Ian H. Giddy/NYU
Capital Structure-1
Capital Structure
Prof. Ian Giddy
New York University
Corporate Finance
CORPORATE
CORPORATEFINANCE
FINANCE
DECISONS
DECISONS
INVESTMENT
INVESTMENT
FINANCING
FINANCING
PORTFOLIO
RISK
RISKMGT
MGT
MEASUREMENT
CAPITAL
DEBT
M&A
Copyright ©2002 Ian H. Giddy
EQUITY
TOOLS
Capital Structure 2
Ian H. Giddy/NYU
Capital Structure-2
Debt Capital Markets
Corporate financing choices: debt
versus equity (illustrations: Kodak,
Merck, Nokia, Telstra, Astra)
l Evaluating financial structure choices:
l
uEstimating
the cost of debt
uEstimating the cost of equity
SAP Case
l Financial structure for a private firm:
“Argus” example
l
Copyright ©2002 Ian H. Giddy
Capital Structure 3
Merck
Merck
Merck:
Merck:
P/E
P/E22
22
Market
MarketCap
Cap$153b
$153b
Copyright ©2002 Ian H. Giddy
Capital Structure 4
Ian H. Giddy/NYU
Capital Structure-3
Nokia
Nokia
Nokia:
Nokia:
P/E
P/E32
32
Market
MarketCap
Cap$104b
$104b
Copyright ©2002 Ian H. Giddy
Capital Structure 5
Telstra
Telstra
Telstra:
Telstra:
P/E
P/E3.5
3.5
Market
MarketCap
Cap$8b
$8b
Copyright ©2002 Ian H. Giddy
Capital Structure 6
Ian H. Giddy/NYU
Capital Structure-4
Equity versus Bond Risk
Assets
Liabilities
Debt
Uncertain
Uncertain
value
value
of
offuture
future
cash
cashflows
flows
Contractual
Contractualint.
int.&&principal
principal
No
upside
No upside
Senior
Seniorclaims
claims
Control
Controlvia
viarestrictions
restrictions
Equity
Residual
Residualpayments
payments
Upside
Upsideand
anddownside
downside
Residual
Residualclaims
claims
Voting
Votingcontrol
controlrights
rights
Copyright ©2002 Ian H. Giddy
Capital Structure 7
Getting the Financing Right
Step 1: The Proportion of Equity & Debt
n
Debt
n
Equity
Copyright ©2002 Ian H. Giddy
Achieve lowest
weighted average
cost of capital
May also affect the
business side
Capital Structure 8
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Capital Structure-5
Getting the Financing Right
Step 2: The Kind of Equity & Debt
n
n
Short
Shortterm?
term?Long
Longterm?
term?
Baht?
Baht?Dollar?
Dollar?Yen?
Yen?
n
n
n
n
Bonds?
Bonds?Asset-backed?
Asset-backed?
Convertibles?
Convertibles?Hybrids?
Hybrids?
n
n
n
n
n
n
n
n
Debt/Equity
Debt/EquitySwaps?
Swaps?
Private?
Private?Public?
Public?
Strategic
Strategicpartner?
partner?
Domestic?
Domestic?ADRs?
ADRs?
n
n
Ownership
Ownership&&control?
control?
n
n
Debt
Equity
Copyright ©2002 Ian H. Giddy
Capital Structure 9
Does Capital Structure Matter?
Assets’ value is the
present value of the
cash flows from the
real business of the
firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
=D+E
You cannot change the value of the
real business just by shuffling paper
- Modigliani-Miller
Copyright ©2002 Ian H. Giddy
Capital Structure 10
Ian H. Giddy/NYU
Capital Structure-6
Does Capital Structure Matter? Yes!
Assets’ value is the
present value of the
cash flows from the
real business of the
firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
=D+E
COST
OF
CAPITAL
Optimal debt ratio?
DEBT
RATIO
Copyright ©2002 Ian H. Giddy
Capital Structure 11
Does Capital Structure Matter? Yes!
Assets’ value is the
present value of the
cash flows from the
real business of the
firm
Value of the firm
=PV(Cash Flows)
VALUE
OFTHE
FIRM
Debt
Equity
Value of the firm
=D+E
Optimal debt ratio?
DEBT
RATIO
Copyright ©2002 Ian H. Giddy
Capital Structure 12
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Capital Structure-7
Does Capital Structure Matter? Yes!
Assets’ value is the
present value of the
cash flows from the
real business of the
firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
=D+E
Value of Firm
= PV(Cash Flows) + PV(Tax Shield) - Distress Costs
Copyright ©2002 Ian H. Giddy
Capital Structure 13
Changing Financial Mix
l
l
l
Debt is always cheaper than equity, partly
because lenders bear less risk and partly
because of the tax advantage associated with
debt.
Taking on debt increases the risk (and the
cost) of both debt (by increasing the
probability of bankruptcy) and equity (by
making earnings to equity investors more
volatile).
The net effect will determine whether the cost
of capital will increase or decrease if the firm
takes on more debt.
Copyright ©2002 Ian H. Giddy
Capital Structure 14
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Capital Structure-8
Debt: Pros and Cons
Advantages of Borrowing
Disadvantages of Borrowing
1. Tax Benefit:
1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit
Higher business risk --> Higher Cost
2. Added Discipline:
2. Agency Cost:
Greater the separation between managers
Greater the separation between stock-
and stockholders --> Greater the benefit
holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
Copyright ©2002 Ian H. Giddy
Capital Structure 15
Siderar: Steel Company in Argentina
Beta
0.68
0.73
0.80
0.88
0.99
1.14
1.44
1.95
2.93
5.86
Cost of Equity
16.95%
17.76%
18.77%
20.07%
21.81%
24.24%
29.16%
37.29%
52.94%
99.87%
Bond Rating
AAA
AA
AB+
BCCC
CC
C
C
C
Interest rate on debt
11.55%
11.95%
12.75%
14.25%
16.25%
17.25%
18.75%
20.25%
20.25%
20.25%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0%
20%
40%
60%
Debt Percentage
Copyright ©2002 Ian H. Giddy
Tax Rate
33.45%
33.45%
33.45%
33.45%
33.45%
33.45%
25.67%
20.38%
17.83%
15.85%
Value ($millions)
Cost of Capital
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
80%
100%
Cost of Debt (after-tax)
7.69%
7.95%
8.49%
9.48%
10.81%
11.48%
13.94%
16.12%
16.64%
17.04%
WACC
16.95%
16.78%
16.71%
16.90%
17.41%
17.86%
20.02%
22.47%
23.90%
25.32%
Firm Value (G)
$1,046
$1,064
$1,071
$1,052
$1,001
$961
$803
$674
$615
$565
1200
1000
800
600
400
200
0
0%
20%
40%
60%
80%
100%
Debt Percentage
Capital Structure 16
Ian H. Giddy/NYU
Capital Structure-9
Measuring the Cost of Capital
Cost of funding equal return that investors
expect
l Expected returns depend on the risks
investors face (risk must be taken in
context)
l Cost of capital
l
uCost
of equity
uCost of debt
uWeighted average (WACC)
Copyright ©2002 Ian H. Giddy
Capital Structure 17
Let’s Start With the Cost of Debt
l
The cost of debt is the market interest
rate that the firm has to pay on its
borrowing. It will depend upon three
componentsu(a)
The general level of interest rates
u(b) The default premium
u(c) The firm's tax rate
Copyright ©2002 Ian H. Giddy
Capital Structure 18
Ian H. Giddy/NYU
Capital Structure-10
What the Cost of Debt Is and Is Not…
The cost of debt is
uthe
rate at which the company can borrow
at today
ucorrected for the tax benefit it gets for
interest payments.
Cost of debt =
kd = LT Borrowing Rate(1 - Tax rate)
The cost of debt is not
u
the interest rate at which the company
obtained the debt it has on its books.
Copyright ©2002 Ian H. Giddy
Capital Structure 19
Estimating the Cost of Debt
l
If the firm has bonds outstanding, and the bonds are traded, the
yield to maturity on a long-term, straight (no special features)
bond can be used as the interest rate.
l
If the firm is rated, use the rating and a typical default spread on
bonds with that rating to estimate the cost of debt.
If the firm is not rated,
l
u
u
l
and it has recently borrowed long term from a bank, use the interest
rate on the borrowing or
estimate a synthetic rating for the company, and use the synthetic
rating to arrive at a default spread and a cost of debt
The cost of debt has to be estimated in the same currency as
the cost of equity and the cash flows in the valuation.
Copyright ©2002 Ian H. Giddy
Capital Structure 20
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Capital Structure-11
Ratings and Spreads
Corporate bond spreads: basis points over Treasury curve
Rating
1 year
2 year
5 year
10 year 30 year Typical Int Coverage Ratios
Aaa/AAA
40
45
60
85
96 >8.50
Aa1/AA+
45
55
70
95
106 6.50-8.50
Aa2/AA
55
60
75
105
116 6.50-8.50
Aa3/AA60
65
85
117
136 6.50-8.50
A1/A+
70
80
105
142
159 5.50-6.50
A2/A
80
90
120
157
179 4.25-5.50
A3/A90
100
130
176
196 3.00-4.25
Baa1/BBB+
105
115
145
186
208 2.50-3.00
Baa2/BBB
120
130
160
201
221 2.50-3.00
Baa3/BBB140
145
172
210
232 2.50-3.00
Ba1/BB+
225
250
300
350
440 2.00-2.50
Ba2/BB
250
275
325
385
540 2.00-2.50
Ba3/BB300
350
425
460
665 2.00-2.50
B1/B+
375
400
500
610
765 1.75-2.00
B2/B
450
500
625
710
890 1.50-1.75
B3/B500
550
750
975
1075 1.25-1.50
Caa/CCC
600
650
900
1150
1300 0.80-1.25
Copyright ©2002 Ian H. Giddy
Capital Structure 21
Other Factors Affecting Ratios
Medians of Key Ratios : 1993-1995
Pretax Interest Coverage
EBITDA Interest Coverage
AAA
AA
A
BBB
BB
B
CCC
13.50
9.67
5.76
3.94
2.14
1.51
0.96
17.08
12.80
8.18
6.00
3.49
2.45
1.51
69.1%
45.5%
33.3%
17.7%
11.2%
6.7%
26.8%
20.9%
7.2%
1.4%
1.2%
0.96%
21.4%
19.1%
13.9%
12.0%
7.6%
5.2%
17.8%
15.7%
13.5%
13.5%
12.5%
12.2%
21.1%
31.6%
42.7%
55.6%
62.2%
69.5%
33.6%
39.7%
47.8%
59.4%
67.4%
69.1%
Funds from Operations / Total Debt
98.2%
(%)
Free Operating Cashflow/ Total
60.0%
Debt (%)
Pretax Return on Permanent Capital
29.3%
(%)
Operating Income/Sales (%)
22.6%
Long Term Debt/ Capital
13.3%
Total Debt/Capitalization
Copyright ©2002 Ian H. Giddy
25.9%
Capital Structure 22
Ian H. Giddy/NYU
Capital Structure-12
The Cost of Equity
Equity is not free!
Expected return = Risk-free rate + Risk Premium
E(RRisky) = RRisk-free -+ Risk Premium
Copyright ©2002 Ian H. Giddy
Capital Structure 23
The Cost of Equity
Standard approach to estimating cost of equity:
Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,
Rf = Riskfree rate
E(Rm) = Expected Return on the Market Index
(Diversified Portfolio)
l
l
In practice,
u Long term government bond rates are used as risk free rates
u Historical risk premiums are used for the risk premium
u Betas are estimated by regressing stock returns against market
returns
Copyright ©2002 Ian H. Giddy
Capital Structure 24
Ian H. Giddy/NYU
Capital Structure-13
The Cost of Capital
Choice
Cost
1. Equity
Cost of equity
- Retained earnings
- New stock issues
- Warrants
- depends upon riskiness of the stock
- will be affected by level of interest rates
Cost of equity = riskless rate + beta * risk premium
2. Debt
- Bank borrowing
Cost of debt
- depends upon default risk of the firm
- Bond issues
- will be affected by level of interest rates
- provides a tax advantage because interest is tax -deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity =
Capital
Cost of capital = Weighted average of cost of equity and
cost of debt; weights based upon market value.
Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]
Copyright ©2002 Ian H. Giddy
Capital Structure 25
Estimating Cost of Capital: Siderar
l
Equity
u Cost
of Equity = 6.00% + 0.71 (16.03%) = 17.38%
u Market Value of Equity = 3.20* 310.89 = 995 million
(94.37%)
l
Debt
u Cost
of debt = 6.00% + 5.25% + 1.25% (default spread)
= 12.5%
u Market Value of Debt = 59 Mil (5.63%)
l
Cost of Capital
Cost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563))
= 17.38%(.9437) + 8.32%(.0563) = 16.87%
Copyright ©2002 Ian H. Giddy
Capital Structure 26
Ian H. Giddy/NYU
Capital Structure-14
Next, Minimize the Cost of Capital
by Changing the Financial Mix
The first step in reducing the cost of capital is to
change the mix of debt and equity used to finance the
firm.
Debt is always cheaper than equity, partly because it
lenders bear less risk and partly because of the tax
advantage associated with debt.
But taking on debt increases the risk (and the cost) of
both debt (by increasing the probability of
bankruptcy) and equity (by making earnings to equity
investors more volatile).
The net effect will determine whether the cost of
capital will increase or decrease if the firm takes on
more or less debt.
l
l
l
l
Copyright ©2002 Ian H. Giddy
Capital Structure 27
Siderar: Optimal Debt Ratio
Beta
0.68
0.73
0.80
0.88
0.99
1.14
1.44
1.95
2.93
5.86
Cost of Equity
16.95%
17.76%
18.77%
20.07%
21.81%
24.24%
29.16%
37.29%
52.94%
99.87%
Bond Rating
AAA
AA
AB+
BCCC
CC
C
C
C
Interest rate on debt
11.55%
11.95%
12.75%
14.25%
16.25%
17.25%
18.75%
20.25%
20.25%
20.25%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0%
20%
40%
60%
Debt Percentage
Copyright ©2002 Ian H. Giddy
Tax Rate
33.45%
33.45%
33.45%
33.45%
33.45%
33.45%
25.67%
20.38%
17.83%
15.85%
Value ($millions)
Cost of Capital
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
80%
100%
Cost of Debt (after-tax)
7.69%
7.95%
8.49%
9.48%
10.81%
11.48%
13.94%
16.12%
16.64%
17.04%
WACC
16.95%
16.78%
16.71%
16.90%
17.41%
17.86%
20.02%
22.47%
23.90%
25.32%
Firm Value (G)
$1,046
$1,064
$1,071
$1,052
$1,001
$961
$803
$674
$615
$565
1200
1000
800
600
400
200
0
0%
20%
40%
60%
80%
100%
Debt Percentage
Capital Structure 28
Ian H. Giddy/NYU
Capital Structure-15
Case Study: SAP
Copyright ©2002 Ian H. Giddy
Capital Structure 29
Case Study: SAP
Debt
0
2500
5000
7500
10000
l
l
l
Rating
AAA
AAA
A
AB+
Interest Interest
rate expense
5.65%
11
5.65%
153
6.37%
331
6.56%
505
10.90%
1,112
Interest
Debt /
coverage capitaliz Debt/book
ratio
ation
equity
138.76
1%
0.1
10.28
7%
0.7
4.73
14%
1.4
3.10
21%
2.1
1.41
27%
2.7
Should SAP take on additional debt? If so,
how much?
What is the weighted average cost of capital
before and after the additional debt?
Can you estimate the benefit/cost to
shareholders if SAP takes on more debt?
Copyright ©2002 Ian H. Giddy
Capital Structure 30
Ian H. Giddy/NYU
Capital Structure-16
Equity is a Cushion; Debt is a Sword
l
l
l
Debt is always cheaper than equity, partly
because lenders bear less risk and partly
because of the tax advantage associated with
debt.
Taking on debt increases the risk (and the
cost) of both debt (by increasing the
probability of bankruptcy) and equity (by
making earnings to equity investors more
volatile).
The net effect will determine whether the cost
of capital will increase or decrease if the firm
takes on more debt.
Copyright ©2002 Ian H. Giddy
Capital Structure 31
Contact
Ian H. Giddy
NYU Stern School of Business
44 West 4th Street, New York, NY 10024, USA
Tel 212-998-0426
ian.giddy@nyu.edu
http://giddy.org
Copyright ©2002 Ian H. Giddy
Capital Structure 36