structure 82giddy.org
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.
Copyright ©2001 Ian H. Giddy Capital Structure 83giddy.org
This is What We’re Trying to Do
D/(D+E) ke kd After-tax Cost of Debt WACC
0 10.50% 8% 4.80% 10.50%
10% 11% 8.50% 5.10% 10.41%
20% 11.60% 9.00% 5.40% 10.36%
30% 12.30% 9.00% 5.40% 10.23%
40% 13.10% 9.50% 5.70% 10.14%
50% 14% 10.50% 6.30% 10.15%
60% 15% 12% 7.20% 10.32%
70% 16.10% 13.50% 8.10% 10.50%
80% 17.20% 15% 9.00% 10.64%
90% 18.40% 17% 10.20% 11.02%
100% 19.70% 19% 11.40% 11.40%
D/(D+E) ke kd After-tax Cost of Debt WACC
0 10.50% 8% 4.80% 10.50%
10% 11% 8.50% 5.10% 10.41%
20% 11.60% 9.00% 5.40% 10.36%
30% 12.30% 9.00% 5.40% 10.23%
40% 13.10% 9.50% 5.70% 10.14%
50% 14% 10.50% 6.30% 10.15%
60% 15% 12% 7.20% 10.32%
70% 16.10% 13.50% 8.10% 10.50%
80% 17.20% 15% 9.00% 10.64%
90% 18.40% 17% 10.20% 11.02%
100% 19.70% 19% 11.40% 11.40%
Copyright ©2001 Ian H. Giddy Capital Structure 84giddy.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
Copyright ©2001 Ian H. Giddy Capital Structure 85giddy.org
Siderar: Optimal Debt Ratio
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
Question: If Siderar’s current debt ratio is 60%, what do you recommend?
Copyright ©2001 Ian H. Giddy Capital Structure 86giddy.org
Siderar: Optimal Debt Ratio
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046
10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565
0
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0% 20% 40% 60% 80% 100%
Debt Percentage
Va
lue
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0.00%
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15.00%
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25.00%
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0% 20% 40% 60% 80% 100%
Debt Percentage
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Copyright ©2001 Ian H. Giddy Capital Structure 87giddy.org
A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > OptimalOverlevered
Actual < OptimalUnderlevered
Is the firm under bankruptcy threat? Is the firm a takeover target?
Yes No
Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withnew equity or with retainedearnings.
No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.
Yes No
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withdebt.
No
Do your stockholders likedividends?
YesPay Dividends No
Buy back stock
Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.
Copyright ©2001 Ian H. Giddy Capital Structure 92giddy.org
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Ian Giddy
NYU Stern School of Business
Tel 212-998-0332
Fax 917-463-7629
http://giddy.org