corporate finance vi escp-eap - european executive mba 14-15 dec. 2005, london weighted average cost...

CORPORATE FINANCEVI

ESCP-EAP - European Executive MBA

14-15 Dec. 2005, London

Weighted Average Cost of Capital (WACC)

Cost of equity, cost of debt

Capital structure

I. Ertürk

Senior Fellow in Banking

After Tax WACC

ED r

V

Er

V

DTcWACC )1(

Tax Adjusted Formula

After Tax WACCExample - Sangria Corporation

The firm has a marginal tax rate of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

After Tax WACCExample - Sangria Corporation - continued

Balance Sheet (Book Value, millions)Assets 100 50 Debt

50 EquityTotal assets 100 100 Total liabilities

Balance Sheet (Book Value, millions)Assets 100 50 Debt



Balance Sheet (Market Value, millions)Assets 125 50 Debt





Debt ratio = (D/V) = 50/125 = .4 or 40%

Equity ratio = (E/V) = 75/125 = .6 or 60%

ED r

V

Er

V

DTcWACC )1(


ED r

V

Er

V

DTcWACC )1(

%84.10

1084.

146.125

7508.

125

50)35.1(

WACC

After Tax WACC

Preferred stock and other forms of financing must be included in the formula.Preferred Stock - Stock that takes priority over common stock in regards to dividends.

EPD r

V

Er

V

Pr

V

DTcWACC )1(

After Tax WACC


25 Preferred Equity50 Common Equity

Total assets 125 125 Total liabilities

%92.9

0992.

146.125

5010.

125

2508.

125

50)35.1(

WACC

Example - Sangria Corporation - continuedCalculate WACC given preferred stock is $25 mil of total equity and yields 10%.

What should be included with debt?

Long-term debt?

Short-term debt?

Cash (netted off?)

Receivables?

Deferred tax?

COST OF CAPITAL

How are costs of financing determined? Return on equity can be derived from market data. Cost of debt is set by the market given the specific

rating of a firm’s debt. Preferred stock often has a preset dividend rate.

Corporate Debt

Subordinate Debt - Debt that may be repaid in bankruptcy only after senior debt is repaid.

Secured Debt - Debt that has first claim on specified collateral in the event of default.

Investment Grade - Bonds rated Baa or above by Moody’s or BBB or above by S&P.

Junk Bond - Bond with a rating below Baa or BBB.

Corporate Debt

Debt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company.

“Default Risk” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily.

“Bond Ratings”are issued on debt instruments to help investors assess the default risk of a firm.

BONDS

INTEREST PAYING DEBT, PRINCIPAL OR FACE VALUE OR PAR VALUE REPAID AT END OF LOANSTATED INTEREST RATE CALLED COUPONDENOMINATIONS (OR PAR VALUES) OF CORPORATE BONDS TYPICALLY $1,000. GOVERNMENT BONDS USUALLY HAVE GREATER PAR VALUES. PRICE OFTEN STATED AS PERCENTAGE OF PAR VALUEBOND SELLING AT PAR IS SELLING “FLAT”- 100% OF PAR AT DISCOUNT IF PRICE < 100% OF PAR AT PREMIUM IF PRICE > 100% OF PAR

MATURITY IS THE LIFE OF THE BONDBONDS PAY INTEREST SEMIANNUALLY OR ANNUALLY

RENAULT

Corporate Debt

Eurodollars - Dollars held on deposit in a bank outside the United States.

Eurobond - Bond that is marketed internationally.Private Placement - Sale of securities to a limited number of

investors without a public offering.Protective Covenants - Restriction on a firm to protect

bondholders.Convertible Bond - Bond that the holder may exchange for a

specified amount of another security.

Convertibles are a combined security, consisting of both a bond and a call option.

6%, 5 year bonds

CASH FLOWS AT END OF EACH YEAR

1995 1996 1997 1998 1999

60 60 60 60 1,060SIMILAR BONDS RETURN 6.9% (YIELD TO MATURITY-YTM)

BOND IS SELLING AT 96.3% (OF PAR VALUE)

PV60

(1.069)60

(1.069)

60

(1.069)

60

(1.069)

1,060

(1.069)9632 3 4 5

COUPONS ARE ANNUITY

PV(BOND) =

PV (COUPON PAYMENTS) + PV (FINAL PAYMENT)

PV(COUPON PAYMENTS) IS THE PV OF AN ANNUITY

PV(BOND)

601

.0691

.069(1.069)

1,000

(1.069)( )5 5

= 246.67 + 716.33

= €963

PRICE OF BOND

AFTER BOND IS ISSUED, INTEREST RATES ON SIMILAR BONDS CHANGE BUT CASH FLOWS FROM BOND STAY SAME

PRICE OF BOND WILL VARY BECAUSE THE PRICE IS THE PV OF THE REMAINING CASH FLOWS

DISCOUNT RATES CHANGE WITH CHANGES IN YIELD TO MATURITY (YTM) OR YIELD ON SIMILAR BONDS

YIELD TO MATURITY

TURN THE QUESTION AROUND ASK WHAT RETURN, r, DO INVESTORS EXPECT WHEN A 5-YEAR, 6% COUPON BOND IS PRICED AT 96.3?WE NEED TO FIND THE VALUE OF r THAT SATISFIES THE EQUATION

r IS THE YIELD TO MATURITY (YTM) OR YIELDWE ASSUME A FLAT TERM STRUCTURE OF INTEREST RATES

96360

(1+R)60

(1+R)

60

(1+R)

60

(1+R)

1,060

(1+R)2 3 4 5

ANNUAL COUPON RATE IS QUOTED AS TWICE THE SEMIANNUAL COUPON RATE 6% COUPON BOND PAYS €30 TWICE A YEAR

BOND YIELD IS QUOTED AS TWICE THE SEMIANNUAL BOND YIELD

PV30

(1.0345)30

(1.0345)

1,030

(1.0345)2 10 . . . . . . . . . . . . . . . . . . . . . . . . . .

BONDS MAKE SEMI-ANNUAL COUPON PAYMENTS

ANNUAL COUPON C, ANNUAL YIELD TO MATURITY r, PRINCIPAL F

2n2n2 )2

(1)2

(1

2............)

2(1

2

)2

(1

2PVrr

C

r

C

r

C

F

VALUE OF A BOND

WHEN MARKET INTEREST RATES RISE, BOND PRICES FALL.

WHEN MARKET INTEREST RATES FALL, BOND PRICES RISE.

BOND PRICE SENSITIVITY TO CHANGES IN INTEREST RATESGREATER

1. LONGER CURRENT MATURITY

2. LOWER THE COUPON RATE.

INTEREST RATE RISK

MORE OF THE PRICE OF THE BOND IS DERIVED

FROM CASH FLOWS (INTEREST AND

PRINCIPAL) THAT OCCUR LATER IN TIME

AND THEREFORE HAVE TO BE DISCOUNTED

MORE

MORE SENSITIVE TO CHANGES IN INTEREST

RATES

LONGER MATURITY BONDS ARE MORE SENSITIVE TO INTEREST RATES

EXAMPLE:

1

(12)60

rIS MORE SENSITIVE TO CHANGES IN r THAN

1

(12)2

r

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure & Corporate Taxes

Capital StructureStructure of Bond Yield Rates

D

E

Bond

Yield

r

Weighted Average Cost of Capitalwithout taxes (traditional view)

r

DV

rD

rE

Includes Bankruptcy Risk

WACC

0% 10% 20% 30% 40% 50% 60%Debt Cost 7.0% 7.1% 7.2% 7.3% 8.0% 9.0% 11.0%Equity Cost 14.0% 14.1% 14.2% 14.5% 15.5% 17.5% 20.0%

WACC 14.0% 13.4% 12.8% 12.3% 12.5% 13.3% 14.6%

Gearing Ratio (Debt / Debt+Equity)

20.0%

14.5% 14.6%14.0%

12.3% 11.0%

7.0% 7.3%

5%

7%

9%

11%

13%

15%

17%

19%

0% 10% 20% 30% 40% 50% 60%Gearing

Cos

t

EquityCost

WACC

Debt Cost

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

European Telecoms 2003

DEBT TO TOTAL CAPITAL

Book Book, Market Market, Adjusted Adjusted

Canada 39% 37% 35% 32%France 48 34 41 28Germany 38 18 23 15Italy 47 39 46 36Japan 53 37 29 17United Kingdom 28 16 19 11United States 37 33 28 23

Patterns of Corporate Financing

Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Pecking Order Theory

Consider the following story:

The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Some Implications:

Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).

Telus Cost of Capital

Liabilities Book Market MV Cost Cost MV weightedValue Value Weight before-tax after-tax cost

Accounts payable and accrued liabilities + other short-term liabilities 1,326 1,326

Short-term obligations 5,033 5,033 30.49% 5.86% 2.92% 0.89%Other short-term liabilities 310 310 1.88% 2.28% 1.14% 0.02%Long-term debt (includes other long-term liabilities) 3,328 3,927 23.79% 9.31% 4.65% 1.11%

Preferred shares 70 59 0.36% 6.15% 6.15% 0.02%

Common shares 4,785Retained earnings 1,563Total common shareholders' equity 6,348 7,175 43.47% 10.61% 4.61%

Total liabilities and equity 16,415 16,504 100.00% 6.65% WACC

9.87% Cost of equity before issue costsTax 50.10% 10.61% Cost of equity after issue costs

corporate finance vi escp-eap - european executive mba 14-15 dec. 2005, london weighted average cost...

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