Capital structure ppt

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Published Date:26-07-2017
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Aswath Damodaran 1 CAPITAL  STRUCTURE:   FINDING  THE  RIGHT  FINANCING   MIX   You  can  have  too  much  debt…  or  too  liEle..  The  Big  Picture..   2 Maximize the value of the business (firm) The Investment Decision The Dividend Decision The Financing Decision Invest in assets that earn a If you cannot find investments Find the right kind of debt return greater than the that make your minimum for your firm and the right minimum acceptable hurdle acceptable rate, return the cash mix of debt and equity to rate to owners of your business fund your operations The hurdle rate How much The return How you choose The optimal The right kind should reflect the should reflect the cash you can to return cash to mix of debt of debt riskiness of the return magnitude and the owners will and equity matches the investment and the timing of the depends upon depend on maximizes firm tenor of your the mix of debt cashflows as welll current & whether they value assets and equity used potential as all side effects. prefer dividends to fund it. investment or buybacks opportunities Aswath Damodaran 2 Pathways  to  the  OpNmal   3 1.  The  Cost  of  Capital  Approach:  The  opNmal  debt  raNo  is  the   one  that  minimizes  the  cost  of  capital  for  a  firm.   2.  The  Enhanced  Cost  of  Capital  approach:  The  opNmal  debt   raNo  is  the  one  that  generates  the  best  combinaNon  of   (low)  cost  of  capital  and  (high)  operaNng  income.   3.  The  Adjusted  Present  Value  Approach:  The  opNmal  debt   raNo  is  the  one  that  maximizes  the  overall  value  of  the  firm.   4.  The  Sector  Approach:  The  opNmal  debt  raNo  is  the  one  that   brings  the  firm  closes  to  its  peer  group  in  terms  of  financing   mix.   5.  The  Life  Cycle  Approach:  The  opNmal  debt  raNo  is  the  one   that  best  suits  where  the  firm  is  in  its  life  cycle.   Aswath Damodaran 3 I.  The  Cost  of  Capital  Approach   4 ¨  Value  of  a  Firm  =  Present  Value  of  Cash  Flows  to  the   Firm,  discounted  back  at  the  cost  of  capital.   ¨  If  the  cash  flows  to  the  firm  are  held  constant,  and   the  cost  of  capital  is  minimized,  the  value  of  the  firm   will  be  maximized.     Aswath Damodaran 4 Measuring  Cost  of  Capital   5 ¨  Recapping  our  discussion  of  cost  of  capital:   ¨  The  cost  of  debt  is  the  market  interest  rate  that  the  firm  has  to  pay  on  its   long  term  borrowing  today,  net  of  tax  benefits.  It  will  be  a  funcNon  of:   (a)  The  long-­‐term  riskfree  rate   (b)  The  default  spread  for  the  company,  reflecNng  its  credit  risk   (c)  The  firm’s  marginal  tax  rate   ¨  The  cost  of  equity  reflects  the  expected  return  demanded  by  marginal   equity  investors.  If  they  are  diversified,  only  the  porNon  of  the  equity  risk   that  cannot  be  diversified  away  (beta  or  betas)  will  be  priced  into  the  cost   of  equity.   ¨  The  cost  of  capital  is  the  cost  of  each  component  weighted  by  its  relaNve   market  value.   Cost  of  capital  =  Cost  of  equity  (E/(D+E))  +  Ader-­‐tax  cost  of  debt  (D/(D+E))   Aswath Damodaran 5 Costs  of  Debt  &  Equity   6 ¨  An  arNcle  in  an  Asian  business  magazine  argued  that   equity  was  cheaper  than  debt,  because  dividend   yields  are  much  lower  than  interest  rates  on  debt.   Do  you  agree  with  this  statement?   a.  Yes   b.  No   ¨  Can  equity  ever  be  cheaper  than  debt?   a.  Yes   b.  No   Aswath Damodaran 6 Applying  Cost  of  Capital  Approach:  The   Textbook  Example   7 Assume the firm has 200 million in cash flows, expected to grow 3% a year forever. Aswath Damodaran 7 The  U-­‐shaped  Cost  of  Capital  Graph…   8 Aswath Damodaran 8 Current  Cost  of  Capital:  Disney   ¨  The  beta  for  Disney’s  stock  in  November  2013  was  1.0013.  The  T.   bond  rate  at  that  Nme  was  2.75%.  Using  an  esNmated  equity  risk   premium  of  5.76%,  we  esNmated  the  cost  of  equity  for  Disney  to   be  8.52%:    Cost  of  Equity  =  2.75%  +  1.0013(5.76%)  =  8.52%     ¨  Disney’s  bond  raNng  in  May  2009  was  A,  and  based  on  this  raNng,   the  esNmated  pretax  cost  of  debt  for  Disney  is  3.75%.  Using  a   marginal  tax  rate  of  36.1,  the  ader-­‐tax  cost  of  debt  for  Disney  is   2.40%.    Ader-­‐Tax  Cost  of  Debt    =  3.75%  (1  –  0.361)  =  2.40%   ¨  The  cost  of  capital  was  calculated  using  these  costs  and  the   weights  based  on  market  values  of  equity  (121,878)  and  debt   (15.961):    Cost  of  capital  =     Aswath Damodaran 9 Mechanics  of  Cost  of  Capital  EsNmaNon   10 1.  EsNmate  the  Cost  of  Equity  at  different  levels  of  debt:     ¤  Equity  will  become  riskier  -­‐  Beta  will  increase  -­‐  Cost  of  Equity   will  increase.   ¤  EsNmaNon  will  use  levered  beta  calculaNon   2.  EsNmate  the  Cost  of  Debt  at  different  levels  of  debt:     ¤  Default  risk  will  go  up  and  bond  raNngs  will  go  down  as  debt   goes  up  -­‐  Cost  of  Debt  will  increase.   ¤  To  esNmaNng  bond  raNngs,  we  will  use  the  interest  coverage   raNo  (EBIT/Interest  expense)   3.  EsNmate  the  Cost  of  Capital  at  different  levels  of  debt   4.  Calculate  the  effect  on  Firm  Value  and  Stock  Price.   Aswath Damodaran 10 Laying  the  groundwork:   1.  EsNmate  the  unlevered  beta  for  the  firm   ¨  The  Regression  Beta:  One  approach  is  to  use  the  regression  beta  (1.25)   and  then  unlever,  using  the  average  debt  to  equity  raNo  (19.44%)  during   the  period  of  the  regression  to  arrive  at  an  unlevered  beta.    Unlevered  beta  =  =  1.25  /  (1  +  (1  -­‐  0.361)(0.1944))=  1.1119   ¨  The  Bo/om  up  Beta:  AlternaNvely,  we  can  back  to  the  source  and   esNmate  it  from  the  betas  of  the  businesses.   Value  of   Propor5on   Unlevered   Business   of  Disney   beta   Business   Revenues   EV/Sales   Value   Propor5on   Media  Networks   20,356   3.27   66,580   49.27%   1.03   66,579.81   49.27%   Parks  &  Resorts   14,087   3.24   45,683   33.81%   0.70   45,682.80   33.81%   Studio   Entertainment   5,979   3.05   18,234   13.49%   1.10   18,234.27   13.49%   Consumer  Products   3,555   0.83   2,952   2.18%   0.68   2,951.50   2.18%   InteracNve   1,064   1.58   1,684   1.25%   1.22   1,683.72   1.25%   Disney  Opera6ons   45,041   135,132   100.00%   0.9239   135,132.11   100.00%   Aswath Damodaran 11 2.  Get  Disney’s  current  financials…   Aswath Damodaran 12 I.  Cost  of  Equity   Levered Beta = 0.9239 (1 + (1- .361) (D/E)) Cost of equity = 2.75% + Levered beta 5.76% Aswath Damodaran 13 EsNmaNng  Cost  of  Debt   Start  with  the  market  value  of  the  firm  =  =  121,878  +  15,961  =  137,839  million     D/(D+E)    0.00%  10.00%  Debt  to  capital   D/E    0.00%  11.11%  D/E  =  10/90  =  .1111    Debt    0    13,784    10%  of  137,839               EBITDA    12,517  12,517    Same  as  0%  debt   DepreciaNon      2,485      2,485    Same  as  0%  debt   EBIT    10,032  10,032    Same  as  0%  debt   Interest    0    434    Pre-­‐tax  cost  of  debt      Debt               Pre-­‐tax  Int.  cov  ∞  23.10  EBIT/  Interest  Expenses   Likely  RaNng  AAA  AAA  From  RaNngs  table   Pre-­‐tax  cost  of  debt    3.15%  3.15%  Riskless  Rate  +  Spread   Aswath Damodaran 14 The  RaNngs  Table   Interest coverage ratio is Rating is Spread is Interest rate 8.50 Aaa/AAA 0.40% 3.15%   6.5 – 8.5 Aa2/AA 0.70% 3.45%   5.5 – 6.5 A1/A+ 0.85% 3.60%   4.25 – 5.5 A2/A 1.00% 3.75%   3 – 4.25 A3/A- 1.30% 4.05%   T.Bond rate =2.75% 2.5 -3 Baa2/BBB 2.00% 4.75%   2.25 –2.5 Ba1/BB+ 3.00% 5.75%   2 – 2.25 Ba2/BB 4.00% 6.75%   1.75 -2 B1/B+ 5.50% 8.25%   1.5 – 1.75 B2/B 6.50% 9.25%   1.25 -1.5 B3/B- 7.25% 10.00%   0.8 -1.25 8.75% Caa/CCC 11.50%   0.65 – 0.8 Ca2/CC 9.50% 12.25%   0.2 – 0.65 C2/C 10.50% 13.25%   0.2 D2/D 12.00% 14.75%   Aswath Damodaran 15 A  Test:  Can  you  do  the  30%  level?   Iteration 1 Iteration 2 (Debt AAA rate) (Debt AA rate) D/(D + E) 20.00% 30.00% 30.00% D/E 25.00% Debt 27,568 EBITDA 12,517 Depreciation 2,485 EBIT 10,032 Interest expense 868 Interest coverage ratio 11.55 Likely rating AAA Pretax cost of debt 3.15% Aswath Damodaran 16 Bond  RaNngs,  Cost  of  Debt  and  Debt   RaNos   Aswath Damodaran 17 Stated  versus  EffecNve  Tax  Rates   ¨  You  need  taxable  income  for  interest  to  provide  a  tax  savings.  Note   that  the  EBIT  at  Disney  is  10,032  million.  As  long  as  interest   expenses  are  less  than  10,032  million,  interest  expenses  remain   fully  tax-­‐deducNble  and  earn  the  36.1%  tax  benefit.    At  an  60%   debt  raNo,  the  interest  expenses  are  9,511  million  and  the  tax   benefit  is  therefore  36.1%  of  this  amount.     ¨  At  a  70%  debt  raNo,  however,  the  interest  expenses  balloon  to   11,096  million,  which  is  greater  than  the  EBIT  of  10,032  million.   We  consider  the  tax  benefit  on  the  interest  expenses  up  to  this   amount:   ¤  Maximum  Tax  Benefit  =  EBIT    Marginal  Tax  Rate  =  10,032  million    0.361   =    3,622  million   ¤  Adjusted  Marginal  Tax  Rate  =  Maximum  Tax  Benefit/Interest  Expenses  =   3,622/11,096  =  32.64%     Aswath Damodaran 18 Disney’s  cost  of  capital  schedule…   Aswath Damodaran 19 Disney:  Cost  of  Capital  Chart   Aswath Damodaran 20

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