AFM 373 Hayes Lecture 8 Capital Structure & WAAC

7/25/2019 AFM 373 Hayes Lecture 8 Capital Structure & WAAC

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AFM 373

Lecture 8

Weighted Average Cost ofCapital (WACC)


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ACC 690 Course Overview

1. Introduction; Managing C/A; Cash Flow Forecasting

2. Managing C/L; Issuing Short Term Debt & ABL3. Issuing LTD; Debt Ratings; Debt Covenants

4. Issuing Equity; IPOs, PE, VC

5. Wtd. Average Cost of Capital; Determining Capital Structure

6. Valuation Overview; Intro to M&A7. Mergers & Acquisitions - Structure; Leveraged Buyouts

8. Mergers & Acquisitions - Process; Due Diligence

9. Capital Budgeting; Lease vs. Buy/Borrow

10. Financial Distress & Turnarounds

11. Financial Risk Management & Derivative Use

12. Dividend & Payout Policy; Managing Corporate Investments


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Weighted Average Cost of Capital

(WACC)

The weighted average cost of capital (WACC)

serves three primary purposes:

1. To evaluate capital project proposals.2. To set performance targets for management to

sustain or grow market values, and

3. To measure management performance.


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Steps in Solving for the WACC

1. Identify the sources of capital (Debt and Equity).

2. Estimate the market values for each source of

capital and determine the market value weights.

3. Estimate the marginal, after-tax, and after-

floatation cost for each source of capital.

4. Calculate the weighted average.


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What is Included in WACC ?

Cost of Each Type of Capital for the Company,proportionally weighted, typically including:

Debt Costs:

Bank loans

Long-term debtbonds/debentures

Equity Costs:

Preferred equity costs

Common equity costs


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Weighted Average Cost of Capital - WACC

PSED

PSK

PSED

DK

PSED

EK psdeWACC

Need to calculate for each type of capital:

1) market value of each type of capital

2) % of each type of capital in total capital,

3) and the respective marginal cost of each (Kd , Ke, Kps)


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Why Use Current Market Rates for

each Type of Capital?

The Firm is making a Key Decision NOW

Therefore, the cost of capital 5 months, 5 years or

5 decades ago is irrelevant.

What is relevant NOW is the rate that each type ofcapital costs in todays economic environment for

this particular firm.

Sometimes called the Marginal Cost of Capital


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Cost of Debt - Kd

This is the current cost to the firm for borrowing

funds based on:

Current interest rate levels

Default risk of company

Tax Shield from Interest


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Importance of Tax Deductibility of Interest

Key Concept:

in WACC equation Kd - is after tax cost of debt,

reflecting that interest is tax deductible

Therefore Kd = rd(1-t)

Where:

rd= pre-tax cost of Debt

t = Marginal tax rate of the firm( Fed+ Prov.)


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WACC- Simple Capital Structure

Once you have the specific marginal costs of capital (after accounting for taxes

and floatation costs) and you have found the appropriate weights to use, the

actual calculation of a WACC is a simple matter.

)1(

V

DTK

V

SKKWACC dea

The cost of equity

times the market

value weight of

equity

The cost of debt

after tax times the

market value weight

of debt


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Weighting Each Capital Component

Each Type of Equity would have its own

weighting component

Each Types of Debt would have its ownweighting component


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WACC - Spreadsheet Example

(1) (2) (3) (4) = (2)*(3)

Type of

Capital

Specific

Marginal Cost

after tax and

floatation

costs

Market

Value

Weights

Weighted

Specific

Marginal

Cost

Long-Term Debt 5.5% 43.0% 0.02365

Preferred Stock 11.4% 11.0% 0.01254

Common Stock 12.9% 46.0% 0.05934

WACC = 9.55%

WACC is the sum of the weightedspecific marginal costs of each source ofcapital.


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Determining - Current Market Value

of a Bond

Requires market value of debt (not book value)

rd = the market rate of debt given default risk (not necessarilythe coupon rate, but the current market rate for that company to issue at)

This is the rate that you discount back the cash flows at.

N

Nt

tt

)r(1

bondofvalueface

)r(1

CouponBondCorporateofValueMkt

d

1

d


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Cost of Preferred Equity

If viewed preferred as perpetual, has a fixed dividend,

(PV of a perpetuity formula)

Preferred Share dividends are paid from after tax

dollars - (do not tax effect the rate)

prefofpricemarket

dividend)(or totalshareperdividendK

ps


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Market Value of Common Equity

For a Public company:

= # of common shares O/S X current stock price

If there are warrants and options, ( in the money) you

must calculate the equity like options current market

value and add to common equity value


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Market Value of Common Equity

Cost of Equity may be observable in the Market, through

comparable securities.

Various models can be used to estimate Cost of Equity.

We will emphasize Capital Asset Pricing Model(CAPM). According to some studies 80%+ use this method.

Originated by Prof. William Sharpe, Stanford U. in 1964

For his work on CAPM, Sharpe shared the 1990 Nobel Prize

in Economics with Markowitz and Miller.


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Capital Asset Pricing Model (CAPM)[calculating the Ke]

jFMFj RRERK ))((

Risk Free Rate

Market Risk Premium

RM= Expected Return on MarketSystematic risk of individual security - tendency ofthe security to move with all the other securities in the market and by how

much

Expected Rate of Return or E(Re)


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Risk-Based Models and the Cost of

Common EquityUsing the CAPM to Estimate the Cost of Common Equity

CAPM can be used to estimate the required return by

common shareholders.

It can be used in situations where DCF methods will

perform poorly (growth firms) CAPM estimate is a market determined estimate

because:

The RF (risk-free) rate is the benchmark return and is measured

directly, today as the yield on 91-day T-bills The market premium for risk (MRP) is taken from current market

estimates of the overall return in the market place less RF (ERM

RF)

i k d d l d h f


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Risk-Based Models and the Cost of Common

EquityUsing the CAPM to Estimate the Cost of Common Equity

As a single-factor model, we estimate the common shareholders required

return based on an estimate of the systematic risk of the firm (measured by the

firms beta coefficient)

Where:

Ke = investors required rate of return

e = the stocks beta coefficient

Rf = the risk-free rate of return

MRP= the market risk premium (ERM - Rf)

MRPRK eFe [ 20-26]

Ri k B d M d l d h C f


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Risk-Based Models and the Cost of

Common EquityEstimating the Market Risk Premium

Rfis observable (yield on 10+ year Govt Bonds) Not T-bill rates

Getting an estimate of the market risk premium is one of the

more difficult challenges in using this model.

We really need a forward looking of MRP or a forward looking

estimate of the ERM

One approach is to use an estimate of the current, expected MRP

by examining a long-run average that prevailed in the past.

MRPRK eFe [ 20-26]


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Canadian Market Risk Premium

(MRP)

(1938-2005)

The consensus is that the Canadian MRP over the

long-term bond yield is between 4.0 and 5.5%.

Stock returns exceeded Bond returns by 5.17%Source: Booth & Cleary ; data from Canadian Institute of Actuaries

Average

Investment Return

Canada T-Bills 5.20%

Canada Bonds 6.62%

Canadian Stocks 11.79%

U.S. Stocks 13.15%

21


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Cost of Common Equity

Estimating Beta

After obtaining estimates of the two

important market rates (Rfand MRP), an

estimate for the company beta is required.

In some cases, Beta may have to be

unlevered and re-levered?

Why ?


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Unlevering and Re-levering Beta

If the debt level changes dramatically, beta forEquity may have to be re-calculated.

For example, a significant new Debt issuance, or a

large Debt repayment.

Why ?

The main impact of leverage on WACC is the

interest tax shield.


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We can unlever and relever Beta using the Hamada

Equation (there are several others that serve the

purpose).

Hamada essentially combined the effects of CAPM

with M&M theory. Assumes constant amount of debt (vs. constant D/E)

It separates out the effect of financial leverage from

the underlying business risk of the firm by comparing

a firm with an unlevered counterpart.

U l i d R l i B t


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an Example going from D/E of 1.5 to 4.0

( assume a 35% Tax rate)

BL =BU * (1+ (D/E*(1-T))

BU = BL / (1+ (D/E*(1-T))

If Original D / (D+E) =.60

Then D / E= .60 /.40 (i.e. 1.5:1)

Original Levered Beta = 1.25

Then Bu = 1.25 / 1+(60/.40) *(1-.35)

Bu= 1.25 / 1.975

Bu=.63

R l i B t E l


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Re-levering Beta- Example

Going from D/E of 1.5:1 to 4:1

with 35% Tax Rate

BL =BU (1+ (D/E)*(1-T))

BU = BL / (1+ (D/E) *(1-T))

New D / (D+E) =.80

Then D / E= .80 /.20 (4:1)

Then New Levered Beta isThen BL = .63 *(1+(1-.35)*.80/.20)

BL= .63 * 2.6

BL= 1.64


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Re-levering Beta- Example

with 35% Tax Rate

Now, use the new levered Beta to

determine revised Ke and WACC!


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Preferred SharesGeneral Features Shares can have a number of designationscommon, ordinary, Class A and

preferred

Preferred shares typically occupy a position between the companies creditorsand common shares

They have a prior claim on assets ahead of common shares in a windup or

dissolution of the company

Prefs are usually entitled to a fixed dividend payment out of net earnings

Cumulative Feature - dividends do not have to be paid, but if skipped unpaiddividends accumulate.

Most are non-voting, unless a certain number of dividends have been missed

(typically 8 quarterly) ; then they have voting privileges

There is no maturity date

Prefs do not have a trust indenture (like debt does). The description of preferreds

is in the companys charter

There are many different features that preferred shares can have, some strengthen

the issuers position and others protect the purchaser


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Preferred Shares - From an Issuers Perspective

Issuers perspective - Prefs are debt that get treated as equity

from rating agencies and regulators the dividend can be suspended - unlike debt, where the co. would go into default

dividend is paid out of after tax dollars, same as a regular common share

dividend

Motivation to Issue Preferred Shares - overall two main types of

issuers:i) Corporations that are regulated a) firms want more equity but regulator says no- ie

company that has rate of return considerations

b) regulator wants firm to have more equity than they wish

ii) Corporations trying to maintain a debt rating (avoid a lower rating), or corporations that do

not want dilution of have control issues

Many features and options - flavour of the times: hard retraction, soft

retraction, redeemable, auction set

Currently Issuers are - approximately 30% Financial Institutions, 50%

utilities, 20 % industrials


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Preferred Share Features

Most preferreds have a fixed dividend expressed as a % of

par or a stated value e.g. 8% of par or $2.00 (par is typically $25)

Other Common Features Convertiblethe holder can convert the pref into common shares at a

predetermined price (conversion price) for a certain time period. Once the

underlying common reaches that level the prefs price starts to reflect the

common stocks mkt price

Redeemablemost convertible prefs are redeemablewhich gives the issuer

the right to force conversion into the underlying shares, when the market price

of these shares is above the conversion price.

Retractablemeans the holder can require the company to buy back theretractable preferred on a specified date(s) and at a predetermined price

(retraction price)


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Preferred Shares - Investor Perspective

Dividend Tax Credit

Because dividends are paid from a companys after tax earnings thegovernment gives investors a bit of a tax break (ie pay less tax ondividends)

Dividend Tax Credit: dividends are taxed at a lower rate

The calculation (which is confusing) consists of grossing up theamount of dividend by 25%, calculating the federal taxes and

deducting a federal tax credit of 16.667% of dividend received . Theprovinces also have their own dividend tax credit for provincial taxes

as a rule of thumb most investors consider preferreds as a debtalternative and gross up Cdn preferred dividends by a set amount inorder to equate (compare) returns with those of interest bearing

instruments (bonds, GICs)


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Market Value WeightsAn Example

Given:

Market price for common stock = $21.50

Bonds are trading for 95% of face value

In order to calculate market value (MV) weights, you will need

to know the total market value of debt, and common stock (and

preferred stock if the company uses it.)

To calculate total MV you need to know the current price of the

security in each class, as well as the total number of securities

outstanding:

Total Market Capitalization = Price Quantity


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Market Value Weights - Example

XYZ Company LimitedBalance Sheet

as at January 30, 2xxx

ASSETS LIABILITIES:

Current Assets $147,000 Current Liabilities $75,250

Net Fixed Assets 15,000,250 8.5% 2020 Mortgage Bonds 4,000,000

Common stock (1,000,000 outstanding) 7,155,000Retained earnings 3,917,000

TOTAL ASSETS $15,147,250 TOTAL LIABILITIES AND O.

EQUITY $15,147,250

Number of common sharesoutstanding is read from the

balance sheet.

Face value of bonds are

$1,000, therefore there mustbe 4,000 bonds outstanding.

The following balance sheet date, when combined with market

price data, wil l allow you to calculate MV weights.


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Market Value WeightsAn Example Continued

Total MV of Equity = Price per share times number of shares = 1M $21.50 = $21.5M

Total MV of Bonds = Price per bond times number of bonds = $950 4,000 = $3,800,000

Type of

Capital

Market

price Number

Total Market

Value

Market

Value

Weight

Bonds $950.00 4,000 $3,800,000 15.02%

Stock $21.50 1,000,000 $21,500,000 84.98%

TOTAL= $25,300,000 100.00%

These weights could now be used to calculate WACC.


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Bond ValueGeneral Formula

)k(

Fk

)k(IB

n

bb

n

b

1

1111

[ 20-12]

Where:I = interest (or coupon ) payments

kb = the bond discount rate (or market rate)

n = the term to maturity

F = Face (or par) value of the bond

In the example, you didnt have to calculate the bond value because you weregiven the fact that it was trading at 95% of par.

In the event that you do, however, simply use this equation


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Floatation Costs

Issuing or floatation costs are incurred by a firm when itraises new capital through the sale of securities in theprimary market.

These costs include: Underwriting discounts paid to the investment dealer

Direct costs associated with the issue including legal andaccounting costs

The result: Net proceeds on the sale of each security is less than what the

investor invests, and

The component cost of capital > investors required return.


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Average Floatation Costs

Commercial paper 0.125%

Medium-term notes 1.0%

Long-term debt 2.0%Equity (large) 5.0%

Equity (small) 5.0% - 10.0%

Equity (private) 10.0% and up

Average Issuing Costs

Floatation costs for

debt securities is

lowest because debt is

normally privately

placed with large

institutional investors

not requiring

underwriting costs andbecause debt is either

issued by high quality

issuers or sits at the

top of the priority of

claims list in the case

of default.


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The Component Cost of Debt

The cost of debt is a function of:

The investors required rate of return The tax-deductibility of interest expense

The floatation costs incurred to issue new debt


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WACCCommon Calculation

Errors Cost of Debt

Any Ideas ??


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WACCCommon Calculation Errors

Cost of Debt

Must Use Using Market Value ofDebt (versus trading at Par 100).

Must use (1-T) to get the after taxcost

Forgetting Floatation Cost


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Cost of Preferred Shares

Any Ideas ??


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Cost of Pref. Shares

Must Use Market Value of Pref Shares

Divide dividend per share by current

market price per pref. share



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Cost of Common Shares

Any Ideas ??


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Cost of Common Shares

Must Use Market Value ofCommon

In CAPM, for Rf, should useLonger Term Govt Debt (10 +Years), not short term T-Bill rates.



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WACC -Summary

WACC measures the firms cost of financing today,based on current capital market conditions.

WACC is the Default Firms Discount Rate.

WACC is used to make capital investment decisions.


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Raptor IndustriesWACC Problem

Review Solution


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Determining Capital Structure

in Practice

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Leverage in Practice

The tradeoff theory helps explain: Why firms choose debt levels that are below the

maximum, to avoid the costs of financial distress.

Industry differences in the use of leverage because of

different financial distress costs and the volatility of

cash flows.


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Needs to be viewed as a dynamic processToo aggressive can lead to financial distress andbankruptcy

Excess conservatism can put you at a competitivedisadvantage by having a higher cost of capital, and

may also flag you as a takeover target. The addition of a reasonable amount of debt to

the capital structure can reduce WACC.

Therefore shareholders receive greater should be

reflected in increase stock price. All of the return, in excess of its WACC, are gains

that accrue to common shareholders

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Management of Capital Structure


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Capital Structure in Practice

Factors favouring corporate ability and willingnessto issue debt:

Capital Market Conditions: Is this a Good Time toIssue Equity? Is this a Good Time to Issue Debt?

Profitability (so the firm can use interest taxshield)

Unencumbered tangible assets to be used ascollateral for secured debt.

Stable business operations over time. Corporate size larger companies may have

greater market acceptance.

Growth rate of the firm.50


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Primary Factors in Determining

Debt Level (Deutsche Bank 2006)

1. Effect on Credit Rating (57%)

2. Ability to Continue Investments (52%)

3. Tax Shield (32%)

4. Ability to Continue Dividends (31%)5. Market Capacity for our Debt (29%)

6. Debt Transaction Costs (25%)

7. Action of Industry Competitors (20%)


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Limits to Debt

What Factors Limit a Companys

Use of Debt ?


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Limits to Debt

Covenants in Existing Debt Securityre: Maximum Leverage

Covenants in Existing Debt Securityre: Minimum Debt service

High Interest Rates

Ability to Service New Debt fromForecast Cash Flow

AFM 373 Hayes Lecture 8 Capital Structure & WAAC

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