OPTIMAL FINANCING MIX II: THE COST OF CAPITAL APPROACH It is be8er to have a lower hurdle rate than a higher one. Set Up and Objective
1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate
4. Define & Measure Risk
5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights
The Financing Decision
Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations
Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing
Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends
36. Closing Thoughts
The Dividend Decision
If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business
Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game
Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation
The Cost of Capital Approach Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. ¨  If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized. ¨ 
3
Applying Cost of Capital Approach: The Textbook Example Expected Cash flow to firm next year
200(1.03)
=
(Cost of capital - g)
(Cost of capital - g)
4
€
The U-­‐shaped Cost of Capital Graph… 5
Current Cost of Capital: Disney ¨ 
¨ 
¨ 
The beta for Disney’s stock in November 2013 was 1.0013. The T. bond rate at that Zme was 2.75%. Using an esZmated equity risk premium of 5.76%, we esZmated the cost of equity for Disney to be 8.52%: Cost of Equity = 2.75% + 1.0013(5.76%) = 8.52% Disney’s bond raZng in May 2009 was A, and based on this raZng, the esZmated pretax cost of debt for Disney is 3.75%. Using a marginal tax rate of 36.1, the aeer-­‐tax cost of debt for Disney is 2.40%. Aeer-­‐Tax Cost of Debt = 3.75% (1 – 0.361) = 2.40% The cost of capital was calculated using these costs and the weights based on market values of equity (121,878) and debt (15.961): Cost of capital = 6
Mechanics of Cost of Capital EsZmaZon 1. EsZmate the Cost of Equity at different levels of debt: Equity will become riskier -­‐> Beta will increase -­‐> Cost of Equity will increase. ¤  EsZmaZon will use levered beta calculaZon ¤ 
2. EsZmate the Cost of Debt at different levels of debt: Default risk will go up and bond raZngs will go down as debt goes up -­‐> Cost of Debt will increase. ¤  To esZmaZng bond raZngs, we will use the interest coverage raZo (EBIT/Interest expense) ¤ 
3. EsZmate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price. 7
Laying the groundwork: 1. EsZmate the unlevered beta for the firm ¨ 
One approach is to use the regression beta (1.25) and then unlever, using the average debt to equity raZo (19.44%) during the period of the. Unlevered beta = = 1.25 / (1 + (1 -­‐ 0.361)(0.1944))= 1.1119 ¨ 
AlternaZvely, we can back to the source and esZmate it from the betas of the businesses. Business Media Networks Parks & Resorts Studio Entertainment Consumer Products InteracZve Disney Opera,ons Value of Propor5on Unlevered Business of Disney beta Value Propor5on $66,580 49.27% 1.03 $66,579.81 49.27% $45,683 33.81% 0.70 $45,682.80 33.81% Revenues $20,356 $14,087 EV/Sales 3.27 3.24 $5,979 3.05 $18,234 13.49% 1.10 $18,234.27 13.49% $3,555 $1,064 0.83 1.58 $2,952 $1,684 2.18% 1.25% 0.68 1.22 $2,951.50 2.18% $1,683.72 1.25% $135,132.1
1 100.00% 8
$45,041 $135,132 100.00% 0.9239 2. Get Disney’s current financials… 9
I. Cost of Equity Levered Beta = 0.9239 (1 + (1- .361) (D/E))
Cost of equity = 2.75% + Levered beta * 5.76%
10
EsZmaZng Cost of Debt Start with the market value of the firm = = 121,878 + $15,961 = $137,839 million D/(D+E)
0.00%
10.00%
Debt to capital D/E
0.00%
11.11%
D/E = 10/90 = .1111 $ Debt
$0 $13,784 EBITDA
DepreciaZon $ 2,485
$12,517
$ 2,485 $12,517 Same as 0% debt Same as 0% debt EBIT
Interest
$10,032
$0 $10,032 $434 Same as 0% debt Pre-­‐tax cost of debt * $ Debt Pre-­‐tax Int. cov
∞
23.10
EBIT/ Interest Expenses Likely RaZng AAA
Pre-­‐tax cost of debt
AAA
3.15%
From RaZngs table 3.15%
Riskless Rate + Spread 10% of $137,839 11
The RaZngs Table Interest coverage ratio is
> 8.50
6.5 – 8.5
5.5 – 6.5
4.25 – 5.5
3 – 4.25
2.5 -3
2.25 –2.5
2 – 2.25
1.75 -2
1.5 – 1.75
1.25 -1.5
0.8 -1.25
0.65 – 0.8
0.2 – 0.65
<0.2
Rating is
Aaa/AAA
Aa2/AA
A1/A+
A2/A
A3/A-
Baa2/BBB
Ba1/BB+
Ba2/BB
B1/B+
B2/B
B3/B-
Caa/CCC
Ca2/CC
C2/C
D2/D
Spread is
Interest rate
0.40%
3.15% 0.70%
3.45% 0.85%
3.60% 1.00%
3.75% 1.30%
4.05% 2.00%
4.75% 3.00%
5.75% 4.00%
6.75% 5.50%
8.25% 6.50%
9.25% 7.25%
10.00% 8.75%
11.50% 9.50%
12.25% 10.50%
13.25% 12.00%
14.75% T.Bond rate =2.75%
12
A Test: Can you do the 30% level? D/(D + E)
D/E
$ Debt
EBITDA
Depreciation
EBIT
Interest expense
Interest coverage ratio
Likely rating
Pretax cost of debt
20.00%
25.00%
$27,568
$12,517
$2,485
$10,032
$868
11.55
AAA
3.15%
Iteration 1
(Debt @AAA rate)
30.00%
30/70=42.86%
$41,352
$12,517
$2,485
$10,032
$1,302
7.70
AA
3.45%
Iteration 2
(Debt @AA rate)
30.00%
$1,427
7.03
AA
3.45%
13
Bond RaZngs, Cost of Debt and Debt RaZos 14
Stated versus EffecZve Tax Rates ¨ 
¨ 
You need taxable income for interest to provide a tax savings. Note that the EBIT at Disney is $10,032 million. As long as interest expenses are less than $10,032 million, interest expenses remain fully tax-­‐deducZble and earn the 36.1% tax benefit. At an 60% debt raZo, the interest expenses are $9,511 million and the tax benefit is therefore 36.1% of this amount. At a 70% debt raZo, however, the interest expenses balloon to $11,096 million, which is greater than the EBIT of $10,032 million. We consider the tax benefit on the interest expenses up to this amount: ¤ 
¤ 
Maximum Tax Benefit = EBIT * Marginal Tax Rate = $10,032 million * 0.361 = $ 3,622 million Adjusted Marginal Tax Rate = Maximum Tax Benefit/Interest Expenses = $3,622/$11,096 = 32.64% 15
Disney’s cost of capital schedule… 16
Disney: Cost of Capital Chart !
17
Disney: Cost of Capital Chart: 1997 18
Task Use the cost of capital approach to esZmate the opZmal financing mix for your company 19
Read Chapter 8