1

OPTIMAL FINANCING MIX IV:

WRAPPING UP THE COST OF
CAPITAL APPROACH
One size does not t all.

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

 Enhanced Cost of Capital Approach

3

Distress cost aected operaIng income: In the enhanced

cost of capital approach, the indirect costs of bankruptcy
are built into the expected operaIng income. As the
raIng of the rm declines, the operaIng income is
adjusted to reect the loss in operaIng income that will
occur when customers, suppliers and investors react.
Dynamic analysis: Rather than look at a single number
for operaIng income, you can draw from a distribuIon
of operaIng income (thus allowing for dierent
outcomes).
3

EsImaIng the Distress Eect- Disney

4

Rating
To
To
To
To
To
To
To

A
ABBB
BB+
BC
D

Drop in EBITDA
(Low)
No effect
No effect
5.00%
10.00%
15.00%
25.00%
30.00%

Drop in EBITDA
(Medium)
No effect
2.00%
10.00%
20.00%
25.00%
40.00%
50.00%

Drop in EBITDA
(High)
2.00%
5.00%
15.00%
25.00%
30.00%
50.00%
100.00%

The OpImal Debt RaIo with Indirect

Bankruptcy Costs
Debt Ratio

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Beta

0.9239

0.9895

1.0715

1.1769

1.3175

1.5573

1.9946

2.6594

3.9892

7.9783

Interest rate on
debt

Cost of Equity
Bond Rating

8.07%

Aaa/AAA

3.15%

8.45%

Aaa/AAA

3.15%

8.92%

Aaa/AAA

3.15%

9.53%

Aa2/AA

3.45%

10.34%

A2/A

3.75%

11.72%

C2/C

11.50%

14.24%

Caa/CCC

13.25%

18.07%

Caa/CCC

13.25%

25.73%

Caa/CCC

13.25%

48.72%

Caa/CCC

13.25%

Tax Rate

36.10%

36.10%

36.10%

36.10%

36.10%

31.44%

22.74%

19.49%

17.05%

15.16%

Cost of Debt (aftertax)

2.01%

2.01%

2.01%

2.20%

2.40%

7.88%

10.24%

10.67%

10.99%

11.24%

WACC

8.07%

7.81%

7.54%

7.33%

7.16%

9.80%

11.84%

12.89%

13.94%

14.99%

Enterprise
Value

$122,633

$134,020

$147,739

$160,625

$172,933

$35,782

$25,219

$21,886

$19,331

$17,311

The optimal debt ratio stays at 40% but the cliff becomes much
steeper.

5

Extension to a family group company: Tata

Motors OpImal Capital Structure

Tata Motors looks like it is over levered (29% actual versus 20% optimal), perhaps
because it is drawing on the debt capacity of other companies in the Tata Group.

Extension to a rm with volaIle earnings:

Vales OpImal Debt RaIo

Replacing Vales current

operating income with
the average over the last
three years pushes up
the optimal to 50%.

7

OpImal Debt RaIo for a young, growth rm:

Baidu

The optimal debt ratio for Baidu is between 0 and 10%, close to its current debt ratio of 5.23%, and
much lower than the optimal debt ratios computed for Disney, Vale and Tata Motors.

Extension to a private business

OpImal Debt RaIo for Bookscape
Debt value of leases = $12.136 million (only debt)

Estimated market value of equity = Net Income * Average PE for Publicly Traded Book
Retailers = 1.575 * 20 = $31.5 million



Debt ratio = 12,136/(12,136+31,500) = 27.81%

The firm value is maximized (and the cost of capital is minimized) at a debt ratio of
30%. At its existing debt ratio of 27.81%, Bookscape is at its optimal.

9

10

Capital Structure for a bank:

An AlternaIve Approach

Consider a bank with $ 100 million in loans outstanding and a book value of equity of $ 6 million.
Furthermore, assume that the regulatory requirement is that equity capital be maintained at 5% of loans
outstanding. Finally, assume that this bank wants to increase its loan base by $ 50 million to $ 150 million
and to augment its equity capital raIo to 7% of loans outstanding.
Loans outstanding aber Expansion

= $ 150 million
Equity aber expansion

= 7% of $150
= $10.5 million
ExisIng Equity



= $ 6.0 million
New Equity needed


= $ 4.5 million
Your need for external equity as a bank/nancial service company will depend upon
a.
Your growth rate: Higher growth -> More external equity
b.
ExisIng capitalizaIon vs Target capitalizaIon: Under capitalized -> More external equity
c.
Current earnings: Less earnings -> More external equity
d.
Current dividends: More dividends -> More external equity

10

11

Determinants of the OpImal Debt RaIo:

1. The marginal tax rate

The primary benet of debt is a tax benet. The

higher the marginal tax rate, the greater the benet
to borrowing:

11

2. Pre-tax Cash ow Return

12

12

3. OperaIng Risk
13

Firms that face more risk or uncertainty in their operaIons (and

more variable operaIng income as a consequence) will have lower
opImal debt raIos than rms that have more predictable
operaIons.
OperaIng risk enters the cost of capital approach in two places:

Unlevered beta: Firms that face more operaIng risk will tend to have
higher unlevered betas. As they borrow, debt will magnify this already
large risk and push up costs of equity much more steeply.
Bond raIngs: For any given level of operaIng income, rms that face more
risk in operaIons will have lower raIngs. The raIngs are based upon
normalized income.

13

7.00%

Figure 16: Equity Risk Premiums and Bond Default Spreads

9.00
8.00

6.00%

6.00

4.00%

5.00

3.00%

4.00
3.00

2.00%

ERP / Baa Spread

7.00
5.00%
Premium (Spread)

14

4. The only macro determinant:

Equity vs Debt Risk Premiums

2.00
1.00%

1.00

0.00%

0.00
ERP/Baa Spread

Baa - T.Bond Rate

ERP

14

15

6ApplicaIon Test: Your rms opImal

nancing mix

Using the opImal capital structure spreadsheet

provided:

EsImate the opImal debt raIo for your rm

EsImate the new cost of capital at the opImal
EsImate the eect of the change in the cost of capital on rm
value
EsImate the eect on the stock price

In terms of the mechanics, what would you need to do

to get to the opImal immediately?
15

Task
Examine the
connecIon
between your
companys
fundamentals &
its opImal debt
raIo

16

Read
Chapter 8