9.15% 8.83% 8.59% 8.50% 10.20% 13.16% 14.36% 15.56% 16.76% 17.96%

Cost of Capital

Value (perpetual growth) $62,279 $66,397 $69,837 $71,239 $51,661 $34,969 $30,920 $27,711 $25,105 $22,948

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Constrained Cost of Capital Approaches

The cost of capital approach that we have described is unconstrained, since our

only objective is to minimize the cost of capital. There are several reasons why a firm

may choose not to view the debt ratio that emerges from this analysis as optimal. First,

the firm™s default risk at the point at which the cost of capital is minimized may be high

enough to put the firm™s survival at jeopardy.

Investment Grade Bonds: An investment

Stated in terms of bond ratings, the firm may grade bond is one with a rating greater than

BBB. Some institutional investors, such as

have a below-investment grade rating. Second, pension funds, are constrained from holding

bonds with lower ratings.

the assumption that the operating income is

unaffected by the bond rating is a key one. If the

operating income declines as default risk increases, the value of the firm may not be

maximized where the cost of capital is minimized. Third, the optimal debt ratio was

computed using the operating income from the most recent financial year. To the extent

that operating income is volatile and can decline, firms may want to curtail their

borrowing. In this section, we will consider ways in which we can bring each of these

considerations into the cost of capital analysis.

Bond Rating Constraint

One way of using the cost of capital approach, without putting firms into financial

jeopardy, is to impose a “bond rating constraint” on the cost of capital analysis. Once this

constraint has been imposed, the optimal debt ratio is the one that has the lowest cost of

capital, subject to the constraint that the bond rating meets or exceeds a certain level.

While this approach is simple, it is essentially subjective and is therefore open to

manipulation. For instance, the management at Disney could insist on preserving a AA

rating and use this constraint to justify reducing its debt ratio. One way to make managers

more accountable in this regard is to measure the cost of a rating constraint.

Cost of Rating Constraint = Maximum Firm Value without constraints

- Maximum Firm Value with constraints

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If Disney insisted on maintaining a AA rating, its constrained optimal debt ratio would be

10%. The cost of preserving the constraint can then be measured as the difference

between firm value at 30% and at 20%.

Cost of Rating Constraint = Value at 30% Debt - Value at 10% Debt

= $71,239 - $ 66,397

= $ 4,842 million

This loss in value is probably overstated since we are keeping operating income fixed.

Notwithstanding this concern, the loss in value that can accrue from having an

unrealistically high rating constraint can be viewed as the cost of being too conservative

when it comes to debt policy.

8.4. ˜: Agency Costs and Financial Flexibility

In the last chapter, we consider agency costs and lost flexibility as potential costs of using

debt. Where in the cost of capital approach do we consider these costs?

a. These costs are not considered in the cost of capital approach

b. These costs are fully captured in the cost of capital through the costs of equity and

debt, which increase as you borrow more money.

c. These costs are partially captured in the cost of capital through the costs of equity and

debt, which increase as you borrow more money.

Sensitivity Analysis

The optimal debt ratio we estimate for a firm is a function of all the inputs that go

into the cost of capital computation “ the beta of the firm, the riskfree rate, the risk

premium and the default spread. It is also, indirectly, a function of the firm™s operating

income, since interest coverage ratios are based upon this income, and these ratios are

used to compute ratings and interest rates.

The determinants of the optimal debt ratio for a firm can be divided into variables

specific to the firm, and macro economic variables. Among the variables specific to the

firm that affect its optimal debt ratio are the tax rate, the firm™s capacity to generate

operating income and its cash flows. In general, the tax benefits from debt increase as the

tax rate goes up. In relative terms, firms with higher tax rates will have higher optimal

debt ratios than will firms with lower tax rates, other things being equal. It also follows

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that a firm's optimal debt ratio will increase as its tax rate increases. Firms that generate

higher operating income and cash flows, as a percent of firm market value, also can

sustain much more debt as a proportion of the market value of the firm, since debt

payments can be met much more easily from prevailing cash flows.

The macroeconomic determinants of optimal debt ratios include the level of

interest rates and default spreads. As interest rates increase, the costs of debt and equity

both increase. However, optimal debt ratios tend to be lower when interest rates are

higher, perhaps because interest coverage ratios drop at higher rates. The default spreads

commanded by different ratings classes tend to increase during recessions and decrease

during recoveries. Keeping other things constant, as the spreads increase, optimal debt

ratios decrease, for the simple reason that higher default spreads result in higher costs of

debt.

How does sensitivity analysis allow a firm to choose an optimal debt ratio? After

computing the optimal debt ratio with existing inputs, firms may put it to the test by

changing both firm-specific inputs (such as operating income) and macro-economic

inputs (such as default spreads). The debt ratio the firm chooses as its optimal then

reflects the volatility of the underlying variables, and the risk aversion of the firm™s

management.

Illustration 8.4: Sensitivity Analysis on Disney™s Optimal Debt Ratio

In the base case, in illustration 8.2, we used Disney™s operating income in 2003 to

find the optimal debt ratio. We could argue that Disney's operating income is subject to

large swings, depending upon the vagaries of the economy and the fortunes of the

entertainment business, as shown in Table 8.11.

Table 8.11: Disney's Operating Income History: 1987 “ 2003

Year EBIT % Change in

EBIT

1987 756

1988 848 12.17%

1989 1177 38.80%

1990 1368 16.23%

1991 1124 -17.84%

1992 1287 14.50%

1993 1560 21.21%

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1994 1804 15.64%

1995 2262 25.39%

1996 3024 33.69%

1997 3945 30.46%

1998 3843 -2.59%

1999 3580 -6.84%

2000 2525 -29.47%

2001 2832 12.16%

2002 2384 -15.82%

2003 2713 13.80%

There are several ways of using the information in such historical data to modify the

analysis. One approach is to look at the firm's performance during previous downturns.

In Disney's case, the operating income in 2002 dropped by 15.82% as the firm struggled

with the aftermath of terrorism. In 2000, Disney™s self-inflicted wounds, from over

investment in the internet business and poor movies, caused operating income to

plummet almost 30%. A second approach is to obtain a statistical measure of the

volatility in operating income, so that we can be more conservative in choosing debt

levels for firms with more volatile earnings. In Disney™s case, the standard deviation in

percentage changes in operating income is 19.54%. Table 8.12 illustrates the impact of

lowering operating from current levels on the optimal debt level.

Table 8.12: Effects Of Operating Income On Optimal Debt Ratio

% Drop in EBITDA EBIT Optimal Debt Ratio

0% $ 2,805 30%

5% $ 2,665 20%

10% $ 2,524 20%

15% $ 2385 20%

20% $ 2,245 20%

The optimal debt ratio declines to 20% when the operating income decreases by 5% but

the optimal stays at 20% for larger decreases in operating income (up to 40%).

In Practice: EBIT versus EBITDA

In recent years, analysts have increasingly turned to using EBITDA as a measure

of operating cashflows for a firm. It may therefore seem surprising that we focus on

operating income or EBIt far more than EBITDA when computing the optimal capital

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structure. The interest coverage ratios, for instance, are based upon operating income and

not EBITDA. While it is true that depreciation and amortization are non-cash expenses

and should be added back to cash flows, it is dangerous for a firm with ongoing

operations to depend upon the cashflows generated by these items to service debt

payments. After all, firms with high depreciation and amortization expenses usually have

high ongoing capital expenditures. If the cash inflows from depreciation and amortization

are redirected to make interest payments, the reinvestment made by firms will be

insufficient to generate future growth or to maintain existing assets.

Normalized Operating Income

A key input that drives the optimal capital Normalized Income: This is a

measure of the income that a firm can

structure is the current operating income. If this

make in a normal year, where there are no

income is depressed, either because the firm is a

extraordinary gains or losses either from

cyclical firm or because there are firm-specific

firm-specific factors (such as write offs

factors that are expected to be temporary, the and one-time sales) or macro economic

optimal debt ratio that will emerge from the factors (such as recessions and economic

analysis will be much lower than the firm™s true booms).

optimal. For example, automobile manufacturing firms would have had very low debt

ratios if the optimal debt ratios had been computed based upon the operating income in

2001 and 2002, which were recession years. If the drop in operating income is

permanent, however, this lower optimal debt ratio is, in fact, the correct estimate.

When evaluating a firm with depressed current operating income, we must first

decide whether the drop in income is temporary or permanent. If the drop is temporary,

we must estimate the normalized operating income for the firm. The normalized

operating income is an estimate of how much the firm would earn in a normal year, i.e., a

year without the specific events that are depressing earnings this year. Most analysts

normalize earnings by taking the average earnings over a period of time (usually 5 years).

mgnroc.xls: There is a dataset on the web that summarizes operating margins

and returns on capital by industry group in the United States for the most recent quarter.

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Operating Income as a Function of Default Risk

In the analysis we just completed for the Disney, we assumed that operating

income would remain constant while the debt ratios changed. While this assumption

simplifies our analysis substantially, it is not realistic. The operating income, for many

firms, will drop as the default risk increases; this, in fact, is the cost we labeled as an

indirect bankruptcy cost in the last chapter. The drop is likely to become more

pronounced as the default risk falls below an acceptable level; for instance, a bond rating

below investment grade may trigger significant losses in revenues and increases in

expenses.

A general model for optimal capital structure would allow both operating income

and cost of capital to change as the debt ratio changes. We have already described how

we can estimate cost of capital at different debt ratios, but we could also attempt to do the

same with operating income. For instance, we could estimate how the operating income

for the Aracruz would change as debt ratios and default risk changes by looking at the

effects of rating downgrades on the operating income of other paper and pulp companies.

If both operating income and cost of capital change, the optimal debt ratio may no

longer be the point at which the cost of capital is minimized. Instead, the optimal has to

be defined as that debt ratio at which the value of the firm is maximized. We will

consider an example of such an analysis in a few pages, when we estimate the optimal

debt ratio for J.P. Morgan.

Illustration 8.5: Applying the Cost of Capital Approach with Normalized Operating

Income to Aracruz Cellulose

Aracruz Cellulose, the Brazilian pulp and paper manufacturing firm, reported

operating income of 887 million BR on revenues of 3176 million BR in 2003. This was

significantly higher than it™s operating income of 346 million BR in 2002 and 196 million

Br in 2001. We estimated the optimal debt ratio for Aracruz, based upon the following

information:

In 2003, Aracruz had depreciation of 553 million BR and capital expenditures

•

amounted to 661 million BR.

Aracruz had debt outstanding of 4,094 million BR with a dollar cost of debt of 7.25%.

•

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The corporate tax rate in Brazil is estimated to be 34%.

•

Aracruz had 859.59 million shares outstanding, trading 10.69 BR per share. The beta

•

of the stock is estimated, using comparable firms, to be 0.70.

In chapter 4, we estimated Aracruz™s current dollar cost of capital to be 10.33%, using an

equity risk premium of 12.49% for Brazil:

Current $ Cost of Equity = 4% + 0.70 (12.49%) = 12.79%

Market Value of Equity = 10.69 BR/share * 859.59= 9,189 million BR

Current $ Cost of Capital

= 12.79% (9,189/(9,189+4,094)) + 7.25% (1-.34) (4,094/(9189+4,094) = 10.33%

We made three significant changes in applying the cost of capital approach to Aracruz as

opposed to Disney:

The operating income at Aracruz is a function of the price of paper and pulp in

•

global markets. While 2003 was a very good year for the company, its income

history over the last decade reflects the volatility created by pulp prices. We

computed Aracruz™s average pre-tax operating margin over the last 10 years to be

25.99%. Applying this lower average margin to 2003 revenues generates a

normalized operating income of 796.71 million BR. We will compute the optimal