Part 2.

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Risk & Return: Cost of Capital

CORPORATE FINANCE (PSBV026NABB)

Nóra Felföldi-Szűcs, PhD

Peter Grace FCA CFA
Department of Finance, Corvinus
University of Budapest
2021 FALL
 11/29/21

This Course – the structure

Foundations of Corporate Finance
1. Time 2. Risk 3. Analysis
Utility
The nature of risk " Financial Statements
Correlation & diversification " Ratios
Portfolio return and standard
deviations
Portfolio Theory
Systematic and issuer-specific
risk
Capital Asset Pricing Model &
Beta
! Capital Structures
 FNÁ1

Topics Today

• Debt and Tax

• Financing Decisions

• Estimating Cost of Capital

• The Miller-Modigliani Theorem (MM World )

• Tax adjusted WACC

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Non-GAAP Cashflow measures
GAAP
Levered Cash Flow
PRE TAX PROFIT X EBT
Tax X - Tax as % of EBT
PROFIT Σ PAT
Eliminate Non-Cash “Accounting” P&L items X Add back Depreciation
Eliminate Non-Operating items e.g. Asset Sale losses
Cash released from NWC (STWC) e.g. AR, AP, Inventory
OPERATING CASHFLOW (Post Tax) Σ Levered Op. CF
INVESTING CASHFLOW X Asset Sale revenue
- CAPEX
FREE CASHFLOW TO FIRM (FCF-F) Σ (naïve) FCF-F
DEBT FINANCING CASHFLOW X + New debt finance, net
FREE CASHFLOW TO EQUITY (FCF-E) Σ FCF-E
EQUITY FIN. CASHFLOW + equity issue - dividends
NET CASHFLOW Change in cash balances
29 November 2021
Effect of Debt Non-GAAP
Leverage Unlevered Cash Flow
= +
Add back Interest EBIT
- Tax Shield of interest - Tax as % of EBIT
Add back Interest, net of Tax NOPLAT
Shield effect (Net Operating Profit After Tax)
Add back Depreciation
e.g. Asset Sale losses
e.g. AR, AP, Inventory
Add back Interest, net Unlevered Op. CF
Asset Sale revenue
- CAPEX
Add back Interest, net Unlevered
FCF-F FCF-F
+ new debt finance, net
 Which method for RoA?

GAAP Non - GAAP Own way Ltd. Half way Ltd.

Return on Assets Net Income Operating Income x (1 − tax rate) Assets 1000 1000
Total Assets Total Assets0 Debt 0 500
Equity 1000 500
Sales 1200 1200
EBIT 360 360
Interest 0 - 40
EBIT 360 320
Tax 72 (20%) 64 (20%)
PAT 288 256
25.6% (GAAP)
RoA 28.8%
28.8% (non-GAAP)
 Book Value vs. Market Value

e.g. Equity e.g. Return of Assets

Equity BV looks backward RoA

• Measures internal returns wrt cost
• measures capital the firm has raised from
shareholders in the past
• Not a measure the value that shareholders
place on those shares today

Equity MV looks forward rA

• depends on the future dividends that • Measures investor returns wrt general
shareholders expect to receive. expectations of the future
 Financing Policy Decisions

Investment decisions Financing decisions Dividend decisions

Choice of NPV>0 projects Capital structure, D/E e.g. Plow back

Aims to find the optimal capital structure to maximise the firm value
 Patterns of Corporate Financing (2)

Dividend decisions Financing decisions

e.g. Plow back Capital structure, D/E

Alternatively firms may prioritise Dividend decision and the choose from available sources:

• internal sources: plowing back profits rather than distribute them to shareholders

• external sources, then

• debt or
• equity sources.
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Typical of mature, low growth companies

 Debt Instruments
• Lender / Form: Bank loan, Issue bonds, Trade credit (from suppliers)

• Key terms
• Maturity: Short term (may be rolled over), Long term
• Collaterals: lending against assets or against cash-flow (unsecured debt)
• Covenants: e.g. Company can transfer control rights to lenders through covenants

• Borrowing perspective decisions

• local or some foreign currency?
• fixed or floating?
• Convertible?

• Investor perspective terms:

• “Priority”: position in order of payment: senior debt vs. subordinated debt
• “Default Risk”: the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily (and equity prices fall to zero too!)
• “Bond Ratings”: grades issued on debt instruments to help investors assess the default risk of a firm
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 Perfect Markets
• There are no taxes, transaction costs
• A large number of rational investors who are price takers
• All investors have free access to financial information relating to a firm's projects.
• All investors can borrow or lend (invest), or to buy and sell shares.
• Homogenous products

• Not realistic # efficient markets

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 Estimation of cost of capital
• Asset markets (asset side of the balance sheet) are less efficient (we are looking for NPV > 0)

• Financial markets (equity and debt) are more efficient (fair price provides NPV = 0)

# rE and rD will be estimated from the capital markets instead of observing directly rA

If firm is financed only by equity:

rA = WACC = rE

where rE can be estimated using CAPM

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 Estimation of cost of capital: investor risk & return
For geared firms, a portfolio of both its Debt (D) and Equity (E)

• Operational return of the portfolio, rA, is built up • Operational risk of the portfolio, βA , borne by the
from the rE and the rD as follows creditors and share-holders is built up as
follows:
D E
rA = r + r + ……. D E
V D V E βA = β + β + …….
V D V E
• Data Sources:
• Data Sources: • Current prices (Bloomberg, etc)
• Current prices (http://www.worldgovernmentbonds.com/, etc) • Stats based on historical market data (sectors
• Stats based on historical market data ~ similar firms, https://pages.stern.nyu.edu/~adamodar/New_Home_Page/dataf
competitors, industrial data, similar securities ile/Betas.html, similar firms, competitors)

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• MRP is the most difficult: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3861152

 What is needed for the estimation?
D E
Operational return, rA = r + r
V D V E

Cost of debt Weights Cost of equity

(leverage)
Market values (D, E)

rD rE = rf + β * (rM – rf)
29 November 2021

Header
The Miller-Modigliani Theorem (MM World )

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 29 November 2021

Header

Modigliani – Miller Theorem I: independence of Leverage

• For unchanged investment policy, the markets are perfect (eg. no taxes), it makes no difference
whether the firm borrows or individual shareholders borrow.

• So the market value of a company does not depend on its capital structure

• If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.

• Value of the firm is independent of the debt ratio.

D E
rA = xr + xr
D+E D D+E E

rA # does not change

 Modigliani – Miller Theorems
Assumptions
• By issuing 1 security rather than 2, company diminishes investor choice.
• This does not reduce value if:
• Investors do not need choice, OR
• There are sufficient alternative securities

Capital structure does not affect cash flows:

• No taxes;
• No bankruptcy costs;
• No effect on management incentives;
• No transaction costs;
• Individuals and corporations borrow at the same risk free rate;
• Efficient market.
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M&M Proposition II: Equity Cost dependence on Leverage

As a corollary of Proposition I:

The required return of equity must change with leverage

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Combining M&M Propositions I and II

V D D
rE = x rA - x rD = rA + (rA - rD ) x
E E E

E D D E
rA = x rE + x rD = x rD + x rE
V V D+E D+E
V E
rD = ( x rA - x rE)
D D
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Leverage and Returns: example

Market Value-based Balance Sheet
Assets Capital
Asset Value 100 40 Debt (D)
60 Equity (E)
Asset Value 100 100 Firm Value (V)

D E
rD= 7.5% rA = xr + xr
D+E D D+E E

40 60
rE= 15% rA = x 0.75 + x 0.15 = 12%
100 100
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Leverage and Returns

What happens if rD increases?

Assets Capital
Asset Value 100 40 Debt (D)
60 Equity (E)
Asset Value 100 100 Firm Value (V)

40 60
rD= 7.875% x 0.7875 + x r = 12%
100 100 E

rA= 12% rE = 14.75%

 Leverage and Risk

D E
Asset or Unlevered Beta, βA = βD x D + E + βE x D+E

Or, equivalently …

D
Equity or Levered Beta, βE = βA + (βA - βD ) x
E
V D
= βA x - βD x
E E

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Outside the MM framework

If there is no tax (t = 0), the investors’ return rA is the Cost of capital WACC (rA = WACC)

What if t ≠ 0?

• For investors’ return rA , weighting the returns of the two types of capital, and assuming perfect markets:
D E
rA = r + r + …….
V D V E
• For WACC, accepting markets are imperfect
• The tax benefit from interest expense deductibility must be included in calculating the cost of funds
• This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.

D E
WACC = r (1 - t) + r + …….
V D V E
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WACC

V D
rE = x WACC - x rD x (1 - t)
E E
E D
WACC = xr + x rD x (1 - t)
V E V
V E
m
= WACC
rD = (D x WACC - D x rE) / (1 - t)
 After Tax WACC: example

A firm has 35% marginal tax rate, 14.6% cost of equity, 8% pre-tax cost of debt and MV-based balance
sheet below
Balance Sheet (Market Value, millions)
Assets 125 50 Debt
75 Equity
Total assets 125 125 Total liabilities

What is its tax-adjusted WACC?

D E
WACC = x r x (1 - t) + xr
V D V E
50 75
WACC = 125 x 0.08 x (1 – 0.35) + 125 x .146

= .1084 (10.84%)
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Illustration
We have a company with gearing D/V = 20% , Debt & Equity costs rD=10%, rE=20% and tax rate t = 50%

1. Calculate rA and WACC

rA = 20% x 10% + 80% x 20% = 18%
WACC = 20% x 10% x (1 - 50% ) + 80% x 20% = 17%

2. How much should the Cost of Equity increase if we increase gearing D/V to 40% and Debt Costs
increase to 13%?
rE = (18% - 40% x 13%) / 60% = 21.33%

3. How will WACC change?

WACC = 40% x 13% x (1 - 50%) + 60% x 21.33% = 15.4%
 29 November 2021

Thank you
for your attention!