8b does debt matter WACC compatibility mode

Cost of Equity The cost of equity is the return required by equity investors, given the risk of the cash flows from the firm There are two major methods for determining There are two

Does Debt Policy Matter?

Brealey, Myers, Partington and Robinson

1st Australian Edition

Slides by

Matthew Will

and Graham

Topics Covered

 Cost of capital and WACC

 Leverage in a Tax Free Environment

 How Leverage Influences Returns

 The Traditional Position

 The Traditional Position

Cost of Equity

 The cost of equity is the return required by

equity investors, given the risk of the cash flows from the firm

 There are two major methods for determining

 There are two major methods for determining the cost of equity

 Dividend growth model

 SML or CAPM

The Dividend Growth Model

Approach

 Start with the dividend growth model formula

D

g P

D R

g R

D P

Dividend Growth Model

Example

 Suppose that your company is expected to

pay a dividend of $1.50 per share next year

There has been a steady growth in dividends

of 5.1% per year and the market expects that

of 5.1% per year and the market expects that

to continue The current price is $25 What is the cost of equity?

% 1 11 111

051

.

50

1

=

= +

=

R

Example: Estimating the Dividend

Growth Rate

 One method for estimating the growth rate is

to use the historical average

 Year Dividend Percent Change

Advantages and Disadvantages of

Dividend Growth Model

 Advantage – easy to understand and use

 Disadvantages

 Only applicable to companies currently paying dividends

Not applicable if dividends aren’t growing at a

 Not applicable if dividends aren’t growing at a reasonably constant rate

 Extremely sensitive to the estimated growth rate –

an increase in g of 1% increases the cost of equity

by 1%

Cost of Debt

 The cost of debt is the required return on company’s

debt

 Usually focus on the cost of long-term debt or bonds

 The required return is best estimated by computing the yield-to-maturity on the existing debt

yield-to-maturity on the existing debt

 We may also use estimates of current rates based on the bond rating we expect when we issue new debt

 The cost of debt is NOT the coupon rate

Example: Cost of Debt

 Suppose we have a bond issue currently

outstanding that has 25 years left to maturity The coupon rate is 9% and coupons are paid semiannually The bond is currently selling

semiannually The bond is currently selling for $908.72 per $1000 bond What is the cost

of debt?

 N = 50; PMT = 45; FV = 1000; PV = -908.75;

CPT I/Y = 5%; YTM = 5(2) = 10%

Cost of Preferred Stock

 Preferred stock is a perpetuity, so we take the

Example: Cost of Preferred

Weighted Average Cost of

Capital - WACC

 Cost of overall capital of a company is the

“average” cost of capital sources of the firm.

 This “average” cost is the required return on

all the assets of the company, based on the

all the assets of the company, based on the market’s perception of the risk of those assets

 The weights are proportions of each type of

capital the company use

Capital Structure Weights

 Notation

 E = market value of equity = # of outstanding shares * price per share

 D = market value of debt = # of outstanding bonds * bond price

 PS = market value of preferred stock= # of outstanding preferred stocks * preferred stock price

 V = market value of the firm = D + E + PS

 Weights

 w E = E/V = proportion of capital financed with equity

 w D = D/V = proportion of capital financed with debt

 wP = PS/V = proportion of capital financed with preferred stock

Example: Capital Structure

Weights

 Suppose you have a market value of equity

equal to $500 million and a market value of debt = $475 million.

 What are the capital structure weights?

 What are the capital structure weights?

• V = 500 million + 475 million = 975 million

• w E = E/V = 500 / 975 = 5128 = 51.28%

• w D = D/V = 475 / 975 = 4872 = 48.72%

Taxes and the WACC

 In evaluating projects, cash flow after tax is the concern

To evaluate this after-tax cash flow, we need to use after-tax cost of capital

 Interest expense reduces tax liability

 This reduction in taxes reduces company’s cost of debt (called

 This reduction in taxes reduces company’s cost of debt (called interest tax shield)

 After-tax cost of debt = R D (1-T C )

 Dividends are not tax deductible, so there is no tax

impact on the cost of equity

Extended Example – WACC

 Equity Information

 400 million shares

 Current stock price = $10

 Last year dividend = $.68

 Debt Information

 $1 billion in outstanding debt (face value)

 Current quote = 110% of face value

 Constant dividend growth rate = 8%

 Face value = $1000

 Coupon rate = 9%, semiannual coupons

 15 years to maturity

 Tax rate = 40%

Extended Example – WACC

 What is the cost of equity?

Extended Example – WACC

 What are the capital structure weights?

M&M PROPOSITION:

DEBT POLICY DOESN’T MATTER

MATTER

M&M (Debt Policy Doesn’t Matter)

 Modigliani & Miller

 Given investment policy, no taxes and perfect capital markets it makes no difference whether the firm borrows, or individual shareholders borrow Therefore, the market value of a

borrow Therefore, the market value of a company does not depend on its capital structure.

 Put another way, given investment policy, total future cash flow and risk are determined

Therefore, How that total cash flow and risk is

M&M (Debt Policy Doesn’t Matter)

Assumptions

 Capital structure does not affect cash flows e.g

 No taxes

 No bankruptcy costs

 No effect on management incentives

 No effect on management incentives

 By issuing 1 security rather than 2, company

diminishes investor choice This does not reduce value if:

Example - Macbeth Spot Removers - All Equity Financed

10,000

$ Shares of

Value Market

$10 share

per Price

1,000 shares

of Number

Data

M&M (Debt Policy Doesn’t Matter)

2,000 1,500

1,000

$500 Income

Operating

D C

B

A

Outcomes

10,000

$ Shares of

Value Market

Expected

of ue Market val

5,000

$ Shares of

Value Market

$10 share

per Price

500 shares

of Number Data

500 500

500

$500 Interest

000 , 2 1,500 1,000

$500 Income

Operating

C B

A

Outcomes

D

Example - Macbeth’s - All Equity Financed

- Debt replicated by investors Who borrow to finance 50%

of their share investment

Outcomes

M&M (Debt Policy Doesn’t Matter)

3.00 2.00

1.00 0

$ investment

on earnings

Net

1.00 1.00

1.00

$1.00 10%

@ Interest :

LESS

4.00 3.00

2.00

$1.00 shares

on two Earnings

D C

B A

MM'S PROPOSITION I

If capital markets are perfect, firms cannot increase value by tinkering with capital structure.

No Magic in Financial Leverage

V is independent of the debt ratio.

The sum of the parts is equal to the whole.

Proposition I and Required

Returns

: Structure Proposed

: Structure Cuttent

Macbeth continued

20 15

(%) share

per return Expected

10 10

($) share per

Price

2.00 1.50

($) share per

earnings Expected

Equity and

Debt Equal

: Structure Proposed

Equity All

: Structure Cuttent

Leverage and Returns

securities all

of ue market val

income operating

expected r

assets on

return Expected = a =

Expected return on assets equals the expected return on the firm’s

=

E D

E r

E D

D r

r

Expected return on assets equals the expected return on the firm’s portfolio of issued securities.

of ue market val

income operating

expected r

r E = A =

When Macbeth is all equity:

M&M Proposition II

15

000 , 10

1500

securities all

of ue market val

income operating

expected r

r = + − Macbeth continued

15

000 ,

=

E

r

Leverage and Risk

1.50 50

($) share per

Earnings equity

All

$1,500

Income

$500 Operating

Macbeth continued

Leverage increases the risk of Macbeth shares

20 0

shares on

Return

2 0

($) share per

Earnings :

debt

% 50

15 5

shares on

Return

1.50 50

($) share per

Earnings equity

All

Leverage and Risk

A

E D

E E

D

D

β β

E

D

β β

β

Returns and Beta

.20=r E

Required Return

.10=r D

All assets

The Traditional Position and

 WACC is the basis for the traditional view of

capital structure, risk and return.

r WACC

DANGER: Handle WACC with care

1 The objective is NOT to minimise WACC

Example - A firm has $2 mil of debt and

100,000 of outstanding shares at $30 each If they can borrow at 8% and the shareholders require 15% return what is the firm’s WACC? require 15% return what is the firm’s WACC?

D = $2 million

E = 100,000 shares X $30 per share = $3 million

Example - A firm has $2 mil of debt and 100,000 of

outstanding shares at $30 each If they can borrow at 8% and the shareholders require 15% return what is the firm’s

V D WACC

r E

Traditional Position and WA

Assuming r E is invariant to leverage:

r D

Absurd!