1Capital Structure

Lecture 12

Private Equity-like Returns

Assumptions: Two assets only:

Treasuries (T): risk free =2 percent SP500 (SP): expected market risk premium (rm-rf)= 6 percent

You have $1 to invest1. What portfolio weights (T,SP) would allow you to obtain

a. A 2% expected return?b. A 8% expected return?c. A 20% expected return?

2. Do we create value by increasing our expected return from 2 to over 20 percent?

2

2Venture Capital-like Returns

Assumptions: Treasuries (T): risk free =2 percent SP500 (SP): expected market risk premium (rm-rf)= 6 percent Procter & Gamble equity beta=0.33 Seagate Technology equity beta=4

You have $1 to invest1. What is the expected return if you only invest in P&Gs equity?

2. What is the expected return if you only invest in Seagates equity?

3. Do we create value by moving a dollar from P&G to Seagates equity?

3

4

The Capital Structure Question

So far we tried to answer the following question:

Which projects should the firm invest in to maximize value?

Key tools: Cash-flows: FCF, NPV, etc Discount rates: beta, CAPM, NPV

The next question: How should the firm raise the

capital necessary to make these investments?

Should the firm: Borrow (issue debt)? Sell shares (issue equity)?

Assets LiabilitiesProjects & Investments

undertaken by firmSecurities

issued by firm:

(Take Positive NPV Projects) Debt

Equity

3Basic differences debt vs. equity

Debt Equity

5

Capital structure in the news

6

Microsoft Corp. sold $10.8 billion of debt in its biggest bond sale on record. The companys cash and short-term investments were $90.2 billion as of the most recent quarter. The company repurchased $2 billion of its own shares in the quarter.

4Capital structure in the news

7

Investors cant get enough of Apple Inc. The iPhone maker sold $6.5 billion in bonds on Monday. Apple in a prospectus said it plans to use proceeds for general corporate purposes, including share buybacks it effectively means a company is taking cash from bondholders to pay shareholders.

Capital structure in the news

8

MONTERREY, 29 ene - La minorista mexicana Soriana dijo el jueves que planea emitir acciones por hasta 600 millones de dlares y vender activos no estratgicos en busca de reducir su deuda, tras anunciar en la vspera que adquirir las tiendas de su rival Comerci. "Estamos pensando hacer una emisin de capital de entre 500 y 600 millones de dlares y vender activos", dijo el director general de Soriana, Ricardo Martn, en una conferencia conanalistas.

5What does optimal capital structure mean?

A firms mix of alternative sources of capital is referred as its capital structure Debt*: bank debt, bonds. Equity: common, preferred, etc.

Definition: optimal capital structure is the mix of securities (e.g., debt and equity) issued by the firm that maximize its value New mission statement: find the leverage ratio (debt to capital ratio) that

maximizes value Understand what should not be emphasized in capital structure debates

Enterprise value is:

How can leverage change enterprise value? Affect free cash flows Change the discount rate: today

9

...1...11 2210 tfirmtfirmfirmfirm rFCF

rFCF

rFCFFCFV

* The providers of debt financing will be referred to as a group as debt-holders, bondholders or the bank

Capital structure: what we wont address

We are interested in estimating the average long term mix of debt and equity that the firm should have

We are not going to estimate year-by-year changes in the capital structure Well assume that capital structure will, on average, tend towards its

optimum or target leverage ratio We are going to set aside several capital structure issues:

Implications of the different types of debt (bank, corporate bonds, etc) Debt maturity: whether to issue short or long term debt

Other securities (preferred stock, convertible debt, warrants, etc) These securities are hybrids of debt and equity: combine features of both The insights from our analysis generalize to these more complex forms of

financing

10

611

Leverage by industry

Aut

o &

Tru

ck M

anuf

actu

rers

Inve

stm

ent S

ervi

ces

Rea

l Est

ate

Ope

ratio

nsE

lect

ric U

tiliti

esA

irlin

eIn

sura

nce

(Life

)In

sura

nce

(Pro

p. &

Cas

ualty

)N

atur

al G

as U

tiliti

esH

otel

s &

Mot

els

Fore

stry

& W

ood

Pro

duct

sC

ongl

omer

ates

Pap

er &

Pap

er P

rodu

cts

Rai

lroad

sC

asin

os &

Gam

ing

Aut

o &

Tru

ck P

arts

Aver

age

(All

U.S

. Firm

s)C

onst

ruct

ion

Ser

vice

sR

etai

l (G

roce

ry)

Com

mun

icat

ions

Ser

vice

sM

otio

n P

ictu

res

Food

Pro

cess

ing

Hea

lthca

re F

acilit

ies

Bro

adca

stin

g &

Cab

le T

VA

dver

tisin

gB

ever

ages

(Alc

ohol

ic)

Ret

ail (

Dep

artm

ent &

Dis

coun

t)To

bacc

oB

ever

ages

(Non

alco

holic

)P

rintin

g &

Pub

lishi

ngR

esta

uran

tsC

ompu

ter S

ervi

ces

Oil

& G

as -

Inte

grat

edR

etai

l (S

peci

alty

)M

ajor

Dru

gsC

ompu

ter H

ardw

are

Med

ical

Equ

ipm

ent &

Sup

plie

sB

iote

chno

logy

& D

rugs

Com

pute

r Net

wor

ksR

etai

l (A

ppar

el)

Sem

icon

duct

ors

Com

mun

icat

ions

Equ

ipm

ent

Com

pute

r Per

iphe

rals

Com

pute

r Sto

rage

Dev

ices

Sof

twar

e &

Pro

gram

min

g

Con

s. F

in. S

vcs.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% Debt Financing by Industry D/(E+D)

12

Leverage and the Cost of Capital

Most large corporations use a mix of debt and equity financing If a firm borrows, or issues stock, investors will demand a risk premium to

compensate them for the risk they are taking The risk, and therefore the risk premium, will vary by security The firms overall cost of capital is the weighted-average cost of all

sources of funding

Weighted-Average Cost of Capital or WACC

Optimal Capital Structure Objective: find the optimal (%E), and (%D) in the WACC Minimize the WACC, maximize value!

Consider the following: The cost of debt financing is lower than the cost of equity financing Does this imply that debt is better?

% of Equity Equity Cost % of Debt Debt CostFinancing of Capital Financing of Capital

WACC

713

A Common View: Debt is Cheap

0%

5%

10%

15%

20%

25%

30%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

% Debt Financing

Equity Cost of Capital

Debt Cost of Capital

WACC

Optimal Capital Structure

Example: WACC and betas

Example: Consider a firm with an unlevered beta of 0.75 Assume rf = 6 % Market risk premium = 4% Use the CAPM to compute the WACC for the following cases:1. 100% equity financed firm2. Firm with D/E ratio of 1/3 (if debt=100, equity=300), with risk-less debt

(debt beta=0)

14

815

Leverage, Risk, and Return

What makes a stock risky? Asset Risk: Underlying business risk associated with the enterprise Financial Risk: Amplification of risk due to leverage

Example: All equity investment of $1,000 with payoffs below (prob= )

As an all-equity firm, investors demand a 15% return this is the firms cost of capital

If the risk-free rate is 5%, the risk premium is 10%

2014 2015 ReturnHigh Low High Low E[R] Vol

-1000 1400 900 40% -10% 15% 25%

Risk Premium 5% 10% 15%E fR r

16

Leverage, Risk, and Return

2014 2015 Return

Unlevered Equity

High Low High Low E[R] Vol

-1000 1400 900 40% -10% 15% 25%Debt CF 500 -525 -525 5% 5% 5% 0%LeveredEquity -500 875 375 75% -25% 25% 50%

Suppose instead the firm raises $500 using debt with a 5% rate What happens to the risk and expected return of equity?

Adding leverage increases the risk of equity The initial cash flows go to debt holders: first to collect As a result, both the volatility and the beta of equity increase

To compensate equity holders, the expected return on equity also increases!

%25)( ERE

917

Leverage, Risk, and Return

But, changes in the capital structure do not affect the WACC

WACC of the all-equity firm:

WACC of the levered firm:

With no debt, the WACC is equal to the unlevered equity cost of capital

As the firm borrows at the low cost of capital for debt, its equity cost of capital rises: the net effect leaves the WACC unchanged

1 15% 0 5% 15%WACC E DE DR R R

D E D E

1 125% 5% 15%2 2WACC E D

E DR R RD E D E

18

M&M and WACC

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

% Debt Financing

Debt Cost of Capital

WACC

Equity Cost of Capital

10

19

Lessons

Leverage increases the risk and the required return of equity Debt is paid first and thus has less (or no) risk Equity has more concentrated risk

In a perfect capital market: Adding leverage does not change the firms WACC

Even though debt is cheaper, the cost of equity goes up by enough to eliminate any benefit

Not surprising: the risk of the project (business) did not changed Adding leverage does not change the total value of the firm

V(Unlevered) = V(Debt) + V(Equity) Whole = Sum of the parts

Modigliani - Miller (M&M) Theorem. Financial policy is irrelevant: Any capital structure is as good as any other!

Bottom Line

If two investments (one with leverage, one without) provide the same cash flows in every scenario, then

they must sell for the same price

Value is determined by cash-flowsNOT

by how these cash-flows are sliced

11

21

M&M and arbitrage

The essence of M&M is that the value of the whole is equal to the sum of the value of the pieces

V(A+B) = V(A) + V(B)

While the individual pieces (debt/equity) may have very different risk and return characteristics from the whole, the total value is not changed

This result follows from the Law of One Price, and is supported by arbitrage: What would you do if V(A+B) V(A) + V(B)?

22

Homemade Leverage

The leverage choice of the firm does not matter to investors If the firms issues debt and equity, those investors who prefer it

without leverage can always buy both securities If the firm is unlevered, investors can create levered equity using

homemade leverage

Example: Buy unlevered Equity for $1,000 using a loan of $500 Initial additional investment= $1000 - $500 = $500

High LowUnlevered Equity: $1400 $900

Repay Loan: -$525 -$525Final Payoff: $875 $375

The same payoffs of the levered firm!

12

23

Financial Policy Irrelevance

M&M implies that corporate financial policy is irrelevant to firm value Capital structure does not affect the amount of capital the firm can raise Trade in other market securities also does not matter

NPV(Buying a Security) = - Price + PV(Cash Flows) = 0

Key Assumption: Perfect Capital Markets No Taxes, no Bankruptcy Costs No Agency Costs No Asymmetric Information Securities are fairly priced

Key Insight: To create value through financial policy, one needs to focus on a market imperfection that can affect cash flows

Corporate finance affects value in the presence of market frictions

Is capital structure really irrelevant?

No! M&M simplifying assumptions do not hold in practice Therefore: capital structure does matter in the real world! M&M is still extremely useful as it is tells us that if capital structure

creates value then it must be because one of M&Ms assumptions is not valid: i.e., it tells us where to look!

Examples of changes in leverage affecting cash-flows: Different tax treatment of debt and equity Costs of financial distress Incentives and agency costs Information asymmetry

Optimal capital structure: how to tradeoff the advantages and disadvantages of debt financing

24

13

Summary

The required return on debt is lower than the required return on equity: Debt is senior But that does not imply that leverage increases value:

1. Leverage (debt financing) increases the risk of equity2. The benefit of debts lower cost is exactly offset by the higher equity cost

of capital Under perfect capital markets the firms weighted average cost of

capital (WACC) is unaffected by financing

While the assumptions behind the M&M theorems are unlikely to hold in practice, the M&M intuition does hold: Capital structure affects value if and only if it affects cash flows If you want to change firm value by changing the capital structure

you need a cash flow story to support your recommendation25

Common fallacies

Firms should issue debt rather than equity to:

1. Prevent existing shareholders dilution Dilution: issuing additional shares (increasing the number of

shares outstanding) reduces the slice of $$$ that goes to old shareholders

2. Increase earnings-per-share

26

14

27

Example: A New Investment

DF Corp. Expected EBIT of $10m/yr forever No growth, No net cap ex or working cap, No taxes (EBIT = FCF) 15 million shares outstanding, no debt Asset beta = 0.75, rf = 6%, market risk premium = 4% Pre-announcement share price

Equity cost of capital = 6% + 0.75(4%) = 9% Enterprise Value = $10/.09 = $111.1 million P0 = 111.1/15 = $7.41/share

New Investment $50 million upfront cost Increase EBIT (FCF) by $8m/yr, with similar risk

NPV = -50 + 8/.09 = -50+88.89 =$38.89 million

How should DF raise the $50 million? Issue debt? equity?

New Investment: dilution?

What happens to DF Corps stock price when the new project is announced? NPV>0, implies stock price should increase Enterprise value prior announcement:

$10/.09 = $111.1 million, Per share =111.1/15 = $7.41/share Enterprise value post announcement and before firm raises funds:

$111.1 million + NPV = $111.1+ 38.89=$150 Stock price = $150 / 15M = $10

Implication: If DF Corp. sells equity, how many shares do they issue? $50M/$10 per share =$5M shares If new shares are fairly priced, the entire NPV of the investment is

captured by the firms existing shareholders

Dilution? Only if DF Corp sells shares at a price lower than $10 Dilution only exists if the shares of DF Corp are not fairly priced Under-pricing does not occur in a perfect capital market

28

15

29

The earnings per share (EPS) fallacy

Equity Issue: 20 million total shares Expected EPS = $18 (10+8)/20 = $0.90

Debt Issue: 15 million total shares Interest payments = $50 6% = $3 million/yr Expected EPS = $(18 3)/15 = $1.00

Is debt better? What about M&M?

30

DF Corp: The EPS Fallacy

Leverage makes EPS more risky: upside/downside

0 3 6 9 12 15 18 21 24

EBIT ($ millions)$(0.20)

$-

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

EPS

No Debt

With Debt

16

DF Corp: The EPS Fallacy

What are we missing? Using leverage increases the required return of equity

Without leverage: Required return of equity=9% Perpetuity:

With leverage: Required return of equity=10% Perpetuity:

In a perfect capital market, while EPS will be affected by leverage, the share price is unaffected Expected EPS increases, but also equity risk Investors objective is to maximize their net worth and not EPS

31

10$09.09.0* gr

PayoutrateEPSP

10$1.00.1* gr

PayoutrateEPSP