Leverage Capital Budgeting and Corporate Objectives Professor Ron Kaniel Simon School of Business University of Rochester 1 Overview Capital Structure does not matter!» Modigliani & Miller propositions Implications for corporate debt policy Capital structure and required returns» The weighted average cost of capital (WACC)» Un-levering betas Optimal debt policy 2 1 1
The Intuition Behind M&M Buy a house today for $100,000 and sell one year later Assume mortgage rate is 10% House Price Size of Mortgage Prob Change 0% 50% 90% 1/3-10% -10% -30% -190% 1/3 10% 10% 10% 10% 1/3 45% 45% 80% 360% Avg. 15% 15% 20% 60% SD 23% 23% 45% 227% 3 The Impact of Leverage Leverage increases shareholders expected return Leverage also increases the riskiness of returns The way an individual house is financed has no effect on:» the value of the house» the volatility of the house price Asset cash flows and risks are independent of financing Limited liability does not affect this conclusion, but returns for borrower and lender are different Firm is only a collection of assets 4 2 2
M&M I: Synopsis In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure» Value of Firm (V) = Value of Debt (D) + Value of Equity (E) (No matter what D and E are since investors can undo anything the firm does with perfect capital markets, so capital structure doesn t matter.)» Only thing that matters for value (size of the pie) is the PV of the cash flows doesn t matter how you divide them up (slice the pie) Debt Equity Equity Equity Debt 5 The Cost of Capital Recall M&M I implies: V l = E + D = V u ( = V a )» All values are market as opposed to book or accounting» V l is value of levered firm, and V u of unlevered firm Return on a portfolio equals weighted average of returns to the securities in the portfolio: E D re rd ru ra E D E D But this implies: D re ru (r U r D) E Risk without leverage (business risk) Additional risk due to leverage (financial risk) 6 3 3
M&M II Leverage, Risk, and the Cost of Capital M&M Proposition II says:» The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio re ra D ra rd E The WACC, E D r WACC r A re rd ru E D ED WACC remains constant!! in perfect capital markets because as D/E changes, r E changes to compensate» For really high leverage, r D will change as well (r D =r A in limit) 7 WACC & Leverage in Perfect Capital Markets V U =1000; r A = 15%; r D =5% Shape of r E and r D dictated by response of cash flows to leverage 8 4 4
Capital Structure and Returns -Example MacBeth Spot Removers is 100% equity financed and considers a debt/equity-swap (also called a leveraged recapitalization): Currently: $12m equity $2m operating income (perpetuity) Plan: Retire equity worth $6m Expected return on debt: 10%» What is the perpetual stream of dividends and interest?» What is the required return on equity after the recapitalization?» What is the required return on assets after the recapitalization? 9 MacBeth Spot Removers Issue $6m debt, retire $6m equity» Cash flows to firm remain unaffected Uses of funds (in perpetuity):» Interest = 0.1*$6m=$600,000» Dividends = Operating Income - Interest = $1.4m» Return on equity = $1.4m/$6m=23.3% Then cost of capital calculations give us:» WACC = 0.5*23.3%+0.5*10%=16.7%» Cost of capital=$2m/$12m=16.7% 10 5 5
Perfect Capital Markets: Leverage and the CAPM The CAPM can be used to compute all of these discount rates:» Use the equity beta to compute the return on equity: E[r E ] = r f + E (E[r M ]- r f ).» Use the debt beta to compute the return on debt: E[r D ] = r f + D (E[r M ]- r f ).» Use the asset beta to compute a return commensurate with the business risk of the assets: E[r A ] = r f + A (E[r M ]- r f ). The beta of the assets ( A ) is also known as the beta of equity in an unlevered firm ( U )» The equity in an unlevered firm has no financial risk, only business risk.» The only source of risk in the unlevered firm is the inherent business risk of the assets themselves. 11 Perfect Capital Markets: Leverage and the Cost of Capital The firm s asset beta is a weighted average of the debt and equity betas: D E A D E V V This implies the following relationship between the firm s equity beta and its leverage: E A D A D E Note: the same relations that hold for required rates of return hold also for betas! 12 6 6
Leverage and Beta Reconsider the leveraged recapitalization of MacBeth Spot Removers. Assume a risk-free interest rate of r f = 10.0% and a market risk premium of [E(r M )-r f ] = 8.0%.» Debt beta = 0» Asset beta =0.833 After the recapitalization we have:» Equity beta = 1.667» Debt beta = 0» Asset beta = 0.5*0+0.5*1.667=0.833 13 Accounting for Leverage in Capital Budgeting Each investment project has its own cost of capital that depends upon the risk of the investment.» NPV must be computed using a discount rate appropriate for the project, not the firm. The risk of the investment project depends upon its unlevered (asset) beta. The unlevered cost of capital can be estimated using the CAPM. How do we find this?» Step 1: Compute the beta of the assets by unlevering another firm s equity beta.» Step 2: Use the CAPM to determine a required return to compensate investors for bearing this inherent business risk.» Step 3: Use this required return to find the NPV. 14 7 7
Capital Budgeting Example Your firm is currently in the computer software business, but is considering investing in the development of a new airline. Information on your firm and the airline industry are given below: Your Airline Firm Industry Equity Beta 1.20 1.95 Debt-Equity Ratio 0 67% Estimate of debt beta - 0.125 15 Your airline project: Capital Budgeting Example» expected to cost $20 million per year for the next 5 years» expected to generate after-tax cash flows of $10 million per year indefinitely thereafter.» the risk-free interest rate is 9%» and the market risk premium is 8%. 16 8 8
Capital Budgeting Example Step 1: Unlever Equity Beta for Airlines Asset Airlines Equity E V Debt Step 3: Calculate the NPV of the Project D V Hence: A 1.95*0.6 0.125*0.4 1.22 Step 2: Calculate the Cost of Capital 0. 1876 r A 0.09 1.22 0.08 NPV 5 $10 $20 38.92million t (1.1876) (1.1876) t t6 t1 17 Two ways of Dealing with Leverage 1) Unlever betas 2) Weighted Average Cost of Capital Security betas Capital structure Cost of Equity Cost of Debt Asset beta Capital structure Cost of capital Cost of capital 18 9 9
Capital Structure in Perfect Capital Markets Summing it Up Conservation of Value Principle for Financial Markets» With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return). This implies that any financial transaction that appears to be a good deal may be exploiting some type of market imperfection. M&M I: V = E + D» Value of the firm is just the sum of E & D, regardless of what they are M&M II: r E = r A + D/E(r A -r D )» Leverage increases risk of equity (not value according to M&M I) 19 What are Perfect Capital Markets What are the assumptions behind M&M? That is, when are the M&M propositions true? 1. no taxes, 2. no bankruptcy costs, 3. no agency costs/benefits, 4. no information asymmetry, and 5. no transaction costs What the!@#$%? What s the point of this?» If financial policy is to matter, it must be that it mitigates (or takes advantage of) one or more of these frictions» Devise financial strategies around minimizing (maximizing) the adverse (beneficial) effects of these frictions 20 10 10
The WACC with Taxes Tax deductibility of interest effectively lowers the cost of debt, r D,tor D (1-τ C ) Example:» Firm with 35% MTR borrower $100,000 @ 10% pa» Interest expense = r D x $100,000 = $10,000» Tax savings = - τ C xr D x $100,000 = -$3,500» After-tax cost of debt = r D (1-τ C ) x $100,000 = $6,500 WACC with taxes: ra E re D rd1 C E r D D E rd rd C ED ED ED ED ED Pre-tax WACC Reduction due to Interest Tax Shield 21 The WACC with and Without Corporate Taxes 22 11 11
Summary Capital structure is irrelevant» unless there are market imperfections to exploit Leverage changes the required rates of return on debt and equity,» but not the required rate of return on a company» unless taxes are important Two ways to calculate cost of capital of the leveraged firm:» Weighted average cost of capital suitable if you know costs of debt and equity» Unlevering betas suitable for new projects or companies More on these issues in subsequent finance classes 23 12 12