Capital Structure Theory & Applications Ruben D. Cohen ruben . cohen @ citi .com   0207 500 5793 Risk Architecture Citigro...
1. Introduction Background, Scope and Outline
Background <ul><li>What is capital structuring? </li></ul><ul><ul><li>Process of interchanging debt, equity and assets </l...
Scope
Outline <ul><li>Introduction </li></ul><ul><li>Modigliani & Miller ( M&M ) ( paper 1 ) </li></ul><ul><ul><li>Derivation </...
End Part 1
2. The Modigliani-Miller ( M&M ) Theorems Motivation & Methodology
Motivation Key Observation 1 Equity, E Debt, D Balance Sheet EBIT EBIT   x  (1- T ) Income Statement What if  T  = 100%? D...
Total Discounted Value derived from Income Statement Effectively, a capital of 100 is being used to operate a firm that’s ...
Theory <ul><li>Key observations create a need to: </li></ul><ul><ul><li>Reconcile the difference in valuations between the...
The  M&M  Methodology Simplistic Derivation EBIT EBIT   x  (1- T ) R D D (1- T ) R E E D   x  (1- T ) E + Total Discounted...
The  M&M  Methodology Proposition I This difference is attributed to tax and debt.  In the absence of taxes, there are no ...
The  M&M  Methodology Proposition II <ul><li>If  FV  =  D + E </li></ul><ul><li>And the value added due to debt =  D  x  T...
The  M&M  Methodology in Practice Creating the FV Curve – Step 1 <ul><li>Question:  Consider the firm has  D  = 80 and  E ...
<ul><li>Question:  The firm is now fully debt free.  It wants to borrow 20 to buy back some of its shares and, at the same...
The  M&M  Methodology in Practice A More Methodical approach <ul><li>Begin with the original financial statement </li></ul...
The  M&M  Methodology in Practice A More Methodical approach <ul><li>Define </li></ul><ul><li>and populate relevant cells ...
The  M&M  Methodology in Practice A More Methodical approach <ul><li>Calculate parameters for  D  = 0 </li></ul><ul><ul><l...
The  M&M  Methodology in Practice A More Methodical approach <ul><li>Recall  E +(1- T ) D  = 100 across all debt levels – ...
The  M&M  Methodology Graphical Representation 0% 50% 100% 150% 200% 0 10 20 30 40 ROE Leverage,
The  M&M  Methodology Effect of Tax Rate T > 0% T = 0
Spreadsheet Demo M&M Methodology
End of Part 2
3. Beta
What is Beta? <ul><li>Defined as:  </li></ul><ul><li>It is a measure of “relative” risk </li></ul><ul><li>It depends on le...
What is Beta? Example with R f   = 5% beta
What is Beta? Example with R f   = 20% beta
What is Beta? Example with R f   = 0 beta
Incorporating Hamada’s Equation Alternative Approach to Capital Structure Analysis Using the Beta
Important Relationships Valid only when the cost of debt,  R D , is constant, independent of leverage (see  paper 3 ) Hama...
Implementation…
Implementation… Populate “ E ” column using  E  =  V U  – D (1- T ) = 100 –  D (1-40%)
Implementation… <ul><li>Populate  D/E  column </li></ul><ul><li>Compute  </li></ul>
Implementation… Populate rest of beta:
Implementation… <ul><li>Populate  ROE : </li></ul><ul><li>Populate  WACC :  </li></ul>
Comparison Beta approach Classical approach Identical Results
Spreadsheet Demo M&M Methodology via Beta
End of Part 3
4. The Risk of Default and Credit Rating Methodologies
Credit Risk and Credit Spread Some Facts <ul><li>The interest rate at which corporations can borrow money depends on the m...
Credit Rating Models <ul><li>Credit agencies, the primary ones being S&P, Moody’s and Fitch, use “credit rating models” to...
Assessing the Risk of Default Different Credit Rating Methodologies <ul><li>There are three main classes of quantitative  ...
The  S&P  Model Key Ratios
The  S&P  Model Rating of the Key Ratios
The  S&P  Model How it works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread http://www2...
The  S&P  Model Worked Example with One Ratio
The  S&P  Model  Worked Example with One Ratio <ul><li>1. Given current  FS , we can calculate: </li></ul><ul><li>Interest...
Necessary Data http://www2.standardandpoors.com/spf/pdf/fixedincome/corporateratings_2006.pdf?vregion=ap&vlang=en
Necessary Data http://www.bonds-online.com/Todays_Market/Corporate_Bond_Spreads.php
The  S&P  Model  Worked Example with One Ratio – Cont’d… Curve Fit for Spread vs Rating
The  S&P  Model  Worked Example with One Ratio – Cont’d… <ul><li>1. Calculate: </li></ul><ul><li>Interest rate = 5/80 =  6...
The  S&P  Model  Worked Example with One Ratio – Cont’d… <ul><li>ICR  =  4.0 , Interest rate =  6.25% , spread =  1.74%   ...
The  S&P  Model  Worked Example with One Ratio – Cont’d… <ul><li>Populate row D = 0 </li></ul>
The  S&P  Model  Worked Example with One Ratio – Cont’d… <ul><li>Use iterative procedure </li></ul>to populate row D = 8
The  S&P  Model  Worked Example with One Ratio – Cont’d… <ul><li>Populate remainder of table using the same iterative proc...
The  Z -Score Model  <ul><li>Based on regression analysis of ratios </li></ul><ul><li>Define: </li></ul>
The  Z -Score Model  Implementation Historical Statistics show that for manufacturers, non-manufacturer industrials, and e...
The  Z -Score Model  US Bond Rating Equivalent Based on the Adjusted Model
Merton’s Model Question:  Borrow $ D  today to start a business. Interest is paid throughout the year and the loan   is to...
Comparison <ul><li>Ratios/Scoring </li></ul><ul><li>Need calibration </li></ul><ul><li>Incorporate more variables </li></u...
End of Part 4
5. Incorporating Default Risk
Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure
Impact of Default Risk <ul><li>Leads to credit spread </li></ul><ul><li>Gives an “optimal capital structure” </li></ul><ul...
Optimization of the Capital Structure <ul><li>Objective is to locate the “optimal capital structure” </li></ul><ul><li>By ...
Procedure Requirements <ul><li>Need a credit-rating model to calculate credit spreads along the curve </li></ul><ul><ul><l...
Procedure Flowchart Original Financial Statement : With default risk Convert to no-default scenario Apply  M&M  methodolog...
Procedure Begin with original financial statement:  With default risk
Procedure Step-by-Step <ul><li>Produce table in the following form </li></ul><ul><li>Fill in cells using the financial sta...
Procedure cont’d Or use curve-fitted <ul><li>Need “ CRM ” </li></ul><ul><li>Fill in remaining cells in the same row </li><...
Procedure cont’d <ul><li>Calculate  V U  =  E 0  =  D * x (1- T )+ E  = 110.7 (1 – 0.4) + 52 = 118.4 </li></ul><ul><li>Pop...
Procedure cont’d <ul><li>Populate next row via the following iteration scheme: </li></ul>& Factors Ratios Implied Spread C...
Procedure cont’d <ul><li>And so on ... </li></ul>
Procedure Outcome
End of Part 5
6. Incorporating Default Risk into Beta Generating the WACC Curve via the Modified Hamada Equation
Important Relationships Recall <ul><li>Valid only when interest rates are constant, independent of leverage. </li></ul><ul...
Procedure Step-by-Step <ul><li>Create table with the following format </li></ul><ul><li>Fill in cells using information fr...
Procedure Step-by-Step <ul><li>Calculate risk-free rate using earlier procedure </li></ul><ul><li>Populate  D* ,  D*/E ,  ...
Procedure Step-by-Step <ul><li>Compute   u  using  D * /E  rather than  D/E </li></ul><ul><li>Compute  V u  = E + D *   ...
Procedure Step-by-Step <ul><li>Populate remaining rows using same methodology as before </li></ul>
Comparison WACC  computed using beta WACC  computed the direct way Shouldn’t make any difference!
End of Part 6
7. Incorporating More Ratios
How It Works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread
Spreadsheet Example <ul><li>Note that the S&P  CRM  depends on 8 or 9 ratios. </li></ul><ul><li>Previous example involved ...
End of Part 7
8. Application to Scenarios <ul><li>M&A  (acquisition) </li></ul><ul><li>Divestiture </li></ul><ul><li>Share and debt issu...
Extension to Other Scenarios <ul><li>Spreadsheet Demo for M&A </li></ul><ul><li>(Acquisition) </li></ul>
Extension to Other Scenarios 2. Spreadsheet Demo for Divestiture
Extension to Other Scenarios 3. Spreadsheet Demo for Share and Debt Issues and Buybacks
End of Part 8
9. Applying Constraints
Applying “Constraints” <ul><li>Question:  What if no suitable assets were available for purchase or there was a preference...
Applying “Constraints” Outcome  = 80/52=1.54 R D *   = 3.99% R D   = 6.25% V u   = 52 + [6.25%/3.99%]   80  (1-40%) = ...
Finding the  OCS  under “Constraints” Extending Along All Leverage <ul><li>Every point along the  E+D  = const. line will ...
Finding the  OCS  under “Constraints” Generalization OCS  occurs at min  V U / FV OCS FV = constant
On the Side Recall <ul><li>From Part 2 (derivation of classical  M&M ) </li></ul><ul><li>Outcome:  NOPAT     operating ca...
On the Side Implications on the S&P CRM <ul><li>The  S&P CRM  contains ratios that involve the  EBIT </li></ul><ul><ul><li...
Finding the  OCS  under “Constraints”   Possible Scenarios 1 & 2 Scenario 2:  The firm wants to keep the equity level cons...
Finding the  OCS  under “Constraints”   Possible Scenarios 3 & 4 Scenario 4:  The firm wants to keep the debt level consta...
Finding the  OCS  under “Constraints”   Results Summary – Capital Structure Curve In general, any type of constraint could...
Finding the  OCS  under “Constraints”   Results Summary - Table 51% 1.54 4. Const  D  at 80 57% 1.54 3. Const  FV  at 132 ...
Applying Constraints Spreadsheet Demonstration E = constant
Applying Constraints Spreadsheet Demonstration FV = constant
Applying Constraints Spreadsheet Demonstration D = constant
End of Part 9
10. Case Studies
Dealing with the  Financial Statement Needed for  M&M  analysis  Needed for  M&M  analysis  B.S. I.S. Needed for CRM  equi...
Case Studies by Company <ul><li>Procter & Gamble (USA) </li></ul><ul><li>Coca-Cola (USA) </li></ul><ul><li>Nestl é  Group ...
Company Analysis Procter & Gamble
Company Analysis Procter & Gamble – Income Statement EBIT Interest* Tax Other inc. *Capital lease charge are generally to ...
Company Analysis Procter & Gamble – Liabilities * ST IB Debt LT IB Debt *Capital leases are generally to be included in th...
Company Analysis Procter & Gamble – ME and BE Market cap = USD205B BV of Equity Ratio  BV/MV  = 0.33
Company Analysis Procter & Gamble – Cash Flow Dep & Amort
Company Analysis   Procter & Gamble – Input into the Model 66,760 B Equity 23,375+12,039 =  35,414  (capital lease negligi...
Company Analysis Procter & Gamble – Model Output
Application Spreadsheets
PG  Comparison
Company Analysis The Coca-Cola Company
Company Analysis Coca-Cola – Income Statement *Capital lease charge are generally to be included in gross interest.  In th...
Company Analysis Coca-Cola – Liabilities & Equity * ST IB Debt LT IB Debt *Capital leases are generally to be included in ...
Company Analysis Coca-Cola – Cash Flow Dep & Amort
Company Analysis   Coca-Cola – Input into the Model 21,744 B Equity 5,919+133+3,277 =  9,329 IB Debt 0.16 BV/MV 5,981 Prof...
Company Analysis Coca-Cola – Model Output
Application Spreadsheets
Company Analysis Nestl é  Group
Company Analysis Nestl é Group  – Income Statement EBIT See Notes Other Income
Company Analysis Nestl é Group  – Note 3 & 5 on Interest and Tax Interest* Tax * Negligible capital lease charge.
Company Analysis Nestl é Group   – Liabilities * ST IB Debt LT IB Debt *Capital leases negligible.
Company Analysis Nestl é  Group – Equity at Market Value MV of Equity BV of Equity Ratio  BV/MV  = 0.28
Company Analysis Nestl é Group   – Cash Flow Dep & Amort Unusual
Company Analysis Nestl é Group  – Input into the Model Spreadsheet 195,661 MV Equity 24,541+6,129 =  30,670 IB Debt 54,234...
Company Analysis Nestl é Group  – Model Output
Application Spreadsheet
Company Analysis Electrolux
Income Statement Electrolux - P. 7 – All figures in  SEKm EBT EBIT+other income See notes for Interest See notes for tax
Income Statement Electrolux - Note 9 – Interest Expense Interest
Income Statement Electrolux - Note 10 – Tax
Balance Sheet Liabilities Electrolux - P. 11 – All figures in  SEKm BE LT debt ST debt
Other Useful Information Electrolux <ul><li>Credit Rating (p. 37) </li></ul><ul><li>Market Cap (p. 76) </li></ul>
Company Analysis Electrolux – Input into the Model 16,040 B Equity 4,887+,701 =  10,588 IB Debt 16,040/34,000 =0.47 BV/MV ...
Company Analysis Electrolux – Model Output Compare
Spreadsheet Demo
Company Analysis The Walt Disney Company
Company Analysis Disney – Income Statement EBT For tax – see notes For interest expense, see notes
Company Analysis Disney – D&A
Company Analysis Disney – Gross Borrowings *Capital leases negligible
Company Analysis Disney – Income Taxes Total tax paid EBT
Company Analysis Disney – Gross Interest Expense *Capital lease charges, negligible
Company Analysis Disney – Shareholders’ Equity BV of Equity MV of equity (market cap) = USD 65B
Company Analysis   Disney – Input into the Model 30,753 B Equity 15,172 IB Debt = 30,753/65,000 = 0.473 BV/MV 4,724 Profit...
Company Analysis   Disney – Model Output See p. 44
Application Spreadsheet
Company Analysis Telenor
Company Analysis Telenor – Income Statement EBT For tax – see notes D&A For interest – see notes
Company Analysis Telenor – Interest & Tax Interest Tax @ effect.Rate of 18.6%
Company Analysis Telenor – Equity & IB Debt Market cap = NOK180,000
Company Analysis   Telenor – Input into the Model (@ Corp. Tax Rate of 18.6%) 74,655 B Equity 39,725+7,521 =  47,249 IB De...
Company Analysis   Telenor – Model Output (@ Eff. Tax Rate of 18.6%) See p. 44
Company Analysis Telenor  – At Corporate Tax Rate Tax @ corp. rate of 28%
Company Analysis   Telenor – Input into the Model (@ Corp. Tax Rate of 28%) 74,655 B Equity 39,725+7,521 =  47,249 IB Debt...
Company Analysis   Telenor – Model Output (@ Corp. Tax Rate of 28%) See p. 44
Application Spreadsheet
Company Analysis Henkel
Company Analysis   Henkel – Input into the Model 5,643 B Equity 3,142 IB Debt =5,643/5,010 =1.13 BV/MV 941 Profit 309 309/...
Company Analysis   Henkel – Model Output
Application Spreadsheet
Comparison Capital Structure & Rating Electrolux Coca-Cola P&G Nestl é
Comparison Capital Structure & Rating @ T = 18.6% @ T = 28% Henkel Telenor Disney Telenor
Comparison Capital Structure & Rating A A+ Disney A A- Henkel BBB+ A Telenor BBB+ A- Electrolux AA A Nestl é A+ AA- Coca C...
Special Request Company Analysis Grundfos
Company Analysis Grundfos – Income Statement (p. 51) EBIT Tax – see note 5 Interest-See note 4
Company Analysis Grundfos – Interest (note 4) Gross interest expense Interest income * Note that pension provisions not in...
Company Analysis Grundfos – Tax (note 5)
Company Analysis Grundfos – D&A (note 3)
Company Analysis Grundfos – IB Debt (exclude pensions) BV of equity = 7,421+1,069 = DKK8,490m Debt
Company Analysis Grundfos – Other information <ul><li>Internal rating = “ A  range” </li></ul><ul><li>BV  of equity/ MV  o...
Company Analysis   Grundfos – Input into the Model (mDKK) 7,421.7+1,069.8 B Equity 893.4+742.2+1720.7 +0.2 IB Debt Guess 0...
Company Analysis   Grundfos – Model Output compare
Application Spreadsheet
End of Part 10
In-class Case Study Template Necessary Data * BP market cap = USD 217.5B Shareholder (Book) Equity Book/Market Equity IB  ...
11. Depository Institutions
Depository Institutions Seeking the Optimal Capital Structure
Depository Institutions A depository (or lending) institution is a simple bank that generates revenues from lending the as...
<ul><li>Significantly more complicated than corporate firms because: </li></ul><ul><li>Two entities, rather than one, are ...
Depository Institutions M&M Treatment of a Simplified Financial Statement <ul><li>Operating income     EBIT  =  R T  ( D...
Depository Institutions Fundamental Relationships <ul><li>Form of M&M’s proposition II is preserved.  </li></ul><ul><li>In...
<ul><li>To protect depositors/bond investors from borrowers’ risk, a bank’s BS must adhere to certain limitations imposed ...
<ul><li>Recall: </li></ul>Depository Institutions Possible Cases Case   R T   R D I Constant   Constant II Constant   Vari...
Depository Institutions Case I -  R T  &  R D   constant Depository Institution R D R T
Depository Institutions Case II – R T  constant, R D  variable    with   Depository Institution R D R T
<ul><li>Definition - Tier 1 capital is the “core capital”.  It includes equity capital and disclosed reserves.  This is as...
<ul><li>With  T 1  = constant, above may be written as: </li></ul><ul><li>Recall:  r  is the borrower’s risk weighting.  T...
Depository Institutions Case III – R D  constant, R T  variable    as    Depository Institution R D R T
Depository Institutions Case IV – R D  variable    as    , R T  variable    as    Depository Institution R D R T
Depository Institutions Case IV – Impact of T 1
Depository Institutions Where is the Optimal? <ul><li>Consider the most realistic case, being Case IV, where  R D   as  ...
Conclusions <ul><ul><li>Reasons for complications </li></ul></ul><ul><ul><ul><li>Lender’s risk </li></ul></ul></ul><ul><ul...
End of Part 11
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Capital Structure

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Capital Structure

  1. 1. Capital Structure Theory & Applications Ruben D. Cohen ruben . cohen @ citi .com 0207 500 5793 Risk Architecture Citigroup, London
  2. 2. 1. Introduction Background, Scope and Outline
  3. 3. Background <ul><li>What is capital structuring? </li></ul><ul><ul><li>Process of interchanging debt, equity and assets </li></ul></ul><ul><li>Why is it important? </li></ul><ul><ul><li>Enables one to “optimize” the value of a firm or its WACC by finding the “best mix” for the amounts of debt and equity on the balance sheet </li></ul></ul><ul><ul><li>Provides a signal that the firm is following proper rules of corporate finance to “improve” its balance sheet. This signal is central to valuations provided by market investors and analysts </li></ul></ul><ul><li>Who is interested in it? </li></ul><ul><ul><li>Academics, because it is controversial and open ended </li></ul></ul><ul><ul><li>Practitioners, because they use it for v aluation, advisory and development and marketing of financial products & strategies </li></ul></ul>
  4. 4. Scope
  5. 5. Outline <ul><li>Introduction </li></ul><ul><li>Modigliani & Miller ( M&M ) ( paper 1 ) </li></ul><ul><ul><li>Derivation </li></ul></ul><ul><ul><li>Implementation </li></ul></ul><ul><li>Beta ( paper 3 ) </li></ul><ul><ul><li>Definition </li></ul></ul><ul><ul><li>Implementation within M&M (Hamada Equation) </li></ul></ul><ul><li>Default risk & credit rating models </li></ul><ul><li>Incorporating default risk to locate the optimal capital structure ( OCS) ( paper 2 ) </li></ul><ul><li>Incorporating default risk into beta ( paper 3 ) </li></ul><ul><li>Extending the OCS methodology to more ratios </li></ul><ul><li>Application to different scenarios </li></ul><ul><ul><li>M&A ’s </li></ul></ul><ul><ul><li>Divestitures </li></ul></ul><ul><ul><li>Share and debt issues and buybacks </li></ul></ul><ul><li>Applying constraints ( paper 4 ) </li></ul><ul><li>Case studies </li></ul><ul><li>Depository institutions ( paper 5 ) </li></ul>
  6. 6. End Part 1
  7. 7. 2. The Modigliani-Miller ( M&M ) Theorems Motivation & Methodology
  8. 8. Motivation Key Observation 1 Equity, E Debt, D Balance Sheet EBIT EBIT x (1- T ) Income Statement What if T = 100%? Discounted value of cash flows to bond and equity holders will be zero. Therefore, value implicit within IS will be ZERO! Does not match the firm’s value of E + D from the BS . or NOPAT To debt holders To equity holders Firm’s Value, D+E Tax
  9. 9. Total Discounted Value derived from Income Statement Effectively, a capital of 100 is being used to operate a firm that’s worth 132! Notion of “efficiency” appears in the ratio 100/132 80 x (1-40%) + 52 = 100 Motivation Key Observation 2 Income Statement Tax D (1- T ) E EBIT EBIT x (1- T ) R E E R D D (1- T )
  10. 10. Theory <ul><li>Key observations create a need to: </li></ul><ul><ul><li>Reconcile the difference in valuations between the IS and the BS </li></ul></ul><ul><ul><li>Exploit the notion of “efficiency” in capital structure </li></ul></ul><ul><li>M&M achieves the 2 objectives </li></ul><ul><li>Main assumptions - Aside from the typical, there are 3: </li></ul><ul><ul><li>Simple corporate firm able to freely exchange generic debt, equity and assets </li></ul></ul><ul><ul><li>EBIT & Tax rate held constant as firm exchanges debt, equity and assets </li></ul></ul><ul><ul><li>No default risk, so that credit spread = 0 at all levels of leverage </li></ul></ul>
  11. 11. The M&M Methodology Simplistic Derivation EBIT EBIT x (1- T ) R D D (1- T ) R E E D x (1- T ) E + Total Discounted Value derived from Income Statement Income Statement “ operating capital” Tax Paid Expected EBIT 20 Interest (at 5%) 4 EBT 16 Tax (at 40%) 6.4 Expected profit 9.6 Assets 132 Debt 80 Equity 52 Total Debt & Equity 132 Income Statement Balance Sheet
  12. 12. The M&M Methodology Proposition I This difference is attributed to tax and debt. In the absence of taxes, there are no benefits, in terms of value, to increasing leverage. In the presence of taxes, such benefits, by way of the interest tax shield, do accrue when leverage is introduced and/or increased. Leads to M&M ’s Proposition I Could be exploited to increase the “efficiency” of the firm – e.g. increase Tax, Debt or the product DT . Tax is difficult to control, but debt could be increased. <ul><li>Value implicit in the IS = D x (1-T) + E (“ operating capital ”) </li></ul><ul><li>Total Firm’s Value ( FV ) = D + E </li></ul>Reconciling Difference = D x T
  13. 13. The M&M Methodology Proposition II <ul><li>If FV = D + E </li></ul><ul><li>And the value added due to debt = D x T </li></ul><ul><li>Then the remainder, D x (1- T ) + E , must represent the “unlevered” value of the firm and is a constant , equal to E 0 = V U </li></ul>Defining  = D/E & solving for R E gives M&M ’s Proposition II “ Operating capital” R U Recall: EBIT (1- T ) = R D D (1- T ) + R E E
  14. 14. The M&M Methodology in Practice Creating the FV Curve – Step 1 <ul><li>Question: Consider the firm has D = 80 and E = 52. It wants to issue enough equity to buy back all debt and completely delever. </li></ul><ul><li>How is this done according to M&M ? </li></ul><ul><li>Answer: We know  V = D x T = 80 x 40% = 32. Therefore to delever completely, the value of the all-equity firm should be 132 – 32 = 100. </li></ul><ul><li>Achieved by issuing 48 in equity and selling off 32 in assets, totalling 80 - enough to buy back all debt. </li></ul>
  15. 15. <ul><li>Question: The firm is now fully debt free. It wants to borrow 20 to buy back some of its shares and, at the same time, purchase some assets. </li></ul><ul><li>How is this done according to M&M ? </li></ul><ul><li>Answer: We know  V = D x T = 20 x 40% = 8, which raises the firm’s value from 100 to 108. </li></ul><ul><li>Therefore, with additional debt of 20 buy back 12 in equity and purchase 8 in assets. </li></ul>The M&M Methodology in Practice Creating the FV Curve – Step 2
  16. 16. The M&M Methodology in Practice A More Methodical approach <ul><li>Begin with the original financial statement </li></ul><ul><li>Create table similar to the one below </li></ul><ul><ul><li>Insert debt in increments </li></ul></ul><ul><ul><li>Populate with information that’s readily available </li></ul></ul>
  17. 17. The M&M Methodology in Practice A More Methodical approach <ul><li>Define </li></ul><ul><li>and populate relevant cells </li></ul>
  18. 18. The M&M Methodology in Practice A More Methodical approach <ul><li>Calculate parameters for D = 0 </li></ul><ul><ul><li>Recall: at D = 0, all equity firm value E 0 = E + D (1- T ) = 52 + 80*(1-40%) = 100 </li></ul></ul><ul><li>Insert in the appropriate row </li></ul>
  19. 19. The M&M Methodology in Practice A More Methodical approach <ul><li>Recall E +(1- T ) D = 100 across all debt levels – i.e. at </li></ul><ul><ul><li>D =20, E = 100-(1-40%)*20 = 88; </li></ul></ul><ul><ul><li>D =40, E = 100-(1-40%)*40 = 76, etc. </li></ul></ul><ul><li>Streamline and automate the process * to populate all cells at different increments of D </li></ul>* If preferred, this could be done using the beta approach (Hamada’s Equation). Either way, the results must be identical
  20. 20. The M&M Methodology Graphical Representation 0% 50% 100% 150% 200% 0 10 20 30 40 ROE Leverage,
  21. 21. The M&M Methodology Effect of Tax Rate T > 0% T = 0
  22. 22. Spreadsheet Demo M&M Methodology
  23. 23. End of Part 2
  24. 24. 3. Beta
  25. 25. What is Beta? <ul><li>Defined as: </li></ul><ul><li>It is a measure of “relative” risk </li></ul><ul><li>It depends on leverage. This comes through R E </li></ul><ul><li>To obtain beta, plot R E - R f vs R M - R f </li></ul><ul><li>Slope of fitted straight line is the beta </li></ul><ul><li>Beta turns out to be independent of R f </li></ul>Market risk premium
  26. 26. What is Beta? Example with R f = 5% beta
  27. 27. What is Beta? Example with R f = 20% beta
  28. 28. What is Beta? Example with R f = 0 beta
  29. 29. Incorporating Hamada’s Equation Alternative Approach to Capital Structure Analysis Using the Beta
  30. 30. Important Relationships Valid only when the cost of debt, R D , is constant, independent of leverage (see paper 3 ) Hamada Equation CAPM Can be derived from definition of WACC
  31. 31. Implementation…
  32. 32. Implementation… Populate “ E ” column using E = V U – D (1- T ) = 100 – D (1-40%)
  33. 33. Implementation… <ul><li>Populate D/E column </li></ul><ul><li>Compute </li></ul>
  34. 34. Implementation… Populate rest of beta:
  35. 35. Implementation… <ul><li>Populate ROE : </li></ul><ul><li>Populate WACC : </li></ul>
  36. 36. Comparison Beta approach Classical approach Identical Results
  37. 37. Spreadsheet Demo M&M Methodology via Beta
  38. 38. End of Part 3
  39. 39. 4. The Risk of Default and Credit Rating Methodologies
  40. 40. Credit Risk and Credit Spread Some Facts <ul><li>The interest rate at which corporations can borrow money depends on the market’s perception of the probability that they will not be able to pay back the debt </li></ul><ul><li>The premium for this rate above the “risk-free” interest rate is known as the “credit spread” </li></ul><ul><li>The credit spread, a direct measure of credit risk, is linked to </li></ul><ul><ul><li>the probability of default </li></ul></ul><ul><ul><li>the recovery rate and </li></ul></ul><ul><ul><li>The term of the loan </li></ul></ul><ul><li>The classification of credit risk into bands is known as “credit rating”. The banding follows AAA, AA, A, BBB, BB, B, CCC, CC, C and Default. </li></ul><ul><li>Pluses and minuses are, in addition, used to add granularity within the different bands (i.e. A+, A-, etc.) </li></ul>
  41. 41. Credit Rating Models <ul><li>Credit agencies, the primary ones being S&P, Moody’s and Fitch, use “credit rating models” to assess a firm’s credit worthiness. These ratings are then binned into categories tabulated below: </li></ul><ul><li>CRM ’s are generally complex and inputs to them are both statistical and subjective, involving historical, as well as forward-looking, elements </li></ul>Weak No BB &  Adequate Yes BBB Strong Yes A Very Strong Yes AA Extremely Strong Yes AAA Financial Capacity Investment Grade Rating
  42. 42. Assessing the Risk of Default Different Credit Rating Methodologies <ul><li>There are three main classes of quantitative CRM ’s, which are used most widely. They are derivatives of: </li></ul><ul><ul><li>Ratio-driven models </li></ul></ul><ul><ul><ul><li>S&P </li></ul></ul></ul><ul><ul><ul><li>Fitch </li></ul></ul></ul><ul><ul><li>Z -Score </li></ul></ul><ul><ul><li>Merton’s model </li></ul></ul><ul><li>There are also other types, which are hybrids </li></ul>
  43. 43. The S&P Model Key Ratios
  44. 44. The S&P Model Rating of the Key Ratios
  45. 45. The S&P Model How it works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread http://www2.standardandpoors.com/spf/pdf/fixedincome/corporateratings_2006.pdf?vregion=ap&vlang=en Comprehensive description available at:
  46. 46. The S&P Model Worked Example with One Ratio
  47. 47. The S&P Model Worked Example with One Ratio <ul><li>1. Given current FS , we can calculate: </li></ul><ul><li>Interest rate </li></ul><ul><li>Interest cover </li></ul><ul><li>Effective rating from table </li></ul><ul><li>Credit Spread </li></ul><ul><li>Risk-free rate </li></ul><ul><li>2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage (this table is needed to create the WACC or FV curves) </li></ul>Assume the S&P CRM depends on a single ratio, i.e. interest coverage ratio = EBIT /interest expense,
  48. 48. Necessary Data http://www2.standardandpoors.com/spf/pdf/fixedincome/corporateratings_2006.pdf?vregion=ap&vlang=en
  49. 49. Necessary Data http://www.bonds-online.com/Todays_Market/Corporate_Bond_Spreads.php
  50. 50. The S&P Model Worked Example with One Ratio – Cont’d… Curve Fit for Spread vs Rating
  51. 51. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>1. Calculate: </li></ul><ul><li>Interest rate = 5/80 = 6.25% </li></ul><ul><li>Interest cover = 20/5 = 4.0 </li></ul><ul><li>Effective rating from table = BBB- </li></ul><ul><li>Credit Spread = 1.74% (from curve fit) </li></ul><ul><li>Risk-free rate = 6.25%-1.74% = 4.51% </li></ul><ul><li>2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage </li></ul>Assume the S&P CRM depends on a single ratio, i.e. interest coverage ratio = EBIT /interest expense , Curve fitted
  52. 52. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>ICR = 4.0 , Interest rate = 6.25% , spread = 1.74% </li></ul><ul><li>Create table (this table is needed to create the WACC or FV curves) </li></ul>D spread(1) ICR Rating spread(2) Interest rate Implied Rating 0 0.24% 10000.00 19 0.24% 4.75% AAA 8 0.24% 52.61 19 0.24% 4.75% AAA 16 0.24% 26.31 19 0.24% 4.75% AAA 24 0.53% 16.53 15 0.53% 5.04% AA- 32 0.78% 11.80 13 0.78% 5.30% A 40 0.78% 9.44 13 0.78% 5.30% A 48 0.95% 7.62 12 0.95% 5.47% A- 56 1.17% 6.29 11 1.17% 5.68% BBB+ 64 1.42% 5.26 10 1.42% 5.94% BBB 72 1.73% 4.44 9 1.73% 6.25% BBB- 80 1.74% 4.00 9 1.74% 6.25% BBB- 88 2.12% 3.43 8 2.12% 6.63% BB+ 96 2.12% 3.14 8 2.12% 6.63% BB+ 104 2.58% 2.71 7 2.58% 7.10% BB 112 3.15% 2.33 6 3.15% 7.67% BB-
  53. 53. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>Populate row D = 0 </li></ul>
  54. 54. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>Use iterative procedure </li></ul>to populate row D = 8
  55. 55. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>Populate remainder of table using the same iterative procedure: </li></ul>
  56. 56. The Z -Score Model <ul><li>Based on regression analysis of ratios </li></ul><ul><li>Define: </li></ul>
  57. 57. The Z -Score Model Implementation Historical Statistics show that for manufacturers, non-manufacturer industrials, and emerging market credits the following regression relationship holds within reason: Z’’ = 6.56X 1 + 3.26X 2 + 6.72X 3 + 1.05X 4
  58. 58. The Z -Score Model US Bond Rating Equivalent Based on the Adjusted Model
  59. 59. Merton’s Model Question: Borrow $ D today to start a business. Interest is paid throughout the year and the loan is to be paid back at the end of one year. If the business were to sell its assets after one year to pay off the loan, would the amount be sufficient to cover it (  $ D )? Portrayed as: Similarity to option-pricing concept : Debt obligation  strike price Asset market value & volatility  Share price & volatility Probability of default  Area under curve behind D One year from today Today Asset Volatility
  60. 60. Comparison <ul><li>Ratios/Scoring </li></ul><ul><li>Need calibration </li></ul><ul><li>Incorporate more variables </li></ul><ul><li>More dependent on historical information </li></ul><ul><li>Probability of default computed indirectly </li></ul><ul><li>Appear to involve more steps to get to the rating </li></ul><ul><li>Heavily dependent on financial statement inputs – More easily applied to private firms. </li></ul><ul><li>Merton </li></ul><ul><li>May not need calibration </li></ul><ul><li>Incorporates less variables </li></ul><ul><li>Less dependent on historical information </li></ul><ul><li>Probability of default computed directly </li></ul><ul><li>Requires less steps and is more direct </li></ul><ul><li>Involves primarily market variables – Difficult to apply to private firms. </li></ul>
  61. 61. End of Part 4
  62. 62. 5. Incorporating Default Risk
  63. 63. Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure
  64. 64. Impact of Default Risk <ul><li>Leads to credit spread </li></ul><ul><li>Gives an “optimal capital structure” </li></ul><ul><li>Idea : tax benefits and default risk work against each other, taking FV - vs -leverage curve through a maximum or the WACC through a minimum </li></ul><ul><li>Approach identical to classical M&M , but must take into account the credit spread due to default risk </li></ul>
  65. 65. Optimization of the Capital Structure <ul><li>Objective is to locate the “optimal capital structure” </li></ul><ul><li>By classical definition, mi nimum WACC is where the optimal capital structure occurs </li></ul><ul><li>Recall: </li></ul><ul><li>Since EBIT x (1- T ) = constant by assumption, then max( E+D) and min( WACC) occur at exactly the same leverage </li></ul><ul><li>The rest is based on the principle of maximizing the firm’s value rather than minimizing the WACC </li></ul>
  66. 66. Procedure Requirements <ul><li>Need a credit-rating model to calculate credit spreads along the curve </li></ul><ul><ul><li>Can use any </li></ul></ul><ul><ul><li>This work utilizes the S&P approach, which is based on ratios </li></ul></ul><ul><li>Important to recall that D * x (1- T ) + E = constant was derived based on the default-free scenario (classical M&M ), where D * is the “default-free debt” </li></ul><ul><li>Must accordingly adjust the BS debt when there is credit risk. Adjustment is of the form: </li></ul><ul><li>With this adjustment, procedure becomes identical to classical M&M’s </li></ul>
  67. 67. Procedure Flowchart Original Financial Statement : With default risk Convert to no-default scenario Apply M&M methodology to obtain FV curve Convert back to default case Final Output FV curve with default
  68. 68. Procedure Begin with original financial statement: With default risk
  69. 69. Procedure Step-by-Step <ul><li>Produce table in the following form </li></ul><ul><li>Fill in cells using the financial statement </li></ul>
  70. 70. Procedure cont’d Or use curve-fitted <ul><li>Need “ CRM ” </li></ul><ul><li>Fill in remaining cells in the same row </li></ul><ul><ul><li>(Note: D* = 6.25%/4.51%  80 = 110.7 ) </li></ul></ul>
  71. 71. Procedure cont’d <ul><li>Calculate V U = E 0 = D * x (1- T )+ E = 110.7 (1 – 0.4) + 52 = 118.4 </li></ul><ul><li>Populate first row at D = 0 </li></ul>
  72. 72. Procedure cont’d <ul><li>Populate next row via the following iteration scheme: </li></ul>& Factors Ratios Implied Spread Calculated cost of Debt = R f + spread CRM Debt Cost of debt Implied Rating
  73. 73. Procedure cont’d <ul><li>And so on ... </li></ul>
  74. 74. Procedure Outcome
  75. 75. End of Part 5
  76. 76. 6. Incorporating Default Risk into Beta Generating the WACC Curve via the Modified Hamada Equation
  77. 77. Important Relationships Recall <ul><li>Valid only when interest rates are constant, independent of leverage. </li></ul><ul><li>Therefore, must modify D/E to account for credit spread. </li></ul>Hamada Equation
  78. 78. Procedure Step-by-Step <ul><li>Create table with the following format </li></ul><ul><li>Fill in cells using information from financial statement </li></ul>
  79. 79. Procedure Step-by-Step <ul><li>Calculate risk-free rate using earlier procedure </li></ul><ul><li>Populate D* , D*/E ,  , ROE , WACC using formulas </li></ul><ul><ul><li>(Note: D* = 6.25%/4.51%  80 = 110.7 ) </li></ul></ul>
  80. 80. Procedure Step-by-Step <ul><li>Compute  u using D * /E rather than D/E </li></ul><ul><li>Compute V u = E + D *  (1-T) = 52+110.7  (1-40%) = 118.4 </li></ul><ul><li>Populate row for D = 0 </li></ul>110.7 9.00 162.7 4.00 1.73%
  81. 81. Procedure Step-by-Step <ul><li>Populate remaining rows using same methodology as before </li></ul>
  82. 82. Comparison WACC computed using beta WACC computed the direct way Shouldn’t make any difference!
  83. 83. End of Part 6
  84. 84. 7. Incorporating More Ratios
  85. 85. How It Works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread
  86. 86. Spreadsheet Example <ul><li>Note that the S&P CRM depends on 8 or 9 ratios. </li></ul><ul><li>Previous example involved a single ratio - interest cover . </li></ul><ul><li>A working spreadsheet with 3 ratios: </li></ul><ul><ul><li>ICR , </li></ul></ul><ul><ul><li>Cash Flow and </li></ul></ul><ul><ul><li>Leverage </li></ul></ul>
  87. 87. End of Part 7
  88. 88. 8. Application to Scenarios <ul><li>M&A (acquisition) </li></ul><ul><li>Divestiture </li></ul><ul><li>Share and debt issues and buybacks </li></ul>
  89. 89. Extension to Other Scenarios <ul><li>Spreadsheet Demo for M&A </li></ul><ul><li>(Acquisition) </li></ul>
  90. 90. Extension to Other Scenarios 2. Spreadsheet Demo for Divestiture
  91. 91. Extension to Other Scenarios 3. Spreadsheet Demo for Share and Debt Issues and Buybacks
  92. 92. End of Part 8
  93. 93. 9. Applying Constraints
  94. 94. Applying “Constraints” <ul><li>Question: What if no suitable assets were available for purchase or there was a preference instead for a 1:1 share buy back? “Constrains” the firm to follow FV = const. </li></ul>To get to the OCS (max FV ) from “current”, issue 43 units in E to buy back 32 units of debt and purchase an additional 11 of assets. With no apparent maximum in the firm’s value, how is the optimal capital structure determined??? This moves the firm on the FV curve, along which V U = const, towards the OCS .
  95. 95. Applying “Constraints” Outcome  = 80/52=1.54 R D * = 3.99% R D = 6.25% V u = 52 + [6.25%/3.99%]  80  (1-40%) = 127  = 40/92=0.43 R D * = 3.99% R D = 4.63% V u = 92 + [4.63%/3.99%]  40  (1-40%) = 120 V u ’s are different
  96. 96. Finding the OCS under “Constraints” Extending Along All Leverage <ul><li>Every point along the E+D = const. line will have a unique V U associated with it (because V U varies with leverage) </li></ul><ul><li>Obtain the locus of V U ’s and the OCS falls where the ratio V U /FV is minimized . </li></ul>Unique unlevered values associated with each FV point.
  97. 97. Finding the OCS under “Constraints” Generalization OCS occurs at min V U / FV OCS FV = constant
  98. 98. On the Side Recall <ul><li>From Part 2 (derivation of classical M&M ) </li></ul><ul><li>Outcome: NOPAT  operating capital </li></ul><ul><ul><li>i.e. EBIT (1- T ) = R u  V u where R u is a proportionality constant (see Part 2) </li></ul></ul>R D D (1- T ) R E E D x (1- T ) E + Total Discounted Value derived from Income Statement “ operating capital” = unlevered value = V u “ NOPAT ” EBIT x (1- T )
  99. 99. On the Side Implications on the S&P CRM <ul><li>The S&P CRM contains ratios that involve the EBIT </li></ul><ul><ul><li>EBIT interest cover and D-to-EBITDA, among others </li></ul></ul><ul><li>Therefore in “constrained” cases, where V u varies with leverage , one must take into account the impact of this variation on the EBIT . </li></ul><ul><li>Once this is accounted for, the ratios containing EBIT and EBITDA could subsequently be adjusted. </li></ul>EBITDA, EBIT, D, E, T, … CRM spread V u Output Until convergence
  100. 100. Finding the OCS under “Constraints” Possible Scenarios 1 & 2 Scenario 2: The firm wants to keep the equity level constant at 52 and exchange debt with assets (raise debt to buy assets or sell assets to buy back debt. Scenario 1: Firm wants to follow Vu = const = 130, as per M&M ’s methodology. OCS @ D/E=51% OCS @ D/E=92% Current @ D/E=154%
  101. 101. Finding the OCS under “Constraints” Possible Scenarios 3 & 4 Scenario 4: The firm wants to keep the debt level constant at 80 and exchange equity with assets (issue equity to buy assets or sell assets to buy back equity. Scenario 3: Firm wants to follow F V = const = 132 by exchanging debt for equity and vice versa at 1:1. OCS @ D/E=57% OCS @ D/E=51%
  102. 102. Finding the OCS under “Constraints” Results Summary – Capital Structure Curve In general, any type of constraint could be created by combining the above.
  103. 103. Finding the OCS under “Constraints” Results Summary - Table 51% 1.54 4. Const D at 80 57% 1.54 3. Const FV at 132 92% 1.54 2. Const E at 52 51% 1.54 1. Const V u at 130 ( M&M ) Leverage at OCS Current leverage, D/E Scenario
  104. 104. Applying Constraints Spreadsheet Demonstration E = constant
  105. 105. Applying Constraints Spreadsheet Demonstration FV = constant
  106. 106. Applying Constraints Spreadsheet Demonstration D = constant
  107. 107. End of Part 9
  108. 108. 10. Case Studies
  109. 109. Dealing with the Financial Statement Needed for M&M analysis Needed for M&M analysis B.S. I.S. Needed for CRM equity (Market value) Interest-bearing liabilities (IB debt) Non-IB liabilities Liabilities & Equity Tax Profits EBT Gross interest on IB debt EBIT D&A EBITDA Costs & Expenses Revenues
  110. 110. Case Studies by Company <ul><li>Procter & Gamble (USA) </li></ul><ul><li>Coca-Cola (USA) </li></ul><ul><li>Nestl é Group (Switzerland) </li></ul><ul><li>Electrolux (Sweden) </li></ul><ul><li>Walt Disney Company (USA) </li></ul><ul><li>Telenor ASA (Norway) </li></ul><ul><li>Henkel (Germany) </li></ul><ul><li>Special Request : Grundfos (Denmark) </li></ul>
  111. 111. Company Analysis Procter & Gamble
  112. 112. Company Analysis Procter & Gamble – Income Statement EBIT Interest* Tax Other inc. *Capital lease charge are generally to be included in gross interest. In this case, it is negligible.
  113. 113. Company Analysis Procter & Gamble – Liabilities * ST IB Debt LT IB Debt *Capital leases are generally to be included in the balance sheet. In this case, they are negligible.
  114. 114. Company Analysis Procter & Gamble – ME and BE Market cap = USD205B BV of Equity Ratio BV/MV = 0.33
  115. 115. Company Analysis Procter & Gamble – Cash Flow Dep & Amort
  116. 116. Company Analysis Procter & Gamble – Input into the Model 66,760 B Equity 23,375+12,039 = 35,414 (capital lease negligible) IB Debt 0.33 BV/MV 10,906 Profit 4,370 4,370/15,274= 28.6% Tax (Tax rate) 15,274 EBT -1,304 (capital lease charge negligible) Interest 15,450+564 = 16,014 EBIT+other income -3,130 D&A 16,014+3,130 = 19,144 EBITDA
  117. 117. Company Analysis Procter & Gamble – Model Output
  118. 118. Application Spreadsheets
  119. 119. PG Comparison
  120. 120. Company Analysis The Coca-Cola Company
  121. 121. Company Analysis Coca-Cola – Income Statement *Capital lease charge are generally to be included in gross interest. In this case, it is negligible. EBIT Interest Other income
  122. 122. Company Analysis Coca-Cola – Liabilities & Equity * ST IB Debt LT IB Debt *Capital leases are generally to be included in the balance sheet. In this case, there are none. Book Equity Market cap = USD137B Ratio BV/MV = 0.16
  123. 123. Company Analysis Coca-Cola – Cash Flow Dep & Amort
  124. 124. Company Analysis Coca-Cola – Input into the Model 21,744 B Equity 5,919+133+3,277 = 9,329 IB Debt 0.16 BV/MV 5,981 Profit 1,892 1,892/7,873 = 24% Tax (Tax rate) 7,873 EBT -456 Interest 7,252+ (236+668+173) EBIT+other income -1,163 D&A 7,252+1,163 = 8,415 EBITDA
  125. 125. Company Analysis Coca-Cola – Model Output
  126. 126. Application Spreadsheets
  127. 127. Company Analysis Nestl é Group
  128. 128. Company Analysis Nestl é Group – Income Statement EBIT See Notes Other Income
  129. 129. Company Analysis Nestl é Group – Note 3 & 5 on Interest and Tax Interest* Tax * Negligible capital lease charge.
  130. 130. Company Analysis Nestl é Group – Liabilities * ST IB Debt LT IB Debt *Capital leases negligible.
  131. 131. Company Analysis Nestl é Group – Equity at Market Value MV of Equity BV of Equity Ratio BV/MV = 0.28
  132. 132. Company Analysis Nestl é Group – Cash Flow Dep & Amort Unusual
  133. 133. Company Analysis Nestl é Group – Input into the Model Spreadsheet 195,661 MV Equity 24,541+6,129 = 30,670 IB Debt 54,234/195,086 = 0.28 BV/MV 9,553 Profit 3,400 3,400/13,529 = 25% Tax (Tax rate) 13,529 EBT -1,481 Interest 14434+576 = 15,010 EBIT+other income 2,620+591= 3,211 D&A 14,434+3,211 = 17,645 EBITDA
  134. 134. Company Analysis Nestl é Group – Model Output
  135. 135. Application Spreadsheet
  136. 136. Company Analysis Electrolux
  137. 137. Income Statement Electrolux - P. 7 – All figures in SEKm EBT EBIT+other income See notes for Interest See notes for tax
  138. 138. Income Statement Electrolux - Note 9 – Interest Expense Interest
  139. 139. Income Statement Electrolux - Note 10 – Tax
  140. 140. Balance Sheet Liabilities Electrolux - P. 11 – All figures in SEKm BE LT debt ST debt
  141. 141. Other Useful Information Electrolux <ul><li>Credit Rating (p. 37) </li></ul><ul><li>Market Cap (p. 76) </li></ul>
  142. 142. Company Analysis Electrolux – Input into the Model 16,040 B Equity 4,887+,701 = 10,588 IB Debt 16,040/34,000 =0.47 BV/MV 1,054 Profit 32.8% Tax rate 4,007 EBT -650 Interest 4,475 + 182 = 4,657 EBIT+other income -2,738 D&A 4,475+2,738= 7,213 EBITDA
  143. 143. Company Analysis Electrolux – Model Output Compare
  144. 144. Spreadsheet Demo
  145. 145. Company Analysis The Walt Disney Company
  146. 146. Company Analysis Disney – Income Statement EBT For tax – see notes For interest expense, see notes
  147. 147. Company Analysis Disney – D&A
  148. 148. Company Analysis Disney – Gross Borrowings *Capital leases negligible
  149. 149. Company Analysis Disney – Income Taxes Total tax paid EBT
  150. 150. Company Analysis Disney – Gross Interest Expense *Capital lease charges, negligible
  151. 151. Company Analysis Disney – Shareholders’ Equity BV of Equity MV of equity (market cap) = USD 65B
  152. 152. Company Analysis Disney – Input into the Model 30,753 B Equity 15,172 IB Debt = 30,753/65,000 = 0.473 BV/MV 4,724 Profit 3,001 3,001/7725= 39% Tax (Tax rate) 7,725 EBT -746 Interest 7,725+746= 8,471 EBIT+other income -1,491 D&A 9,962 EBITDA
  153. 153. Company Analysis Disney – Model Output See p. 44
  154. 154. Application Spreadsheet
  155. 155. Company Analysis Telenor
  156. 156. Company Analysis Telenor – Income Statement EBT For tax – see notes D&A For interest – see notes
  157. 157. Company Analysis Telenor – Interest & Tax Interest Tax @ effect.Rate of 18.6%
  158. 158. Company Analysis Telenor – Equity & IB Debt Market cap = NOK180,000
  159. 159. Company Analysis Telenor – Input into the Model (@ Corp. Tax Rate of 18.6%) 74,655 B Equity 39,725+7,521 = 47,249 IB Debt 74,655/180,000 = 0.41 BV/MV 16,189 Profit 3,782 3,782/19,971= 18.6% Tax (Tax rate) 19,971 EBT -2,650 Interest 22,621 EBIT+other income -14,333 D&A 19,971+14,333+2650 = 36,954 EBITDA
  160. 160. Company Analysis Telenor – Model Output (@ Eff. Tax Rate of 18.6%) See p. 44
  161. 161. Company Analysis Telenor – At Corporate Tax Rate Tax @ corp. rate of 28%
  162. 162. Company Analysis Telenor – Input into the Model (@ Corp. Tax Rate of 28%) 74,655 B Equity 39,725+7,521 = 47,249 IB Debt 74,655/180,000 = 0.41 BV/MV 16,189 Profit 5,592 5,592/19,971= 28% Tax (Tax rate) 19,971 EBT -2,650 Interest 22,621 EBIT+other income -14,333 D&A 19,971+14,333+2650 = 36,954 EBITDA
  163. 163. Company Analysis Telenor – Model Output (@ Corp. Tax Rate of 28%) See p. 44
  164. 164. Application Spreadsheet
  165. 165. Company Analysis Henkel
  166. 166. Company Analysis Henkel – Input into the Model 5,643 B Equity 3,142 IB Debt =5,643/5,010 =1.13 BV/MV 941 Profit 309 309/1250= 25% Tax (Tax rate) 1,250 EBT -269 Interest 1,344+84+91 =1,591 EBIT+other income 337 D&A 1,344+337=1,681 EBITDA
  167. 167. Company Analysis Henkel – Model Output
  168. 168. Application Spreadsheet
  169. 169. Comparison Capital Structure & Rating Electrolux Coca-Cola P&G Nestl é
  170. 170. Comparison Capital Structure & Rating @ T = 18.6% @ T = 28% Henkel Telenor Disney Telenor
  171. 171. Comparison Capital Structure & Rating A A+ Disney A A- Henkel BBB+ A Telenor BBB+ A- Electrolux AA A Nestl é A+ AA- Coca Cola AA- A P&G S&P rating Model rating Firm
  172. 172. Special Request Company Analysis Grundfos
  173. 173. Company Analysis Grundfos – Income Statement (p. 51) EBIT Tax – see note 5 Interest-See note 4
  174. 174. Company Analysis Grundfos – Interest (note 4) Gross interest expense Interest income * Note that pension provisions not included in interest. Therefore exclude pensions from debt and assume staffing cost.
  175. 175. Company Analysis Grundfos – Tax (note 5)
  176. 176. Company Analysis Grundfos – D&A (note 3)
  177. 177. Company Analysis Grundfos – IB Debt (exclude pensions) BV of equity = 7,421+1,069 = DKK8,490m Debt
  178. 178. Company Analysis Grundfos – Other information <ul><li>Internal rating = “ A range” </li></ul><ul><li>BV of equity/ MV of equity (for the sector) assumed as 0.50 (could be varied) </li></ul>
  179. 179. Company Analysis Grundfos – Input into the Model (mDKK) 7,421.7+1,069.8 B Equity 893.4+742.2+1720.7 +0.2 IB Debt Guess 0.5 BV/MV 935.6 Profit 437.2 437.2/1,372.8 = 32% Tax (Tax rate) 1,372.8 EBT -201.5 Interest 1,609.6-118-1.2+21+63 =1,574.3 EBIT+other income -879.1 D&A 1,696.6+879.1=2,488.7 EBITDA
  180. 180. Company Analysis Grundfos – Model Output compare
  181. 181. Application Spreadsheet
  182. 182. End of Part 10
  183. 183. In-class Case Study Template Necessary Data * BP market cap = USD 217.5B Shareholder (Book) Equity Book/Market Equity IB Debt (Incl. capital leases & pensions) Tax Rate Gross Interest Expense Other Income Dep. & Amort. EBITDA Amount Financial Statement Item
  184. 184. 11. Depository Institutions
  185. 185. Depository Institutions Seeking the Optimal Capital Structure
  186. 186. Depository Institutions A depository (or lending) institution is a simple bank that generates revenues from lending the assets on its BS . Depository Institution Counterparty (Borrower) Equity Investor Depositor/ Bond Investor D E D+E R T [ D+E ] Tax
  187. 187. <ul><li>Significantly more complicated than corporate firms because: </li></ul><ul><li>Two entities, rather than one, are subject to credit/default Risk </li></ul><ul><ul><li>The Bank (as borrower from investors/depositors) and </li></ul></ul><ul><ul><li>the Counterparty (as borrower from the Bank). </li></ul></ul><ul><li>The operating income ( EBIT ) of the bank is not constant, but varies with the size of its BS </li></ul><ul><li>There are limits to lending </li></ul><ul><ul><li>In order to protect depositors and investors, banks cannot lend to the third party only what they borrow. A pre-determined amount of the money lent out must be equity. </li></ul></ul><ul><ul><li>This amount of equity is dictated by certain “regulatory capital” ratios, determined by the borrower’s “risk rating” and the size of the bank’s BS. </li></ul></ul><ul><li>Above limitations create strong interdependence between bank and borrower </li></ul>Depository Institutions Main Differences with Corporate Firms
  188. 188. Depository Institutions M&M Treatment of a Simplified Financial Statement <ul><li>Operating income  EBIT = R T  ( D + E ) </li></ul><ul><li> </li></ul><ul><li>Interest expense = R D  D </li></ul><ul><li>Profit = R E  E = [ R T  ( D + E ) - R D  D ]  (1- T ) </li></ul><ul><li> </li></ul><ul><li>IS Value = </li></ul>
  189. 189. Depository Institutions Fundamental Relationships <ul><li>Form of M&M’s proposition II is preserved. </li></ul><ul><li>Inverse proportionality relation between WACC & FV is lost. </li></ul><ul><li>Fundamental constant in this case is D/E , instead of D (1- T )+ E </li></ul>
  190. 190. <ul><li>To protect depositors/bond investors from borrowers’ risk, a bank’s BS must adhere to certain limitations imposed on some of its financial ratios. </li></ul><ul><li>Limitations are known as “Regulatory Capital” and the ratios involved are called “Tier 1”, “Tier 2”, etc., going down in order of importance. These are used to describe the “capital adequacy” of the bank and e nsure that capital allocation is risk sensitive. </li></ul><ul><li>Tier 1 capital is the “core capital”, which includes equity capital and disclosed reserves. </li></ul><ul><li>Tier 2 capital is the “secondary bank capital”. It includes items such as undisclosed reserves, general loss reserves, subordinated debt , and more. </li></ul><ul><li>These restrictions make the bank and borrower highly interdependent on each other and, thus, significantly complicate the analysis. </li></ul>Depository Institutions Limitations
  191. 191. <ul><li>Recall: </li></ul>Depository Institutions Possible Cases Case R T R D I Constant Constant II Constant Variable III Variable Constant IV Variable Variable Depository Institution Out: R D In: R T
  192. 192. Depository Institutions Case I - R T & R D constant Depository Institution R D R T
  193. 193. Depository Institutions Case II – R T constant, R D variable  with  Depository Institution R D R T
  194. 194. <ul><li>Definition - Tier 1 capital is the “core capital”. It includes equity capital and disclosed reserves. This is assigned a maximum limit of typically 8%. </li></ul><ul><li>Applied to the simplified financial statement of a lender, lending assets E + D to a single borrower: </li></ul><ul><ul><li>RWA = risk weighted assets </li></ul></ul><ul><ul><li>r = risk weighting of borrower </li></ul></ul>Depository Institutions Impact of the Tier 1 Capital Restriction
  195. 195. <ul><li>With T 1 = constant, above may be written as: </li></ul><ul><li>Recall: r is the borrower’s risk weighting. Therefore, </li></ul><ul><li>Combining: </li></ul>Depository Institutions Relationship Between r and R T
  196. 196. Depository Institutions Case III – R D constant, R T variable  as   Depository Institution R D R T
  197. 197. Depository Institutions Case IV – R D variable  as   , R T variable  as   Depository Institution R D R T
  198. 198. Depository Institutions Case IV – Impact of T 1
  199. 199. Depository Institutions Where is the Optimal? <ul><li>Consider the most realistic case, being Case IV, where R D  as   and R T  as   : </li></ul><ul><li> WACC is a decreasing function of leverage,  . </li></ul><ul><li>Note that not all T 1 s have a max at some finite leverage. </li></ul><ul><li>Note that max R E does not coincide with min WACC . </li></ul><ul><li>Etc., etc.,... </li></ul>
  200. 200. Conclusions <ul><ul><li>Reasons for complications </li></ul></ul><ul><ul><ul><li>Lender’s risk </li></ul></ul></ul><ul><ul><ul><li>Borrower’s risk </li></ul></ul></ul><ul><ul><ul><li>Interdependence between the two </li></ul></ul></ul><ul><ul><li>Discussed different scenarios </li></ul></ul><ul><ul><li>Concluded that there is no straightforward way to define the OCS </li></ul></ul>
  201. 201. End of Part 11
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