Costs of Capital

FIN 4250
Financing Issues
Fall 2005
Dr. Tuftes FIN 4250 Notes
What Are the Big Financing Issues?

Cost of Capital Divisional Hurdles Capital Structure Leverage Refunding Dividends
Fall 2005
What Is Capital?
Funding for long term investment Two types
Fixed payout
Bonds, preferred stock, etc.
Variable payout
Common stock, retained earnings
Fall 2005
What is the Cost of Capital?

Each type of capital has its own cost (measured as a rate) The cost of capital is a weighted average of these rates
So, our goal is to calculate WACC the weighted average cost of capital
Fall 2005
How Is the Cost of Capital Weighted?

Most firms have a capital structure that they are content to leave unchanged
Say, X% in bonds, and (100-X%) in equity
The Modigliani-Miller Theorem suggests that changing capital structure does little to the bottom line So, the cost of capital is weighted by those proportions unless there are other considerations
Fall 2005 Dr. Tuftes FIN 4250 Notes 5
How Is the Cost of Capital Used, and How Does It Behave?

A firm uses the cost of capital to figure out how to finance the marginal investment
Marginal in the sense of next or additional
Typically retained earnings are a cheaper way to fill your variable payout category (because there are flotation costs with issuing new equity)
So, most firms WACC is lower for small investments, and higher for large ones
What Is the Difficulty in Calculating Cost of Capital?

Firms have different ways in which they raise capital The problems are that:
Their costs are quoted in different ways There are idiosyncrasies with each type of security
Fall 2005
What Should Go Into the Cost of Capital?

Capital is long term
Debt Common stock Preferred stock Retained earnings
Other long term items can be added
Fall 2005
Is the Cost of Bond Financing the Rate On Existing Bonds?

No rates change
You want the marginal rate that you would pay on new financing Note that flotation costs are often ignored because they are small for bonds
The marginal rate is caused by three things

The risk-free rate (which incorporates expectations of inflation) The risk premium (determined by the market and your prospects) Tax considerations
Is the Earnings/Price Ratio the Cost of Common Stock?

Yes if the firm is not expected to grow
Of course, in this case you probably wouldnt be as worried about the cost of capital anyway
No if the firm is growing
Fall 2005
10
Is the Dividend/Price Ratio the Cost of Preferred Stock?

No Preferred stock often has higher placement costs Most preferred dividends (70%) are nontaxable
Fall 2005
11
How Do I Calculate the Cost of Bonds?

The current price must equal the PV of the maturity value, plus the PV of the stream of coupons P = M/(1+k)N + sum{C/(1+k)n}
Solve for k
Deflate k by the appropriate tax rate to get the cost of bonds, kd=k(1-t)
What Are the Pitfalls with the Cost of Bonds?

Thin trading
Use a bond rating as a proxy
Yield curve extrapolation

Is the horizon your costing currently available?
Callability
This is a mess because you have to incorporate how the yield curve might effect your decision to call but it can be done
How Do I Calculate the Cost of Common Stock?

Use the CAPM Use discounted cash flow
Note that you have to use this method to reasonably account for flotation costs on new issues
Fall 2005
14
How Do I Use the CAPM to Calculate the Cost of Equity?

Obtain:
A risk-free rate The market risk premium The for your firm
Be aware that all of those must be chosen appropriately for the horizon of your project which might be different than what you would use to make a portfolio investment decision Calculate the cost of capital ks = krf + (km-krf) Note that there isnt a reasonable way to incorporate flotation costs
How Do I Use Discounted Cash Flow to Calculate the Cost of Equity?

Obtain the:
Current price Expected future dividends Expected future growth rate
Calculate:
kcs = g + D(1+g)/(P-Flotation Costs)
Fall 2005
16
Where Do I Get an Expected Growth Rate to Use for Costing?

Use analysts forecasts Use the product of the retention rate and the return on equity
Fall 2005
17
How Do I Calculate the Cost of Preferred Stock?

Cost is the dividend divided by the amount you clear after flotation, weighted by how much is taxable. kps = (1-.3t)D/(Price-Flotation Cost)
Fall 2005
18
How Do I Value the Cost of Retained Earnings?

Retained earnings and common stock are costed in the same ways Use the:
CAPM (see above) Discounted cash flow (see above) Construct a guesstimate:
From your current bond yield plus a risk premium
Then make a judgment call combining all of them

How Do I Construct Weighted Cost of Capital?

The rates are weighted across the components by their share of your capital structure
Need to decide whether to use book or market value, lean towards the latter
Usually there are two possibilities:

Bonds, preferred stock, and retained earnings, or Bonds, preferred stock, and new equity issues
The difference is how much the flotation costs of new issues effect your choice to retain earnings
What Is a Marginal Cost of Capital Chart?

This shows the rates, as well as the step at the cutoff where new equity has to be issued for a large enough investment Generally shown as two flat segments with a step
In reality, the rightward segment will eventually slope upward reflecting limited ability to place large amounts of common stock
How Is Depreciation Handled?

Depreciation is a source of internal cash flow, just like retained earnings Therefore, count it as a retained earning in your calculations
Fall 2005
22
What Factors Effect the Cost of Capital That A Firm Cant Control?
Interest rates Tax rates
Fall 2005
23
What Factors Effect the Cost of Capital That A Firm Can Control?
Capital structure
Perhaps you can assume more debt to lower the cost of capital
Dividend policy
Perhaps you can reduce your dividends to reduce the cost of capital
Investment policy
Perhaps you can choose less risky projects
What Are the Potential Pitfalls In Calculating the Cost of Capital?

Private ownership less data Small firms less data Measurement problems
What is the risk-free rate What is the expected growth rate? What is the risk premium?
Capital structure may change

What Are the Mistakes to Avoid?

Use the current rather than the historical cost of debt Dont mix a historical risk premium with a current risk-free rate in the CAPM Unless the firm has an explicit target, your share weights should be based on market valuations Accounts payable and accruals are not sources of capital
How Is Cost of Capital Used with Hurdles?

Estimate the rate the company has to earn on an investment to make it worthwhile Compare the cost of capital to that rate
Invest if rate > cost of capital Dont invest otherwise
Fall 2005
27
What About Corporate Divisions With Different Projects?

Different divisions within a firm will have investment opportunities with different rates of return
But, remember that rates of return are correlated with risk
A pitfall for a company is that the riskier division(s) may have more projects that clear the investment hurdle so a company that doesnt have divisional hurdles may find itself getting riskier through time
How Can the Volatility of Different Divisions Be Measured?

You can calculate betas for different divisions Obviously this will be easiest if the divisions are stand-alone and have their own equity Alternatively, you can Look at the betas for firms that have operations similar to your divisions Recall that beta is the ratio of the variances of your risk premium to that of the market, and proxy for those premiums with earnings Make an adjustment based on standard deviations of earnings without reference to beta
How Will Cost of Capital Vary Across Divisions?

This really depends on whether your fixed payout items are issued for the corporation as a whole or by each division It doesnt matter as much if common stock is issued by the corporation rather than by the divisions
This is because most divisions have either an explicit or implicit capability of retaining earnings
How Will Cost of Capital Behave If Debt Is Corporate But Earnings Can Be Retained at the Division Level?
The only difference in cost of capital will be from how beta effects the weight you put on common stock or retained earnings
Fall 2005
31
What Are the Pitfalls In Having Corporate Debt But Divisional Equity (or Retained Earnings)?
This may still allow the risky division to grow faster as it takes advantage of cheaper debt available from the corporation
Fall 2005
32
How Will Cost of Capital Behave If All Capital Is Raised at the Division Level?
Now the bond market will also be pricing the risk of the division, and the higher risk division will not have an advantage On the other hand, what is the point of having a division (as opposed to an independent firm) in this case?
What Are the Pitfalls In Letting Divisions Have Their Own Debt?
Firms dont know too much about the appropriateness of their own capital structure, so how would you know how much debt each division could carry? Who will back up the debt
Division: then whats the point of keeping them as a subsidiary? Corporation: there is a moral hazard for divisional managers
How Serious a Short-Term Problem Can Differences In Divisional Risk Be?

This problem becomes smaller as:
The firm gets larger The projects get smaller The time frame is shorter
For example, suppose the firm has X% debt. Adopting projects with Y% debt will only slowly move the overall structure from X% to Y%.
Are There Incentive Problems With Divisions?

Firms exist because they are better at reducing transactions costs than markets
This is the Coase Theorem
But markets trade off risk for return in a cheap and decentralized way Financing with divisions is a problem the Coase Theorem says we should go the other way
Incentive problems come about when we do that incompletely
What Is Capital Structure?

The breakdown of the firms capital (longterm financing) into fixed and variable payout items
And then into finer categories
Fall 2005
37
What Is the Appropriate Capital Structure?

The short answer is that there isnt one The long answer is that we probably cant tell what the appropriate capital structure is, so most firms work under the assumption that they shouldnt change the existing capital structure drastically
It worked before, it will work again
Fall 2005
38
Why Should We Care About Capital Structure?

Firms have business risk generated by what they do But then firms adopt additional financial risk when they finance with debt
They trade off access to capital at lower rates for potential loss of control if they cant make payments
In principle, you can measure these with return on equity

A leverage firm will have a higher ROE, but its hard to demonstrate this because it isnt clear what to compare it to
What Is the (Nave) Theory of Capital Structure?

The Modigliani-Miller Theorem says that (in the absence of distortionary taxes) a firm cant improve its profitability by changing its capital structure
This is basically a you-cant-game-the-system result The problem with it is that in the real world, we do have distortionary taxes
What Is the (Not-So-Nave) Theory of Capital Structure?

Our tax system favors debt financing without limits Theoretically then, it is optimal to be infinitely leveraged
This may seem strange, but it follows because the cost of being overleveraged (bankruptcy) is not explicit or tangible
Fall 2005
41
What Is An Even Less Nave Theory of Capital Structure?

Marginal tax rates on equity are not as high as we think
Double taxation is a misnomer the rates arent added theyre compounded
Marginal tax rates on debt may be higher than we think

Individual rates are often higher than corporate and capital gains rates
We may be pretty close to the basic ModiglianiMiller result

Capital Structure
What are the pros and cons? Is there an ideal one?
Fall 2005
43
What Are the Advantages of Financing with Debt?

Tax benefit Because it requires a consistent cash flow, it disciplines managers
Fall 2005
44
What are the Disadvantages of Financing with Debt?

Increased risk of loss of control (through bankruptcy) Increased potential for conflict between equity holders and debt holders Loss of flexibility for future financing
Fall 2005
45
What are the Tax Benefits of Debt?

Tax write-off (100% of interest in the U.S.) Most countries have this
Some try to correct for it
Carrot: the U.K. - tax credit on dividends Stick: Germany - tax penalty on retained earnings
Fall 2005
46
Why Is Firm Value Positively Correlated with Reasonable Debt Levels?

All firms increase their value by issuing debt, since there is a positive present value associated with not paying taxes on interest you will pay in the future This gain is the tax rate expected on future earnings times the face value of debt at issue Note that this tax rate is not marginal, since it covers all the debt not just changes in debt Note that this says nothing about costs of debt
What Savings Are Realized from Debt Finance?

Effective interest rates on debt are lower
kD = r(1-t) Note that we use the marginal tax rate since we are talking about new debt Note that this is only a benefit if your actually making earnings that can be taxed.
Fall 2005
48
What Can We Predict About the Relationship of Taxes and Debt?

Firms that face higher tax rates should have more leverage
We see this with REITs, which dont pay corporate taxes, and are less leveraged than similar firms
Firms that can shield themselves in other ways say through depreciation should have less debt Changes in tax rates should be correlated with changes in leverage ratios Countries with higher taxes should have more leveraged firms
How Does Debt Discipline a Firm?

Free cash flows those over which managers have some discretion invite management inefficiency For practical purposes, there has to be some limit to how much you need to discipline your managers so this isnt an argument for infinite leverage
Fall 2005
50
What Can We Infer From the Propensity of Debt to Rein In Management?

Managers with a preference for equity financing probably dont want investors watching them too closely Countries in which shareholders have more power should also be ones in which leverage is higher Takeover targets are less leveraged than other firms Operating efficiency is higher in leveraged firms
Fall 2005
51
When Is Bankruptcy More Likely?

Operating cash flows are small relative to debt obligations Operating cash flows are relatively volatile
Fall 2005
52
What Are the Direct Costs of Bankruptcy?

Not very high
1% of assets held 5 years prior to bankruptcy 5% of assets at the time of bankruptcy
This reflects slow dissolution of assets prior to filing
Costs are higher if the firm is holding assets that are less liquid
Fall 2005
53
What Are the Indirect Costs of Bankruptcy?

Declining revenue associated with bankruptcy fears on the part of customers Stricter terms on payables
Fall 2005
54
What Features Are Likely to Lead to Higher Indirect Costs?

Sellers of products with:
Long lives Lots of replacement parts Lots of service
Sellers of products whose quality cant be determined in advance Firms producing products with lots of complements
What Sort of Firms Will Use More Debt Because of the Nature of Bankruptcy Costs?
Stable cash flows Debt payments that can be linked to cash flows Implicit or explicit government backup Firms whose assets are easily divisible and marketable
Brand names are likely to be associated with lower debt
What Is the Agency Problem with Borrowing?

Equity holders:
Control decision making Prefer riskier projects (since equity is like a call option)
Debt holders
Can end up assuming more risk than they want to Owning a bond is like selling the company a put in exchange for a risk-free note
What Aspects of Financial Management Are Affected by this Agency Problem?

Project choice Choice of project financing Cash disbursement
Fall 2005
58
How Does the Agency Problem Affect Project Choice?

Managers devise projects and calculate hurdle rates Bondholders lend money based on hurdle rates and perceived risk of projects Once money is lent, equity holders have an incentive to find even riskier projects
This transfer wealth from bondholders to equityholder Perversely, equityholders may even be interested in projects with negative NPV because they are high risk, and on net are winners for equityholders
How Do Bondholders Protect Themselves?

With debt covenants that restrict the decision-making freedom of managers and equityholders
Fall 2005
60
What Is the Agency Problem for Project Finance?

Equityholders have the authority to give issuers of new debt priority (in bankruptcy) over existing debt
This transfers some of the wealth of old debtholders to equityholders
Fall 2005
61
How Do Bondholders Protect Themselves from Being Disprioritized?

Write a put clause into the bond contract
This allows the bonds to be sold back to the firm - at the holders discretion and at face value
Fall 2005
62
What Is the Agency Problem with Cash Disbursement?

In the absence of viable projects, equityholders usually want to either:
Pay out cash as dividends, or Use it to repurchase stock
Debtholders prefer that cash be retained to ensure that they get paid
There is evidence that bond prices go down after dividend announcements
How Do Debtholder Protect Themselves Against Poor Use of Cash?

Covenants that restrict dividend rates Hybrid securities like convertible bonds
Fall 2005
64
What Are the Implications of the Agency Cost Problems?

Bond prices will be higher due to expectations of abuse Direct costs of monitoring covenants will push bond prices higher Indirect costs of foregone opportunities that covenants restrict
Fall 2005
65
What Are the Implications of Loss of Flexibility from Debt Finance?

How do we value this? Flexibility is more valuable when: You have more potential projects You have better potential projects Your projects will yield more volatile cash flows This is consistent with why Microsoft or Intel uses little (long-term) debt but holds much cash
What Is the EBIT-EPS Tradeoff?

EBIT and EPS are positively correlated Assuming a standard strategy of issuing debt to buy stock,
A graph of the two will be steeper as the firm becomes more leveraged
Fall 2005
67
What Are the Most Important Factors for Managers In Assuming Debt?
Survey evidence (on a 1-5 scale)
5: flexibility, long-term survivability 4: predictable, maximize value, maintain independence, maintain rating 2: maintain comparability with other firms in the industry
Fall 2005
68
W hat Is the Modigliani-Miller [1958] Theorem?

Assumptions
No taxes No issuance costs No costs to bankruptcy No agency costs
Not surprisingly, they find that capital structure doesnt matter

This is the list if pros and cons from the beginning of the capital structure section
What Happens to Modigliani-Miller With Taxes and Interest WriteOffs?

Allowing for taxes with a write-off of interest - makes the optimal capital structure 100% debt
Fall 2005
70
What Happens to (Modigliani)Miller with Realistic Taxes On All Parties?

Capital structure wont matter if:
All tax rates are zero Tax rates on debt and equity are the same Taxes on personal income (which is the relevent rate for debt) are substantially higher than on corporations making up for the double taxation of equity
What Is the Practical Implication of the Modigliani-Miller Theorem?

They were the first to point out that there were tradeoffs worth thinking about
Up to this time you determined you capital structure through imitation
It implies that a firm is made or broken on the basis of project choice

Bad choices cant be fixed with finance Good choices cant be ruined with finance
How Is Modigliani-Miller Helpful?

Its really saying that the cost of capital doesnt change when you change your capital structure How is this possible?
As you shift more towards an asset with a low rate, you increase the costs associated with that method as well Its a zero profit condition for capital structure changes
Project decisions canand should be made on the merits of the project, not on how it is financed
What Are the Two Practical Views On Debt?

There is no optimal level of debt Debt is preferable up to some threshold level
Fall 2005
74
How Else Do Firms Choose a Capital Structure?

Base it on where you are in your growth cycle Look at comparable firms Use some hierarchy to help make your choices
Fall 2005
75
Does Financing Mix Change Across the Firms Life Cycle?

On net, the costs of debt appear to decline as the business grows to maturity (and into decline)
Increasing factors:
Tax benefits Added discipline
Declining factors
Bankruptcy costs Agency costs Need for flexibility
Does Financing Mix Depend On Your Industry?

There is strong empirical evidence to support this This doesnt mean this is evidence of a management strategy
Each firm may be drawn to a similar capital structure by the costs and benefits of debt
Fall 2005
77
Is There a Financing Hierarchy?

Yes, and it appears to be related to flexibility and control In order, managers prefer to finance with
Retained earnings Straight debt Convertible debt Common stock Preferred stock Convertible preferred stock
Is Information Asymmetry Related to the Financing Hierarchy?

If managers believe the stock is already underpriced they may reject good projects rather than raise external funding, and vice versa This suggests that retained earnings are preferred because they allow projects to be judged on their merits rather than on the image their financing will project
What Is the Significance of the Financing Hierarchy?

The street seems to use this ranking as an indicator of financial strength
If you are issuing convertible preferred, it is a sign of weakness
More extremely, issuing securities at all is a sign of weakness

If you prefer retained earnings, and you have to issue securities, it is a sign you arent doing well enough to support the projects coming your way

Costs of Capital

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Costs of Capital

Uploaded by

Copyright:

Available Formats

FIN 4250

Dr. Tuftes FIN 4250 Notes

What Are the Big Financing Issues?

Dr. Tuftes FIN 4250 Notes

Dr. Tuftes FIN 4250 Notes

What is the Cost of Capital?

Dr. Tuftes FIN 4250 Notes

How Is the Cost of Capital Weighted?

How Is the Cost of Capital Used, and How Does It Behave?

What Is the Difficulty in Calculating Cost of Capital?

Dr. Tuftes FIN 4250 Notes

What Should Go Into the Cost of Capital?

Other long term items can be added

Dr. Tuftes FIN 4250 Notes

Is the Cost of Bond Financing the Rate On Existing Bonds?

The marginal rate is caused by three things

Is the Earnings/Price Ratio the Cost of Common Stock?

No if the firm is growing

Dr. Tuftes FIN 4250 Notes

Is the Dividend/Price Ratio the Cost of Preferred Stock?

Dr. Tuftes FIN 4250 Notes

How Do I Calculate the Cost of Bonds?

What Are the Pitfalls with the Cost of Bonds?

Yield curve extrapolation

How Do I Calculate the Cost of Common Stock?

Dr. Tuftes FIN 4250 Notes

How Do I Use the CAPM to Calculate the Cost of Equity?

How Do I Use Discounted Cash Flow to Calculate the Cost of Equity?

Dr. Tuftes FIN 4250 Notes

Where Do I Get an Expected Growth Rate to Use for Costing?

Dr. Tuftes FIN 4250 Notes

How Do I Calculate the Cost of Preferred Stock?

Dr. Tuftes FIN 4250 Notes

How Do I Value the Cost of Retained Earnings?

Then make a judgment call combining all of them

How Do I Construct Weighted Cost of Capital?

Usually there are two possibilities:

What Is a Marginal Cost of Capital Chart?

How Is Depreciation Handled?

Dr. Tuftes FIN 4250 Notes

Dr. Tuftes FIN 4250 Notes

What Are the Potential Pitfalls In Calculating the Cost of Capital?

Capital structure may change

What Are the Mistakes to Avoid?

How Is Cost of Capital Used with Hurdles?

Dr. Tuftes FIN 4250 Notes

What About Corporate Divisions With Different Projects?

How Can the Volatility of Different Divisions Be Measured?

How Will Cost of Capital Vary Across Divisions?

Dr. Tuftes FIN 4250 Notes

Dr. Tuftes FIN 4250 Notes

How Serious a Short-Term Problem Can Differences In Divisional Risk Be?

Are There Incentive Problems With Divisions?

What Is Capital Structure?

Dr. Tuftes FIN 4250 Notes

What Is the Appropriate Capital Structure?

Dr. Tuftes FIN 4250 Notes

Why Should We Care About Capital Structure?

In principle, you can measure these with return on equity

What Is the (Nave) Theory of Capital Structure?

What Is the (Not-So-Nave) Theory of Capital Structure?

Dr. Tuftes FIN 4250 Notes

What Is An Even Less Nave Theory of Capital Structure?

Marginal tax rates on debt may be higher than we think