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- 1. Capital Structure Theory & Applications Ruben D. Cohen ruben . cohen @ citi .com 0207 500 5793 Risk Architecture Citigroup, London
- 2. 1. Introduction Background, Scope and Outline
- 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. Scope
- 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. End Part 1
- 7. 2. The Modigliani-Miller ( M&M ) Theorems Motivation & Methodology
- 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. 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. 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. 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. 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. 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. 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. <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. 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. The M&M Methodology in Practice A More Methodical approach <ul><li>Define </li></ul><ul><li>and populate relevant cells </li></ul>
- 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. 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. The M&M Methodology Graphical Representation 0% 50% 100% 150% 200% 0 10 20 30 40 ROE Leverage,
- 21. The M&M Methodology Effect of Tax Rate T > 0% T = 0
- 22. Spreadsheet Demo M&M Methodology
- 23. End of Part 2
- 24. 3. Beta
- 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. What is Beta? Example with R f = 5% beta
- 27. What is Beta? Example with R f = 20% beta
- 28. What is Beta? Example with R f = 0 beta
- 29. Incorporating Hamada’s Equation Alternative Approach to Capital Structure Analysis Using the Beta
- 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. Implementation…
- 32. Implementation… Populate “ E ” column using E = V U – D (1- T ) = 100 – D (1-40%)
- 33. Implementation… <ul><li>Populate D/E column </li></ul><ul><li>Compute </li></ul>
- 34. Implementation… Populate rest of beta:
- 35. Implementation… <ul><li>Populate ROE : </li></ul><ul><li>Populate WACC : </li></ul>
- 36. Comparison Beta approach Classical approach Identical Results
- 37. Spreadsheet Demo M&M Methodology via Beta
- 38. End of Part 3
- 39. 4. The Risk of Default and Credit Rating Methodologies
- 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. 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. 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. The S&P Model Key Ratios
- 44. The S&P Model Rating of the Key Ratios
- 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. The S&P Model Worked Example with One Ratio
- 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. Necessary Data http://www2.standardandpoors.com/spf/pdf/fixedincome/corporateratings_2006.pdf?vregion=ap&vlang=en
- 49. Necessary Data http://www.bonds-online.com/Todays_Market/Corporate_Bond_Spreads.php
- 50. The S&P Model Worked Example with One Ratio – Cont’d… Curve Fit for Spread vs Rating
- 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. 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. The S&P Model Worked Example with One Ratio – Cont’d… <ul><li>Populate row D = 0 </li></ul>
- 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. 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. The Z -Score Model <ul><li>Based on regression analysis of ratios </li></ul><ul><li>Define: </li></ul>
- 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. The Z -Score Model US Bond Rating Equivalent Based on the Adjusted Model
- 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. 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. End of Part 4
- 62. 5. Incorporating Default Risk
- 63. Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure
- 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. 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. 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. 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. Procedure Begin with original financial statement: With default risk
- 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. 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. 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. 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. Procedure cont’d <ul><li>And so on ... </li></ul>
- 74. Procedure Outcome
- 75. End of Part 5
- 76. 6. Incorporating Default Risk into Beta Generating the WACC Curve via the Modified Hamada Equation
- 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. 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. 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. 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. Procedure Step-by-Step <ul><li>Populate remaining rows using same methodology as before </li></ul>
- 82. Comparison WACC computed using beta WACC computed the direct way Shouldn’t make any difference!
- 83. End of Part 6
- 84. 7. Incorporating More Ratios
- 85. How It Works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread
- 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. End of Part 7
- 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. Extension to Other Scenarios <ul><li>Spreadsheet Demo for M&A </li></ul><ul><li>(Acquisition) </li></ul>
- 90. Extension to Other Scenarios 2. Spreadsheet Demo for Divestiture
- 91. Extension to Other Scenarios 3. Spreadsheet Demo for Share and Debt Issues and Buybacks
- 92. End of Part 8
- 93. 9. Applying Constraints
- 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. 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. 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. Finding the OCS under “Constraints” Generalization OCS occurs at min V U / FV OCS FV = constant
- 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. 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. 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. 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. Finding the OCS under “Constraints” Results Summary – Capital Structure Curve In general, any type of constraint could be created by combining the above.
- 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. Applying Constraints Spreadsheet Demonstration E = constant
- 105. Applying Constraints Spreadsheet Demonstration FV = constant
- 106. Applying Constraints Spreadsheet Demonstration D = constant
- 107. End of Part 9
- 108. 10. Case Studies
- 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. 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. Company Analysis Procter & Gamble
- 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. 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. Company Analysis Procter & Gamble – ME and BE Market cap = USD205B BV of Equity Ratio BV/MV = 0.33
- 115. Company Analysis Procter & Gamble – Cash Flow Dep & Amort
- 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. Company Analysis Procter & Gamble – Model Output
- 118. Application Spreadsheets
- 119. PG Comparison
- 120. Company Analysis The Coca-Cola Company
- 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. 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. Company Analysis Coca-Cola – Cash Flow Dep & Amort
- 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. Company Analysis Coca-Cola – Model Output
- 126. Application Spreadsheets
- 127. Company Analysis Nestl é Group
- 128. Company Analysis Nestl é Group – Income Statement EBIT See Notes Other Income
- 129. Company Analysis Nestl é Group – Note 3 & 5 on Interest and Tax Interest* Tax * Negligible capital lease charge.
- 130. Company Analysis Nestl é Group – Liabilities * ST IB Debt LT IB Debt *Capital leases negligible.
- 131. Company Analysis Nestl é Group – Equity at Market Value MV of Equity BV of Equity Ratio BV/MV = 0.28
- 132. Company Analysis Nestl é Group – Cash Flow Dep & Amort Unusual
- 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. Company Analysis Nestl é Group – Model Output
- 135. Application Spreadsheet
- 136. Company Analysis Electrolux
- 137. Income Statement Electrolux - P. 7 – All figures in SEKm EBT EBIT+other income See notes for Interest See notes for tax
- 138. Income Statement Electrolux - Note 9 – Interest Expense Interest
- 139. Income Statement Electrolux - Note 10 – Tax
- 140. Balance Sheet Liabilities Electrolux - P. 11 – All figures in SEKm BE LT debt ST debt
- 141. Other Useful Information Electrolux <ul><li>Credit Rating (p. 37) </li></ul><ul><li>Market Cap (p. 76) </li></ul>
- 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. Company Analysis Electrolux – Model Output Compare
- 144. Spreadsheet Demo
- 145. Company Analysis The Walt Disney Company
- 146. Company Analysis Disney – Income Statement EBT For tax – see notes For interest expense, see notes
- 147. Company Analysis Disney – D&A
- 148. Company Analysis Disney – Gross Borrowings *Capital leases negligible
- 149. Company Analysis Disney – Income Taxes Total tax paid EBT
- 150. Company Analysis Disney – Gross Interest Expense *Capital lease charges, negligible
- 151. Company Analysis Disney – Shareholders’ Equity BV of Equity MV of equity (market cap) = USD 65B
- 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. Company Analysis Disney – Model Output See p. 44
- 154. Application Spreadsheet
- 155. Company Analysis Telenor
- 156. Company Analysis Telenor – Income Statement EBT For tax – see notes D&A For interest – see notes
- 157. Company Analysis Telenor – Interest & Tax Interest Tax @ effect.Rate of 18.6%
- 158. Company Analysis Telenor – Equity & IB Debt Market cap = NOK180,000
- 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. Company Analysis Telenor – Model Output (@ Eff. Tax Rate of 18.6%) See p. 44
- 161. Company Analysis Telenor – At Corporate Tax Rate Tax @ corp. rate of 28%
- 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. Company Analysis Telenor – Model Output (@ Corp. Tax Rate of 28%) See p. 44
- 164. Application Spreadsheet
- 165. Company Analysis Henkel
- 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. Company Analysis Henkel – Model Output
- 168. Application Spreadsheet
- 169. Comparison Capital Structure & Rating Electrolux Coca-Cola P&G Nestl é
- 170. Comparison Capital Structure & Rating @ T = 18.6% @ T = 28% Henkel Telenor Disney Telenor
- 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. Special Request Company Analysis Grundfos
- 173. Company Analysis Grundfos – Income Statement (p. 51) EBIT Tax – see note 5 Interest-See note 4
- 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. Company Analysis Grundfos – Tax (note 5)
- 176. Company Analysis Grundfos – D&A (note 3)
- 177. Company Analysis Grundfos – IB Debt (exclude pensions) BV of equity = 7,421+1,069 = DKK8,490m Debt
- 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. 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. Company Analysis Grundfos – Model Output compare
- 181. Application Spreadsheet
- 182. End of Part 10
- 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. 11. Depository Institutions
- 185. Depository Institutions Seeking the Optimal Capital Structure
- 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. <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. 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. 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. <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. <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. Depository Institutions Case I - R T & R D constant Depository Institution R D R T
- 193. Depository Institutions Case II – R T constant, R D variable with Depository Institution R D R T
- 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. <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. Depository Institutions Case III – R D constant, R T variable as Depository Institution R D R T
- 197. Depository Institutions Case IV – R D variable as , R T variable as Depository Institution R D R T
- 198. Depository Institutions Case IV – Impact of T 1
- 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. 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. End of Part 11

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