This chapter has provided background on four tools that can be used to analyze

capital structure.

The first approach is based upon operating income. Using historical data or forecasts,

•

we develop a distribution of operating income across both good and bad scenarios.

We then use a pre-defined acceptably probability of default to specify the maximum

borrowing capacity.

The second approach is the cost of capital “ the weighted average of the costs of

•

equity, debt, and preferred stock, where the weights are market value weights and the

costs of financing are current costs. The objective is to minimize the cost of capital,

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which also maximizes the value of the firm. A general framework is developed to use

this model in real-world applications and applied to find the optimal financing mix

for Disney. We find that Disney, which had almost about $ 14 billion in debt in 2004,

would minimize its cost of capital at a debt level of 30%, leading to an increase in

market value of the firm of about $ 3 billion. Even allowing for a much diminished

operating income, we find that Disney has excess debt capacity.

The third approach estimates the value of the firm at different levels of debt by

•

adding the present value of the tax benefits from debt to the unlevered firm™s value,

and then subtracting out the present value of expected bankruptcy costs. The optimal

debt ratio is the one that maximizes firm value.

The final approach is to compare a firm's debt ratio to 'similar' firms. While

•

comparisons of firm debt ratios to an industry average are commonly made, they are

generally not very useful in the presence of large differences among firms within the

same industry. A cross-sectional regression of debt ratios against underlying financial

variables brings in more information from the general population of firms and can be

used to predict debt ratios for a large number of firms.

The objective in all of these analyses is to come up with a mix of debt and equity that will

maximize the value of the firm.

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Live Case Study

The Optimal Financing Mix

Objective: To estimate the optimal mix of debt and equity for your firm, and to evaluate

the effect on firm value of moving to that mix.

Key Questions:

Based upon the cost of capital approach, what is the optimal debt ratio for your firm?

•

Bringing in reasonable constraints into the decision process, what would your

•

recommended debt ratio be for this firm?

Does your firm have too much or too little debt

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- relative to the industry in which they operate?

- relative to the market?

Framework for Analysis

1. Cost of Capital Approach

What is the current cost of capital for the firm?

•

What happens to the cost of capital as the debt ratio is changed?

•

At what debt ratio is the cost of capital minimized and firm value maximized?

•

(If they are different, explain)

What will happen to the firm value if the firm moves to its optimal?

•

What will happen to the stock price if the firm moves to the optimal, and

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stockholders are rational?

2. Building Constraints into the Process

What rating does the company have at the optimal debt ratio? If you were to

•

impose a rating constraint, what would it be? Why? What is the optimal debt

ratio with this rating constraint?

How volatile is the operating income? What is the “normalized” operating

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income of this firm and what is the optimal debt ratio of the firm at this level

of income?

3. Relative Analysis

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Relative to the industry to which this firm belongs, does it have too much or

•

too little in debt? (Do a regression, if necessary)

Relative to the rest of the firms in the market, does it have too much or too

•

little in debt? (Use the market regression, if necessary)

Getting Information about optimal capital structure

To get the inputs needed to estimate the optimal capital structure, examine the 10-

K report or the annual report. The ratings and interest coverage ratios can be obtained

from the ratings agencies (S&P, Moody™s) and default spreads can be estimated by

finding traded bonds in each ratings class.

You can download information on other firms in the industry individually or look

at databases such as Value Line.

Online sources of information:

http://www.stern.nyu.edu/˜adamodar/cfin2E/project/data.htm

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Problems

1. Rubberman Corporation, a manufacturer of consumer plastic products, is evaluating its

capital structure. The balance sheet of the company is as follows (in millions):

Assets Liabilities

Fixed Assets 4000 Debt 2500

Current Assets 1000 Equity 2500

In addition, you are provided the following information:

(a) The debt is in the form of long term bonds, with a coupon rate of 10%. The bonds are

currently rated AA and are selling at a yield of 12% (the market value of the bonds is

80% of the face value).

(b) The firm currently has 50 million shares outstanding, and the current market price is

$80 per share. The firm pays a dividend of $4 per share and has a price/earnings ratio of

10.

(c) The stock currently has a beta of 1.2. The six-month Treasury bill rate is 8%.

(d) The tax rate for this firm is 40%.

I. What is the debt/equity ratio for this firm in book value terms? in market value terms?

II. What is the debt/(debt+equity) ratio for this firm in book value terms? in market value

terms?

III. What is the firm's after-tax cost of debt?

IV. What is the firm's cost of equity?

V. What is the firm's current cost of capital?

2. Now assume that Rubberman Corporation is considering a project that requires an

initial investment of $100 million and has the following projected income statement:

EBIT $20 million

- Interest $ 4 million

EBT $16 million

Taxes $ 6.40 million

Net Income $ 9.60 million

(Depreciation for the project is expected to be $5 million a year forever.)

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This project is going to be financed at the same debt/equity ratio as the overall firm and is

expected to last forever. Assume that there are no principal repayments on the debt (it too

is perpetual).

I. Evaluate this project from the equity investors' standpoint. Does it make sense?

II. Evaluate this project from the firm's standpoint. Does it make sense?

III. In general, when would you use the cost of equity as your discount rate/benchmark?

IV. In general, when would you use the cost of capital as your benchmark?

V. Assume, for economies of scale, that this project is going to be financed entirely with

debt. What would you use as your cost of capital for evaluating this project?

3. Rubberman is considering a major change in its capital structure. It has three options:

Option 1: Issue $1 billion in new stock and repurchase half of its outstanding debt. This

will make it a AAA rated firm (AAA rated debt is yielding 11% in the market place).

Option 2: Issue $1 billion in new debt and buy back stock. This will drop its rating to A-.

(A- rated debt is yielding 13% in the market place).

Option 3: Issue $3 billion in new debt and buy back stock. This will drop its rating to

CCC (CCC rated debt is yielding 18% in the market place).

I. What is the cost of equity under each option?

II. What is the after-tax cost of debt under each option?

III. What is the cost of capital under each option?

IV. What would happen to (a) the value of the firm; (b) the value of debt and equity; and

(c) the stock price under each option , if you assume rational stockholders?

V. From a cost of capital standpoint, which of the three options would you pick, or would

you stay at your current capital structure?

VI. What role (if any) would the variability in XYZ's income play in your decision?

VII. How would your analysis change (if at all) if the money under the three options

listed above were used to take new investments (instead of repurchasing debt or equity)?

VIII. What other considerations (besides minimizing the cost of capital) would you bring

to bear on your decision?

IX. Intuitively, why doesn™t the higher rating in option 1 translate into a lower cost of

capital?

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4. Rubberman Corporation is interested in how it compares with its competitors in the

same industry.

XYZ Corporation Other Competitors

Debt/Equity Ratio 50% 25%

Variance in EBITDA 20% 40%

EBITDA/MV of Firm 25% 15%

Tax Rate 40% 30%

R&D/ Sales 2% 5%

a. Taking each of these variables, explain at an intuitive level whether you would expect

XYZ Corporation to have more more or less debt than its competitors and why.

b. You have also run a regression of debt/equity ratios against these variables for all the

firms on the New York Stock Exchange and have come up with the following regression

equation:

D/E = .10 - .5 (Variance in EBITDA) + 2.0 (EBITDA/MV) + .4 (Tax rate) + 2.5

(R&D/Sales)

(All inputs to the regression were in decimals, i.e. 20% was inputted as .20 ....)

Given this cross-sectional relationship, what would you expect XYZ's debt/equity ratio to

be?

5. As CEO of a major corporation, you have to make a decision on how much you can

afford to borrow. You currently have 10 million shares outstanding, and the market price

per share is $50. You also currently have about $200 million in debt outstanding (market

value). You are rated as a BBB corporation now.

(a) Your stock has a beta of 1.5 and the six-month T.Bill rate is 8%.

(b) Your marginal tax rate is 46%.

(c) You estimate that your rating will change to a B if you borrow $100 million. The

BBB rate now is 11%. The B rate is 12.5%.

I. Given the marginal costs and benefits of borrowing the $100 million, should you go

ahead with it ?

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II. What is your best estimate of the weighted average cost of capital with and without the

$100 million in borrowing ?

III. If you borrow the $100 million, what will the price per share be after the borrowing

IV. Assume that you have a project that requires an investment of $100 million. It has

expected before-tax revenues of $50 million, and costs of $30 million a year in

perpetuity. Is this a desirable project by your criteria? Why or Why not?

V. Does it make a difference in your decision if you were told that the cash flows from

the project in (IV) are certain?

6. You have been hired as a management consultant by AD Corporation to evaluate

whether it has an appropriate amount of debt (the company is worried about a leveraged

buyout). You have collected the following information on AD's current position:

(a) There are 100,000 shares outstanding, at $20/share. The stock has a beta of 1.15.

(b) The company has $500,000 in long-term debt outstanding and is currently rated

'BBB'. The current market interest rate is 10% on BBB bonds and 6% on T.Bills.

(c) The company's marginal tax rate is 40%.

You proceed to collect the data on what increasing debt will do to the company's ratings:

Additional debt* New Rating Interest Rate

$500,000 BB 10.5

$1,000,000 B 11.5

$1,500,000 B- 13.5

$2,000,000 C 15

* In addition to the existing debt of $500,000

I. How much additional debt should the company take on?

II. What will the price per share be after the company takes on new debt?

III. What is the weighted average cost of capital before and after the additional debt?

IV. Assume that you are considering a project that has the following earnings in

perpetuity and is of comparable risk to existing projects.

Revenues/year $1,000,000

Cost of goods sold $ 400,000 (Includes depreciation of $100,000)

EBIT $ 600,000

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