Week 5

Question 1

What is the Miller-Modigliani theorem?

Answer 1

The miller-Modigliani theorem applies in a world where:
There are no taxes,
Managers always do what is best for stockholders,
No firm ever goes bankrupt,
Equity investors are honest with lenders(no attempts to subterfuge or find loopholes in loan agreement),
And firms know their future financing needs with certainty.

In this world the capital structure of a firm is irrelevant to its value, and its value is instead based on the quality of its investments.

The firms cost of capital will also not change as a result of the capital structure, this is because as a firm increases its leverage the cost of equity will increase enough to offset any gains to the leverage.

Question 2

What is the typical firm financing hierarchy? Why is this the case?

Answer 2

Firms commonly follow a financing hierarchy, with retained earnings being the preferred choice, then debt, and then equity. This occurs because managers value flexibility, control, and low costs.

Question 3

How can we attempt to find the optimal capital structure? Why is this important?

Answer 3

There is an optimal mix of debt and equity that maximizes firm value. We can find this with:
The cost of capital approach,
The enhanced cost of capital approach,
The adjusted present value approach,
the sector approach,
and the life cycle approach.

Question 4

What is the typical cost of capital used by firms?

Answer 4

Typically the cost of capital used by firms is the WACC.

Question 5

How does the cost of capital approach work for finding the optimal debt ratio?

Answer 5

In the cost of capital approach the optimal debt ratio is the one that minimizes the cost of capital for the firm. The value of a firm is the 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.
This works because the value of a firm is the present value of cash flows, discounted at the cost of capital.

Question 6

How does the enhanced cost of capital approach work for finding the optimal debt ratio?

Answer 6

In the enhanced cost of capital approach the optimal debt ratio is the one that minimizes the cost of capital for a firm.

Question 7

How does the adjusted present value approach work for finding the optimal debt ratio?

Answer 7

In the adjusted present value approach the optimal debt ratio is the one that maximized the overall value of the firm.

Question 8

How does the sector approach work for finding the optimal debt ratio?

Answer 8

In the sector approach, the optimal debt ratio is the one that brings the firm closest to its peer group in terms of financial mix.

Question 9

How does the life cycle approach work for finding the optimal debt ratio?

Answer 9

In the life cycle approach the optimal debt ratio is the one that best suits where the firm is in its life cycle.

Question 10

How do we typically find the pre-tax cost of debt?

Answer 10

The pre-tax cost of debt is given by the long-term riskfree rate + the default spread for the company, we then have to multiply this by (1- the firm’s marginal tax rate).

Question 11

How do we factor in convertible debt and preferred stock into the WACC?

Answer 11

If we have convertible debt we must separate it into the debt component and equity component for the WACC. For the preferred stock we need to add a component which is the preferred dividend yield * the weight of the preferred stock.

Question 12

Is equity always more expensive than debt?

Answer 12

While equity is normally more expensive than debt, if the stock is undervalued the equity can be cheaper than debt.`
Also, cost of equity is the risk free rate + the equity risk premium * beta. Beta can be negative, sometimes leading to the cost of equity being lower than the cost of debt.

Question 13

What occurs to the after-tax cost of debt and equity of a firm as it takes on more debt?

Answer 13

As a firm takes on more debt it’s after-tax cost of debt and cost of equity tends to increase as the firm is riskier. This means a firm cannot always increase it’s value by shifting towards more debt.

Question 14

What are the steps in cost of capital estimation?

Answer 14

1. Estimate the cost of equity at different levels of debt using the levered beta calculation.
2. Estimate the cost of debt at different levels of debt (the default risk goes up and the bond rating goes down as the debt goes up), estimate this using the interest coverage ratio (EBIT/interest expense).
3. Estimate the cost of capital as these different levels of debt.
4. Calculate the effect on firm value and stock price.

Question 15

What occurs to a firm’s effective tax rate as it’s debt increases? Why?
What is our adjusted marginal tax rate?

Answer 15

As a firm’s debt ratio increases its effective tax rate will likely decrease, this is because when the interest expense becomes higher than EBIT we lose some of the tax shield, as we can only deduct up to the EBIT this gives us a maximum tax benefit of EBIT * marginal tax rate.

Also, an adjusted marginal tax rate of maximum tax benefit divided by the interest expenses

Question 16

Why does the cost of capital graph as a product of debt ratio have kinks?

Answer 16

Because the cost of debt is based on rating and this can be discontinuous we can have kinks in the cost of capital graph where these ratings change.

Question 17

What should we do to show the importance of taking on more debt once we know the optimum level?

Answer 17

To show why we should take on more debt we should perform the full valuation of the company with the suggested optimal debt level.
This involves: estimating the cash flows to the firm, work out the implied growth rate in the current market value, and then revalue the firm with the new cost of capital.
When doing this, we assume the current value of the firm is correctly priced, and when changing the debt to capital ratio the investors expectations stay unchanged.

We could also do this by starting with the current market value and isolating the effect of changing the capital structure on the cash flow and the resulting value, adding this resulting value to the existing value.

We can find this increase in value as:
Increase in value = annual savings next year/(cost of capital - g), when doing this we have an annual growth rate, which is typically set equal to the risk free rate or inflation rate. The estimate from the incremental cash flows will typically be lower than the full revaluation as the growth rate is smaller.

Question 18

Why might a company take on debt for share buybacks? What shareholders will benefit the most?

Answer 18

A company may take on debt to perform share buy backs, if its debt is less than optimal and it has no good projects.
In this scenario, either the shareholders which sell the shares will benefit or the shareholders who hold the shares, depending on the repurchase price. This repurchase price should be the old stock price plus the increase in value per share so that both shareholder types are benefited the same. If the repurchase price is higher than this the selling shareholders benefit more, if the repurchase price is lower than this the holding shareholders will benefit more.

Question 19

How do we compute the number of shares outstanding after a buyback given a buyback price?
What about the equity value after recapitalization?

Answer 19

If we have the buyback price we can compute the number of shares outstanding after the buyback:

Increase in debt = debt at optimal - current debt.
number of shares after buyback = number of shares before - (increase in debt/buyback price).

equity value after buyback = optimal enterprise value + cash - debt.

Question 20

How can we calculate the value of a share after buyback? What does this mean for which shareholders benefited?

Answer 20

Value per share after buyback = equity value after buyback / number of shares after buyback. If the share price after buying is higher than the buyback price then the holders are benefited most, if the share price after buyback is lower than the buyback price the sellers are benefitted most.

Question 21

What are the two major ways to check our downside risk? Why is this important when changing the optimum debt level? Why are constraints important?

Answer 21

In changing our debt levels to the optimum debt level we may increase our exposure to downside risk. We can check this by testing the sensitivity of our assumptions with what if analysis, typically on operating income, tax rates, and macro variables, and checking what the optimal debt ratio would be with different levels.
We could instead or also do an economic scenario approach (scenario analysis).
We will often want to put constraints on the optimal debt ratio to reduce our exposure to downside risk. E.g requiring that the firm has a minimum rating.

Question 22

Why does management often set a minimum debt rating?

Answer 22

Management often specifies a minimum desired rating, driven by:

• protection against downside risk in operating income
• A drop in ratings might affect operating income
• There is an ego factor associated with high ratings.

Question 23

What is the cost of a rating constraint?

Answer 23

The cost of a rating constraint is the difference between the unconstrained optimum value and the value of the firm with the constraint.

Question 24

Is it necessarily wrong for a company to be overleveraged or underleveraged if it is part of a larger firm?

Answer 24

Just because a company is overleverages or underleverages does not mean it is wrong , as it may be part of a larger group that is correctly leveraged.

Question 25

How does the optimal debt ratio of young, growth firms compare to older firms?

Answer 25

Young, growth firms typically have a much lower optimal debt ratio as they do not have much income.

Question 26

What are the limitations of the cost of capital approach?

Answer 26

The limitations of the cost of capital approach are:

• It is static, if the operating income changes the optimal debt ratio will change.
• It ignores indirect bankruptcy costss
• The operating income is assumed to stay fixed as the debt ratio and ratings change.
• Beta and ratings are based upon rigid assumptions of how market risk and default risk are borne as the firm borrows more money and the resulting costs.

Question 27

How does the enhanced cost of capital work in detail?

Answer 27

In the enhanced cost of capital we take into account the change in operating income. The indirect costs of bankruptcy are built into the expected operating income. As the rating of the firm declines the operating income is adjusted to reflect the loss in operating income as customers, suppliers, and investors react (the distress effect).
The analysis is dynamic, drawing from a distribution of operating income, and allowing for different outcomes. This is achieved by estimating the effect on EBIT for different ratings.

Question 28

Why is the optimal debt ratio and interest coverage ratio often difficult with regards to financial firms? Because of this how do financial firms typically reach their optimal ratio?

Answer 28

Financial service firms do not typically see debt as a financing source, but instead as a material to produce their product. This means interest coverage ratio spreads must be estimated separately for financial service firms. When doing this we typically ignore more short-term liabilities, and only focus on long-term debt for the interest coverage ratios.
Financial service firms are regulated and so have to meet capital ratios defined in terms of book value, meaning they may struggle to move to an optimal debt ratio. Typically this will mean financial services firms must increase their equity rather than their debt to reach their optimum debt ratio.

Question 29

What are the potential financing strategies for a financial institution?

Answer 29

The financing strategies for a financial institution are: Regulatory minimum strategy, the self-regulatory strategy, or the combination strategy.

Question 30

How does the regulatory minimum strategy work?

Answer 30

In the regulatory minimum strategy, a financial firm trys to maintain the bare minimum equity capital as regulatorily required, in the most aggressive of these they will exploit loopholes to invest in businesses where these ratios are set to low relative to the business risk.

Question 31

How does the self-regulatory strategy work?

Answer 31

In the self-regulatory the firm gains equity not to meet the regulatory capital ratios, but instead, to ensure that losses from the business can be covered from existing equity. Assessing how much equity is needed based on the riskiness of their businesses and the potential for losses.

Question 32

How does the combination strategy for financial firms work?

Answer 32

In the combination strategy the regulatory capital ratios act as a floor for established businesses, with the firm adding buffers for safety where needed.

Question 33

How does the adjusted present value approach work with regards to finding optimal capital structure?
What are the steps?
What does this mean for going down a rating and the value of the firm?

Answer 33

In the adjusted present value approach to optimal capital structure, the value of the firm is the sum of the value of the firm without debt and the effect of debt on firm value:
Firm value = unlevered firm value + (tax benefits of debt - expected bankruptcy cost from the debt).
The steps:
1. Estimate the unlevered firm value, either by estimating the unlevered beta, a cost of equity based on this, and then valuing the forum using the cost of equity, or use
Unlevered firm value = current market value - tax benefits of debt(current) + expected bankruptcy costs from debt.

2. Estimate the tax benefits at different levels of debt. We typically make the assumption that savings are perpetual, in which case tax benefits = dollar debt * tax rate.
3. Estimate a probability of bankruptcy at each debt level and multiply by the cost of bankruptcy (both direct and indirect costs) to estimate the expected bankruptcy cost.

This will mean that as long as going down a rating increases tax benefits more than the expected cost of bankruptcy it will increase the value of the firm.

Question 34

How do we estimate the probability of bankruptcy?

Answer 34

To estimate the probability of bankruptcy we estimate the synthetic rating that the firm will have at each level of debt, then we estimate the probability of bankruptcy over time at that level of debt (use studies). Then we need to estimate the cost of bankruptcy, with the direct costs usually being 5-10% of firm value and the indirect costs being harder.
The indirect costs will be higher will be higher in sectors with operating costs more affected by default risk (less defensive) and lower for defensive industries.

Question 35

How does relative analysis work for debt ratio? What affects it?

Answer 35

In relative analysis we assume the “safest” place for any firm is close to the industry average. We can make subjective adjustments to arrive at the right debt ratio:
Higher tax rates increase the debt ratio,
Lower insider ownership increases the debt ratios (greater discipline),
More stable income increases the debt ratios (lower bankruptcy costs),
More intangible assets lowers the debt ratios (more agency problems).

Question 36

How can we do better than simple averages for relative analysis?

Answer 36

To move past the simple averages for relative analysis we can perform a regression:

1. Run a regression of debt ratio on the variables that are believed to determine debt ratios in the sector e.g tax rate or earnings variability, we check this regression for statistical significance and predictive ability.
2. Estimate the values of the proxies for the firm under consideration. This gives us a predicted debt ratio.
3. Compare the actual debt ratio to the predicted ratio.

Question 37

Should we just use one method of finding the optimal debt ratio?

Answer 37

No, we will often want to summarize the optimal debt ratios and look at all of them to see if a firm is currently under or over leveraged.