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SIM Capital Structure.ppt

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  • The same results are presented here in a graphical format. In the Miller-Modigliani world, this would be a flat line.
  • The main advantage from expansion through acquisition was that 500,000 tones of production capacity were purchased for $ 210.6 mm Vs. building 300,000 tones at $ 500mm. The $ 280mm saved through acquisition was invested in modernization of existing Korean plants so that total production capacity at Sammi Steel rose from 240,000 in 1988 to 750,000 in 1991. Domestic and Foreign investors supported Sammi’s move to acquire the Atlas group of factories as a good strategic move and the Sammi share price rose from 21,489 Korean won on 12/31/88 to 25700 on 12/31/89.
  • The main advantage from expansion through acquisition was that 500,000 tones of production capacity were purchased for $ 210.6 mm Vs. building 300,000 tones at $ 500mm. The $ 280mm saved through acquisition was invested in modernization of existing Korean plants so that total production capacity at Sammi Steel rose from 240,000 in 1988 to 750,000 in 1991. Domestic and Foreign investors supported Sammi’s move to acquire the Atlas group of factories as a good strategic move and the Sammi share price rose from 21,489 Korean won on 12/31/88 to 25700 on 12/31/89.
  • An ill-timed decision: The acquisitions were based on the premise that there would be an explosion in world demand for steel. However, 1991 saw a world recession and slowing down of demand in the developed world. As such Sammi miscalculated the extent of demand for steel and over-expanded. The post acquisition phase saw new competitors ( Inchun Iron & Steel and Pohang Iron and Steel) enter the specialty steel market steel. A contraction in demand with a glut of supply of specialty steel products resulted in a price war. Sammi, recently weakened by large borrowings to finance acquisitions and modernization programs was not able to absorb price cuts. Margins were squeezed as prices steadily fell by 35% over 2 years. Further, there was a tightening of flow of funds in the domestic economy so that the official interest rates rose. As Sammi was more heavily leveraged than its competitors due to having borrowed to finance the recent acquisitions, it was more severely hit by the liquidity crunch and interest rate hikes. A depressed demand for steel products resulted in further under-utilization of capacity and the first lay-offs in the company since Hyun-Chul Kim had taken over the reins of the company in 1980. It appears that Sammi did not use an external M&A expert to negotiate the price on the Atlas factories. It is believed that the factories being out-dated and requiring further investment before they would generate positive cash flows were worth less than the $210.6 mm that was paid for them. Several analysts covering the deal felt that Sammi would have been wise to have a seasoned international investment banker represent them in the acquisition negotiations.
  • In an effort to strike at the root internal cause for deterioration in the value of the company, Sammi has undertaken several initiatives in the areas of cost control, productivity and market penetration: Productivity: The impact of a major modernization investment in existing and acquired plants is now being felt, as Sammi is in a better position to cope with a recovering steel market Cost Control: By maintaining a lean organization, Sammi hopes to be in a more resilient state to deal with the unexpected demand shocks of a global market New Markets: Sammi is identifying new customer segments, product uses and geographical markets in a bid to expand their operations Divesting Old Businesses: Sammi has sold off loss making units and business lines which eat away at Sammi’s core competencies. Some of the businesses sold off in the period 1993-1995 are Sammi Precision, Sammi Metal and Technology. Much of the convertible debt issued to finance the Atlas purchase and modernization plans have come up for conversion into equity. This will reduce the interest burden by nearly 6%. However, whether the resultant dilution in the EPS can be avoided will depend on growth in revenues and operating margin.
  • The Value Based Management model shows us that the company’s market value is maximized when revenue growth is accomplished through moderate increase in financial risk and with commensurate increases in productivity. Application of these principles to Sammi Steel highlights the internal reasons for the fall in market value of the company: Growth in revenues which is not translated into healthier operating margins does not add to the market value of the company. Hence, growth in revenues should be accompanied by productivity gains in cost control and efficient allocation of resources Growth through excessive leveraging of the assets of the organization eats away at equity value as it increases the financial costs of growth As is seen above, the market value of Sammi plunged to nearly half its peak of 25,700 Ks won, when the acquisition of Atlas was announced, to 10,500 Ks won in 1994 due to a combination of contraction in the industry, low productivity, high borrowing costs and high costs of production. This against a steady increase in the Korean Industrial Index of 13% over 6 years.
  • As the growth rate for a firm is changed during the course of a valuation, the other characteristics also have to change for consistency.
  • These are the basic questions that we will try to answer in this part of the discussion.
  • This summarizes the trade off that we make when we choose between using debt and equity.
  • Firms like to preserve flexibility. The value of flexibility should be a function of how uncertain future investment requirements are, and the firm’s capacity to raise fresh capital quickly. Firms with uncertain future needs and the inability to access markets quickly will tend to value flexibility the most, and borrow the least.
  • This summarizes the trade off that we make when we choose between using debt and equity.
  • This is the critical second step that all risk and return models in finance take. As examples, Project-specific Risk: Disney’s new Animal Kingdom theme park: To the degree that actual revenues at this park may be greater or less than expected. Competitive Risk: The competition (Universal Studios, for instance) may take actions (like opening or closing a park) that affect Disney’s revenues at Animal Kingdom. Industry-specific risk: Congress may pass laws affecting cable and network television, and affect expected revenues at Disney and ABC, as well as all other firms in the sector, perhaps to varying degrees. International Risk: As the Asian crisis deepens, there may be a loss of revenues at Disneyland (as tourists from Asia choose to stay home) and at Tokyo Disney Market risk: If interest rates in the US go up, Disney’s value as a firm will be affected. From the perspective of an investor who holds only Disney, all risk is relevant. From the perspective of a diversified investor, the first three risks can be diversified away, the fourth might be diversifiable (with a globally diversified portfolio) but the last risk I not.
  • We attach the long term cost of borrowing to all debt (whether short or long term), because we assume that the long term rolled-over cost of borrowing short term will be equal to the long term rate.You also do not want to make it appear to firms that they can lower their cost of capital by simply substituting short term for long term debt. Whether you give debt the tax benefit will depend upon whether you have taxable income in the first place. If you are losing money or have huge net operating losses carried forward, there will be no tax advantage associated with debt. The historical cost of borrowing should never be used as the cost of debt because it is backward looking.
  • This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.
  • This is a simple example, where both the costs of debt and equity are given. Note that both increase as the debt ratio goes up, but the cost of capital becomes lower at least initially as you take on more debt ( because you are substituting in cheaper debt for more expensive equity) At 40%, the cost of capital is minimized. It is the optimal debt ratio.
  • Studies that have looked at the likelihood of a firm being taken over (in a hostile takeover) have concluded that Small firms are more likely to be taken over than larger firms Closely held firms are less likely to be taken over than widely held firms Firms with anti-takeover restrictions in the corporate charter (or from the state) are less likely to be taken over than firms without these restrictions Firms which have done well for their stockholders (positive Jensen’s alpha, Positive EVA) are less likely to be taken over than firms which have done badly. Whether a firm is under bankruptcy threat can be assessed by looking at its rating. If its rating is B or less, you can argue that the bankruptcy threat is real. Looking at historical ROE or ROC, relative to the cost of equity and capital, does assume that the future will look like the past.
  • Transcript

    • 1.  
    • 2. Prof. Ian Giddy New York University Capital Structure Planning SIM/NYU The Job of the CFO
    • 3. Why Financial Restructuring?
      • The Asian Bet
      • The Solution, Part I: Recapitalization
      • The Solution, Part II: Financial Restructuring
      • The Solution, Part III: Corporate Restructuring
    • 4. The Asian Bet
      • High growth disguised speculative financing structures
      • Governments shielded companies and banks from capital market discipline
      • Too much debt
      • Too much foreign-currency debt
      • Closely held ownership relying on reinvested earnings
    • 5. The Asian Bet
      • High growth disguised speculative financing structures
      • Governments shielded companies and banks from capital market discipline
      • Too much debt
      • Too much foreign-currency debt
      • Closely held ownership relying on reinvested earnings
      • The three excesses
      • Too much debt
      • Too much labor
      • Too much capacity
      Example: Hyundai Group
    • 6. How the Bet was Lost
      • Vulnerable economies, newly liberalized, succumbed to currency crises
      • Economic downturns followed
      • Companies were unable to service even domestic debt, never mind foreign currency debt
      • Still unreformed, many Asian companies remain misfinanced
      Example: Hyundai Group
    • 7. What is Corporate Restructuring?
      • Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.
      • Designed to increase the value of the firm
      Restructuring Improve capitalization Change ownership and control Improve debt composition
    • 8. It’s All About Value
      • How can corporate and financial restructuring create value?
      Operating Cash Flows Debt Equity Assets Liabilities Fix the business Or fix the financing
    • 9. Restructuring What mix of debt is best suited to this business? Fix the kind of debt or hybrid financing What can be done to make the equity more valuable to investors? Fix the kind of equity Value the changes new control would produce Fix management or control Revalue firm under different leverage assumptions – lowest WACC Fix the financing – improve D/E structure Value the merged firm with synergies Fix the business – strategic partner or merger Value assets to be sold Fix the business mix – divestitures Use valuation model – present value of free cash flows Figure out what the business is worth now
    • 10. Getting the Financing Right Step 1: The Proportion of Equity & Debt Debt Equity
      • Achieve lowest weighted average cost of capital
      • May also affect the business side
    • 11. Getting the Financing Right Step 2: The Kind of Equity & Debt Debt Equity
      • Short term? Long term?
      • Baht? Dollar? Yen?
      • Bonds? Asset-backed?
      • Convertibles? Hybrids?
      • Debt/Equity Swaps?
      • Private? Public?
      • Strategic partner?
      • Domestic? ADRs?
      • Ownership & control?
    • 12. Does Capital Structure Matter?
      • Assets’ value is the present value of the cash flows from the real business of the firm
      • Value of the firm
      • =PV(Cash Flows)
      • Debt
      • Equity
      • Value of the firm
      • = D + E
      You cannot change the value of the real business just by shuffling paper - Modigliani-Miller
    • 13. Does Capital Structure Matter? Yes!
      • Assets’ value is the present value of the cash flows from the real business of the firm
      • Value of the firm
      • =PV(Cash Flows)
      • Debt
      • Equity
      • Value of the firm
      • = D + E
      COST OF CAPITAL DEBT RATIO Optimal debt ratio?
    • 14. Does Capital Structure Matter? Yes!
      • Assets’ value is the present value of the cash flows from the real business of the firm
      • Value of the firm
      • =PV(Cash Flows)
      • Debt
      • Equity
      • Value of the firm
      • = D + E
      VALUE OFTHE FIRM DEBT RATIO Optimal debt ratio?
    • 15. Does Capital Structure Matter? Yes!
      • Assets’ value is the present value of the cash flows from the real business of the firm
      • Value of the firm
      • =PV(Cash Flows)
      • Debt
      • Equity
      • Value of the firm
      • = D + E
      Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs
    • 16. Managing the capital base
      • Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000
      • Flexibility to redeem non-voting shares and buy back ordinary shares
      • Flexibility to dispose remaining non-core assets
      • Utilizing excess capital for organic growth and acquisitions
    • 17. Changing Financial Mix
      • Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt.
      • Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
      • The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.
    • 18. Debt: Pros and Cons Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit: Higher tax rates --> Higher tax benefit 1. Bankruptcy Cost: Higher business risk --> Higher Cost 2. Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit 2. Agency Cost: Greater the separation between stock- holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost
    • 19. See Saw Business Uncertainty Financial Risk Operating Leverage Financial Leverage
    • 20. Young and Old Size Maturity Operating Leverage Financial Leverage Operating Leverage Financial Leverage
    • 21. Disney Weighted Average Cost of Capital and Debt Ratios Debt Ratio WACC 9.40% 9.60% 9.80% 10.00% 10.20% 10.40% 10.60% 10.80% 11.00% 11.20% 11.40% 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
    • 22. Siderar: Steel Company in Argentina
    • 23. Capital Structure: East vs West VALUE OFTHE FIRM DEBT RATIO Optimal debt ratio? Intel TPI
    • 24. Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas
    • 25. Perceived Benefits to Sammi From Acquisition of Atlas Steel
      • Achieve $280mm savings by acquiring Atlas Steel and related companies
        • Cost of setting up own production facility would have been $500 mm
        • Savings were channeled into restructuring production facilities at existing plants
      • Sammi’s share price rose 9% on news of strategic acquisitions
    • 26. How Should the Acquisition Have Been Financed? Assets added: $210 million Debt added: $210 million (C$250m)
    • 27. How Should the Acquisition Have Been Financed? Assets added: $210 million Debt added: $210 million (C$250m) Loan: C$180m Ret earn: C$70m Plus w.cap.: Eurobond with warrants US$50m
    • 28. Problems faced by Sammi from the Acquisition
      • Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages
      • Future refinancing of debt caused earnings after interest costs to fall 17%
      • Purchase price of $210.6 mm found to have been excessive
      • The acquisition was ill-timed
      • Existing and new plants suffered from low capacity utilization of around 65%
    • 29. Sammi Steel in 1995
      • Sammi Atlas pushed to raise productivity by 15%
      • A leaner organization: Work force had shrunk by 19.4% since 1988
      • 4 year freezes on salaries to limit labor costs
      • Unrelated and unprofitable businesses have been sold off
      • New export zones identified in China and South-East Asia
      • Conversion of debt into equity to reduce interest costs by 6%;
      • Result: dilution in EPS, unless offset by increased volume of sales
    • 30. Analysis of Change in Value of Sammi Steel
    • 31. March 1997
      • Sammi Steel is bankrupt!
    • 32. March 1997
      • Sammi Steel is bankrupt!
      • Dr F R Structuring
      • Diagnosis
      • Prevention
      • and Cure
    • 33. Financing Choices
      • Assets’ value is the present value of the cash flows from the real business of the firm
      • Value of the firm
      • =PV(Cash Flows)
      • From
      • How much debt?
      • to
      • What kind of debt?
      • and
      • What kind of equity?
      You can make a difference - Pepper-Giddy
    • 34. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBT EQUITY TOOLS MEASUREMENT Case Study: “Intralinks”
    • 35. Prof. Ian Giddy New York University Financing Growth Companies
    • 36. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBT EQUITY TOOLS MEASUREMENT
    • 37. The CFO Questions
      • How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
      • How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
      • How much (cheap) debt should we have?
      • What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
      • How should we manage our financial risks?
    • 38. Financing X Inc
    • 39. Financing X Inc
    • 40. Financing X Inc
    • 41. Corporate Financing Life-Cycle
      • Leverage
      Growth companies Mature companies
    • 42. Firm Characteristics as Growth Changes
      • Variable High Growth Firms tend to Stable Growth Firms tend to
      • Risk be above-average risk be average risk
      • Dividend Payout pay little or no dividends pay high dividends
      • Net Cap Ex have high net cap ex have low net cap ex
      • Return on Capital earn high ROC (excess return) earn ROC closer to WACC
      • Leverage have little or no debt higher leverage
      Earnings Gearing (Leverage) 0
    • 43. Financing Growth Companies: The Agenda
      • Where can we get the initial equity financing we need to grow?
      • Do we want money, management, or more?
      • When do we want to sell out, and how?
      • When is the right time for debt for a growth company? What kind?
    • 44. What Kind of Equity?
      • Sources of Equity
        • Private investors
        • Strategic investors
        • Interventionist investors
        • Public market
      • And Kinds
        • Common stock
        • Stock with restricted voting rights
        • Hybrids, including convertibles
    • 45. .comfax (now Messageclick)
      • Started in September 1997, .comfax enables users to send faxes and receive faxes over the internet at a low cost.
      • By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day.
      • Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money.
      • What form of equity financing would be appropriate for .comfax?
    • 46. Pre-IPO Equity Financing
      • Friends and family
      • Angel
      • Venture capital
      • Strategic partners
    • 47. Pre-IPO Equity Financing
      • Friends and family
      • Angel
      • Venture capital
      • Strategic partners
      asiajack.com
    • 48. Private Equity Funds
      • Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring.
      • The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.
    • 49. Silipos Inc
    • 50. Silipos Inc, 1999 Where do you want to go? Debt? Acquisition? IPO? Sell?
    • 51. IntraLinks
    • 52. IntraLinks’ Choices
      • Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.
      • Seek out one or more private equity investors, ones who believed in the company’s product and its management.
      • Do an initial public offering (IPO).
      • Find another corporation who would be willing to acquire IntraLinks .
    • 53. Why Venture Capitalists Prefer Preferred
      • Senior status in bankruptcy
      • Does not put a value on the shares
      • Is convertible into common stock before the IPO
      • Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero)
    • 54. Case Study: Photronics
    • 55. Case Study: Photronics Photronics is the world's leading and fastest growing manufacturer of photomasks. Photomasks are high precision quartz plates that contain microscopic images of electronic circuits. A key element and enabling technology in the manufacture of semiconductors, photomasks are used to transfer circuit patterns onto semiconductor wafers during the fabrication of integrated circuits. They are produced in accordance with circuit designs provided by customers at strategically located manufacturing facilities in North America, Europe and Asia.
    • 56. Case Study: Photronics Sales, 1994-99
    • 57. The Company’s Debt
    • 58. Should Photronics Have More Debt?
      • Benefits of Debt
        • Tax Benefits
        • Adds discipline to management
      • Costs of Debt
        • Bankruptcy Costs
        • Agency Costs
        • Loss of Future Flexibility
    • 59. The CFO Questions
      • How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?
      • How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?
      • How much (cheap) debt should we have?
      • What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?
      • How should we manage our financial risks?
    • 60. Some Useful Websites
      • giddy.org/jcfo.htm
      • giddy.org
      • giddyonline.com
      • shareinvestor.com
      • dialpad.com
      • onebox.com
    • 61. Measuring the Cost of Capital
      • Cost of funding equal return that investors expect
      • Expected returns depend on the risks investors face (risk must be taken in context)
      • Cost of capital
        • Cost of equity
        • Cost of debt
        • Weighted average (WACC)
    • 62. A $1 Investment in Different Types of Portfolios: 1926-1996 Index ($) $4,495.99 $33.73 $13.54 $8.85 $1,370.95 Small Company Stocks Large Company Stocks Long-Term Government Bonds Treasury Bills Inflation Year-End
    • 63. Equity Risk
      • The risk (variance) on any individual investment can be broken down into two sources. Some of the risk is specific to the firm, and is called firm-specific, whereas the rest of the risk is market wide and affects all investments.
      • The risk faced by a firm can be fall into the following categories –
        • (1) Project-specific ; an individual project may have higher or lower cash flows than expected.
        • (2) Competitive Risk , which is that the earnings and cash flows on a project can be affected by the actions of competitors.
        • (3) Industry-specific Risk , which covers factors that primarily impact the earnings and cash flows of a specific industry.
        • (4) International Risk , arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced
        • (5) Market risk , which reflects the effect on earnings and cash flows of macro economic factors that essentially affect all companies
    • 64. Equity versus Bond Risk Uncertain value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Assets Liabilities Debt Residual payments Upside and downside Residual claims Voting control rights Equity
    • 65. Corporate Cash Flow Valuation: The Steps
      • Estimate the discount rate or rates to use in the valuation
        • Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm)
        • Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real
        • Discount rate can vary across time.
      • Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm)
      • Estimate the future earnings and cash flows on the asset being valued, generally by estimating an expected growth rate in earnings.
      • Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does.
      • Choose the right DCF model for this asset and value it.
    • 66.  
    • 67. Let’s Start With the Cost of Debt
      • The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components-
        • (a) The general level of interest rates
        • (b) The default premium
        • (c) The firm's tax rate
    • 68. What the Cost of Debt Is and Is Not…
      • The cost of debt is
        • the rate at which the company can borrow at today
        • corrected for the tax benefit it gets for interest payments.
      • Cost of debt =
      • k d = LT Borrowing Rate(1 - Tax rate)
      • The cost of debt is not
        • the interest rate at which the company obtained the debt it has on its books.
    • 69. Estimating the Cost of Debt
      • If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate.
      • If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.
      • If the firm is not rated,
        • and it has recently borrowed long term from a bank, use the interest rate on the borrowing or
        • estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt
      • The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.
    • 70. Estimating Synthetic Ratings
      • The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio
      • Interest Coverage Ratio = EBIT/Interest Expenses
      • For Siderar, for instance
        • Interest Coverage Ratio = 161/48 = 3.33
        • Based upon the relationship between interest coverage ratios and ratings, we would estimate a rating of A- for Siderar.
        • Given the rating of A-, default spread is 1.25%
    • 71. Interest Coverage Ratios, Ratings and Default Spreads
        • If Interest Coverage Ratio is Estimated Bond Rating Default Spread
        • > 8.50 AAA 0.20%
        • 6.50 - 8.50 AA 0.50%
        • 5.50 - 6.50 A+ 0.80%
        • 4.25 - 5.50 A 1.00%
        • 3.00 - 4.25 A– 1.25%
        • 2.50 - 3.00 BBB 1.50%
        • 2.00 - 2.50 BB 2.00%
        • 1.75 - 2.00 B+ 2.50%
        • 1.50 - 1.75 B 3.25%
        • 1.25 - 1.50 B – 4.25%
        • 0.80 - 1.25 CCC 5.00%
        • 0.65 - 0.80 CC 6.00%
        • 0.20 - 0.65 C 7.50%
        • < 0.20 D 10.00%
    • 72. Other Factors Affecting Ratios Medians of Key Ratios : 1993-1995
    • 73. Estimating Siderar’s Cost of Debt (in $)
      • Riskfree Rate = 6%
      • Country default spread = 5.25% (Argentine default spread)
        • I am assuming that all Argentine companies have to pay at least this spread.
      • Rating for Siderar = A-
      • Default spread = 1.25%
      • Pre-tax cost of borrowing for first 5 years= 6% + 5.25% + 1.25% = 12.50%
    • 74. The Cost of Equity
      • Equity is not free!
      • Expected return = Risk-free rate + Risk Premium
      • E(R Risky ) = R Risk-free -+ Risk Premium
    • 75. The Cost of Equity
      • Consider the standard approach to estimating cost of equity:
      • Cost of Equity = R f + Equity Beta * (E(R m ) - R f )
      • where,
      • R f = Riskfree rate
      • E(R m ) = Expected Return on the Market Index (Diversified Portfolio)
      • In practice,
        • Short term government security rates are used as risk free rates
        • Historical risk premiums are used for the risk premium
        • Betas are estimated by regressing stock returns against market returns
    • 76.  
    • 77. Estimating Beta
      • The standard procedure for estimating betas is to regress stock returns (R j ) against market returns (R m ) -
      • R j = a + b R m
        • where a is the intercept and b is the slope of the regression.
      • The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
      • This beta has three problems:
        • It has high standard error
        • It reflects the firm’s business mix over the period of the regression, not the current mix
        • It reflects the firm’s average financial leverage over the period rather than the current leverage.
    • 78. Beta Estimation: The Old Fashioned Way
    • 79. Determinants of Betas
      • Product or Service : The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market.
        • Cyclical companies have higher betas than non-cyclical firms
        • Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products
      • Operating Leverage : The greater the proportion of fixed costs in the cost structure of a business, the higher the beta will be of that business. This is because higher fixed costs increase your exposure to all risk, including market risk.
      • Financial Leverage : The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risk.
    • 80. The Cost of Capital
          • Choice Cost
          • 1. Equity Cost of equity
          • - Retained earnings - depends upon riskiness of the stock
          • - New stock issues - will be affected by level of interest rates
          • - Warrants
          • Cost of equity = riskless rate + beta * risk premium
          • 2. Debt Cost of debt
          • - Bank borrowing - depends upon default risk of the firm
          • - Bond issues - will be affected by level of interest rates
          • - provides a tax advantage because interest is tax-deductible
          • Cost of debt = Borrowing rate (1 - tax rate)
          • Debt + equity = Cost of capital = Weighted average of cost of equity and
          • Capital cost of debt; weights based upon market value.
          • Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]
    • 81. Estimating Cost of Capital: Siderar
      • Equity
        • Cost of Equity = 6.00% + 0.71 (16.03%) = 17.38%
        • Market Value of Equity = 3.20* 310.89 = 995 million (94.37%)
      • Debt
        • Cost of debt = 6.00% + 5.25% + 1.25% (default spread) = 12.5%
        • Market Value of Debt = 59 Mil (5.63%)
      • Cost of Capital
      • Cost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563))
      • = 17.38%(.9437) + 8.32%(.0563) = 16.87%
    • 82. Next, Minimize the Cost of Capital by Changing the Financial Mix
      • The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm.
      • Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt.
      • But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
      • The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.
    • 83. This is What We’re Trying to Do
    • 84. Cost of Capital and Leverage: Method Estimated Beta With current leverage From regression Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Cost of equity With different leverage E(R)=Rf+Bl(Rm-Rf) Equity Leverage, EBITDA And interest cost Interest Coverage EBITDA/Interest Rating (other factors too!) Cost of debt With different leverage Rate=Rf+Spread+? Debt
    • 85. Siderar: Optimal Debt Ratio Question: If Siderar’s current debt ratio is 60%, what do you recommend?
    • 86. Siderar: Optimal Debt Ratio
    • 87. A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Is the firm a takeover target? Yes No Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with new equity or with retained earnings. No 1. Pay off debt with retained earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt. Yes No Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends No Buy back stock Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares.
    • 88.  
    • 89.
      • giddyonline.com
    • 90.
      • w w w . g i d d y . o r g
    • 91.  
    • 92. giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332 Fax 917-463-7629 [email_address] http://giddy.org