Capital Structure: The Case of
Walt Disney Co.
•
•
•
•
Cost of Capital
Debt level and cost of capital
Firm value
Managerial decisions (if time
permits)
1
Purpose of this case
• To integrate MM propositions with firm valuation
• To integrate Chapter 21 as well
• One of the key assumptions in Chapters 16-18 is that interest rate is
constant
• However, when there is default probability, firm’s interest rate will
change
– In Chapter 21, default probability is tied to firm’s credit rating
– In general, when firms increase leverage, default probability increases,
credit rating worsens, and interest rate rises
• How does this dynamics affect firm cost of capital and firm value?
– This lecture provides a rough estimate based on knowledge covered in
Chapters 12-21.
2
Disney’s 2006 Statements
Reveneue
-cost of revenue
EBIT
34,285
28,807
6,153
-interest expenses
706
Income before Taxes
5,447
-Taxes
Income
Price, 2006 FY close (Sept. 30, 2006)
Shares outstanding
1,890
3,374
$30.91
2,090 million
Market equity
64,602
Debt
13,817
short-term debt
2,682
long-term debt
11,135
S&P Credit rating
A-
Interest coverage ratio
8.7
3
Estimating Cost of Capital
1.
Estimating cost of equity
•
Use CAPM
• Note that CAPM says EXPECTED return equals beta times expected
risk premium
•
2.
Estimating cost of debt
•
•
3.
A reasonable estimate for expected value is to use historical average
For a firm with rating, opportunity cost of debt can be estimated with
default spread based on its credit rating.
• Cost of debt = Corresponding gov’t bond rate + default spread
Empirical analysis shows that credit ratings can be modeled well with
three factors: industry, size, and interest coverage. For simplicity, we will
assume that interest coverage ratio is the only determinant for credit
rating
Estimating cost of capital
•
•
WACC
Tax rate can be estimated based on either current tax code or historical
tax payouts.
4
Equations that we need
• Beta and leverage; (MM-II with corporate taxes)
• CAPM;
• Cost of capital with taxes
B
 equity  [1  (1  Tc ) ] unlevered
S
rS  r f   S ( rm  r f )
S
S
WACC  rS  (1  Tc ) rB
V
V
5
Estimating Cost of Debt: The Ratings Table
If interest coverage ratio is
(see bondsonline.com for more ratings info.)
greater than
≤ to
Spread is
-100000
0.5
D
20.00%
0.5
0.8
C
12.00%
0.8
1.2
CC
10.00%
1.25
1.5
CCC
8.00%
1.5
2.0
B-
6.00%
2
2.5
B
4.00%
2.5
3.0
B+
3.25%
3
3.5
BB
2.50%
3.5
4.0
BB+
2.00%
4
4.5
BBB
1.50%
4.5
6.0
BBB+
1.00%
6
7.5
A-
0.85%
7.5
9.5
A
0.70%
9.5
12.5
A+
0.50%
12.5
100000.0
>AA
0.35%
6
Current Cost of Capital (1)
• Equity
– Cost of equity = riskfree rate + beta * market risk premium =
2.14 + 1.05 * (9.78 - 2.14) = 10.16 (%)
• Notes: (1) Use past 5-year average for expected riskfree rate and
risk premium; (2) Beta is also estimated using past 5-year
monthly stock and market return.
– Market value of equity = $ 30.91*2,090 = $64,062 Million
– Leverage: Equity / (Debt + Equity) = 64,062/(64,062+ 13,817)
= 82.26%
• Note: Book value of debt (long-term debt + short-term debt) is
used as an estimate for market value of debt.
7
Current Cost of Capital (2)
• Debt
– After-tax cost of debt
= (Gov’t bond rate + default spread) (1-t)
= (4.4% + 0.85%) (1-0.35) = 3.41%
• Note 1: (1) Past 5-year average of 10-year T-bond yield is used
as gov’t bond rate. (2) Tax rate is based on tax code. 2006 FY
actual tax rate is consistent with the tax code. (3) current credit
rating: A-, corresponding to a spread of 0.85%.
• Note 2: I deviate from the Rating Table by using Disney’s actual
credit rating. If we follow the Table strictly, Disney’s rating
associated with its coverage ratio should be A (with a default
spread of 0.70%).
• WACC = 10.16% (.8226) + 3.41% (1-.8226) = 8.96%
8
The Question: Is there money left on the table for Disney?
• If Disney alters its current debt structure, how does it affect
the firm value?
• Motivation: In his famous article, “How Big Are the Tax
Benefits of Debt?”, Professor John Graham of Duke
estimates that on average, the typical (US) firm could double
tax benefits by issuing debt until the point that the marginal
tax benefit begins to decline.
– The paper is attached on the course webpage for your
reference.
9
The procedures
1. Estimate the cost of equity at different levels of debt
2. Estimate the cost of debt at different levels of debt
• The more debt you take, the lower your interest coverage ratio,
and the higher the interest rate.
3. Estimate the weighted average cost of capital at different
levels of debt
4. Calculate the effect on firm value and stock price
– Since firm value is inversely related to WACC, once we know
WACC we know the firm value.
– Consider bankruptcy costs as well
10
Estimating Cost of Equity
Current Beta = 1.05
Current debt/value ratio: 17.74%
Expected Market premium = 7.64% T-bill rate = 2.14%
t = 35%
(1) Calculate unlevered beta and cost of unlevered equity (r0)
(2) Calculate beta and cost of equity when B/V = 30%.
11
Table 1: Cost of equity schedule
0
B/(B+S)
%10%
20%
30%
40%
50%
60%
70%
80%
90%
%11%
25%
43%
67%
100% 150% 233% 400% 900%
0$7,842
$15,684
$23,526
$31,368
$39,210
$47,051
$54,893
$62,735
$70,577
.
9
20.99
1.07
1.18
1.32
1.52
1.82
2.32
3.32
6.31
.
1
8 9.69
% %
10.33
%
11.14
%
12.23
%
13.76
%
16.05
%
19.86
%
27.49
%
50.38
%
0
B/S
$
$ Debt
0
Beta
9
Cost of Equity
12
7.00
60.00%
6.00
50.00%
40.00%
4.00
30.00%
3.00
20.00%
2.00
1.00
10.00%
0.00
0.00%
0.
00
%
10
.0
0%
20
.0
0%
30
.0
0%
40
.0
0%
50
.0
0%
60
.0
0%
70
.0
0%
80
.0
0%
90
.0
0%
Beta
5.00
Cost of Equity
Cost of equity
Debt/V
13
Can you do the 30% level?
B/(B+S)
10%
30%
B/S
11%
43%
$ Debt
$1,102
$3,307
EBIT
$6,153
$6,153
Interest
372.5
1270.4
Interest Coverage
Likely Rating
Pre-tax cost of debt
The chain effect: As you take more
debt, your interest payment is likely
to be higher, which lowers your
interest coverage ratio, which lowers
your rating, which increases your
interest rate.
You need to find an interest rate that
matches the resulting coverage ratio
and the rating. (Trial and error.)
After-tax cost of
debt
Cost of Capital
14
Table 2 Estimating cost of debt
D/(D+E)
0%
10%
20%
30%
40%
50%
60%
D/E
0%
11%
25%
43%
67%
100%
150%
$ Debt
$0
$1,102
$2,205
$3,307
$4,409
$5,512
$6,614
EBIT
$6,153
$6,153
$6,153
$6,153
$6,153
$6,153
$6,153
Interest
0.0
372.5
799.9
1270.4
2007.5
4077.8
6775.4
Interest Coverage
∞
16.52
7.69
4.84
3.06
1.51
0.91
Likely Rating
AAA
AAA
A
BBB+
BB+
B-
CC
Pre-tax cost of debt
4.75%
4.75%
5.10%
5.40%
6.40%
10.40%
14.40%
After-tax cost of
debt
3.09%
3.09%
3.32%
3.51%
4.16%
6.76%
9.36%
15
Cost of Capital
Table 1 + Table 2  WACC
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0%
10%
20%
30%
40%
50%
Cost of debt
60%
70%
80%
90%
WACC
16
The U-Shape of Cost of Capital
• Cost of capital goes down at first, then goes up with debt.
• This is because of the interest rate dynamics
– If you take more debt, debt becomes riskier
– Therefore, interest rate increases with debt.
– Taking more debt has two effects:
• Higher proportion of lower cost of debt capital
• Interest grows with proportion of debt
• At first, the first effect is dominant; then the second effect will
dominate, resulting in U-shape of cost of capital.
• If interest rate remains constant, then we are back to MM
world with corporate taxes
– The optimal debt is then close to 100%.
17
WACC and Firm Value (when there is no growth)
•
Firm value = UCF/WACC
where UCF is the cash flow to the unlevered firm.
– You can verify this from Chapter 18.
•
View
Value * WACC
as the annual costs of running the company.
•
Change in WACC then changes the costs of running the
company.
– Assume this change is perpetual for simplicity.
– Discount the $ change by the new WACC you’ll arrive at the changes in
firm value.
– i.e., if there is a change in WACC
New firm value = old firm value - old firm value *(WACCnew –WACCold)/
WACCnew
18
Effect on Firm Value
• Firm Value before the change = 13.8 + 64.6 = 78.4
billion
B/V = 17.74%. WACC0 = 9.18%.
Annual Cost = $78.4 *9.18%= $7.20 billion
• Change to 30% debt (B/V = 30%)
– WACC1 = 30%* 3.51% + 70%*11.14% = 8.85%
– Annual Cost = $78.4 *8.85%= $6.94 billion
– Δ WACC = 0.33%, Change in Annual Cost = $ 0.26 billion
• If there is no growth in the firm value
– Increase in firm value = $0.26/ .0885 = $2.94 billion
– Change in Stock Price = $2.94billion/2.09 billion = $1.41 per
share
19
If there is growth in firm value over time
• Estimate first the implied growth rate, g, through the following
perpetual growth formula:
Firm value Today = UCF(1+g)/(WACC0-g),
where UCF is the cash flow to the unlevered firm. Solve for g.
• Increase in firm value is then
change in annual cost * (1+g) /(WACC1-g)
• Attribute this increase in value to stockholders and derive increase in
stock price
• With growth, change in value is more sensitive to change in leverage.
• UCF = 6,153 (1-0.35)
78.4 = UCF (1+g) /(0.0918-g)
• g= 0.0388
• Increase in firm value = 0.26 (1+0.0388)/(0.0885-0.0388) = 5.43
• Increase in share price = 5.43/2.09 = $2.60/share
20
Firm Value
B/(B+S)
10%
20%
30%
40%
50%
60%
70%
Cost of Capital
9.03%
8.92%
8.85%
9.00%
10.26%
12.04%
13.42%
Value (no
growth)
77,827
78,754
79,381
75,335
68,503
58,398
52,369
21
Firm Value as a function of Debt ratio
Firm Value
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Firm Value
22
A Managerial Decision: The Repurchase Price
Let us suppose that the CFO approached you asking about buying back
stocks. The fund for stock buyback (repurchases) will be raised from
the bond market. Assume that the bond issuing costs are negligible.
The current price is $30.91. Assuming that firm operating income will
remain constant at the current level.
(1) Realizing that the current debt ratio is relatively low, he wants to
double the debt size. He wants to know the maximum price for the
stock buyback.
23
Cont’d
(2) Will your answer change if the firm value will be estimated to
grow by 4% a year?
24
Integrating the Bankruptcy Costs:
Estimating Expected Bankruptcy Cost
• Probability of Bankruptcy
• Estimate the rating that the firm will have at each level of
debt
• Estimate the probability that the firm will go bankrupt over
time, at that level of debt (Use studies that have estimated
the empirical probabilities of this occurring over time Altman does an update every year)
25
Cost of Bankruptcy
• The direct bankruptcy cost is the easier component. It is
generally between 5-10% of firm value, based upon
empirical studies. Let’s take 10% for Disney (Why?).
• The indirect bankruptcy cost is much tougher. It should be
higher for sectors where operating income is affected
significantly by default risk (like airlines) and lower for
sectors where it is not (like groceries). Let’s take 15% for
Disney.
26
Ratings and Default Probabilities
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Rating
AAA
AA
A+
A
ABBB
BB
B+
B
BCCC
CC
C
D
Default Risk
0.01%
0.28%
0.40%
0.53%
1.41%
2.30%
12.20%
19.28%
26.36%
32.50%
46.61%
52.50%
60%
75%
27
Estimating Bankruptcy Costs
• Current rating:
– A-, default risk: 1.41%
– Costs on firm value:
– New firm value:
• Change to 30% debt/V ratio
– Rating: BBB+, default risk:
– Costs on firm value:
– New firm value:
28
Exercise
• Find a new firm, say, RIM, and give a rough estimate on
how its firm value will change if it assumes a 10% of debt.
29