OPTIMAL
FINANCING
MIX
V:
ALTERNATE
APPROACHES
If
you
count
the
good
stu,
you
also
have
to
count
the
bad
stu.
Set Up and Objective
1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate
4. Define & Measure Risk
5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights
The Financing Decision
Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations
Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing
Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends
36. Closing Thoughts
The Dividend Decision
If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business
Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game
Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation
I.
The
APV
Approach
to
OpImal
Capital
Structure
In
the
adjusted
present
value
approach,
the
value
of
the
rm
is
wriOen
as
the
sum
of
the
value
of
the
rm
without
debt
(the
unlevered
rm)
and
the
eect
of
debt
on
rm
value
Firm
Value
=
Unlevered
Firm
Value
+
(Tax
Benets
of
Debt
-
Expected
Bankruptcy
Cost
from
the
Debt)
The
opImal
dollar
debt
level
is
the
one
that
maximizes
rm
value
ImplemenIng
the
APV
Approach
Step
1:
EsImate
the
unlevered
rm
value.
This
can
be
done
in
one
of
two
ways:
Step
2:
EsImate
the
tax
benets
at
dierent
levels
of
debt.
The
simplest
assumpIon
to
make
is
that
the
savings
are
perpetual,
in
which
case
EsImaIng
the
unlevered
beta,
a
cost
of
equity
based
upon
the
unlevered
beta
and
valuing
the
rm
using
this
cost
of
equity
(which
will
also
be
the
cost
of
capital,
with
an
unlevered
rm)
AlternaIvely,
Unlevered
Firm
Value
=
Current
Market
Value
of
Firm
-
Tax
Benets
of
Debt
(Current)
+
Expected
Bankruptcy
cost
from
Debt
Tax
benets
=
Dollar
Debt
*
Tax
Rate
Step
3:
EsImate
a
probability
of
bankruptcy
at
each
debt
level,
and
mulIply
by
the
cost
of
bankruptcy
(including
both
direct
and
indirect
costs)
to
esImate
the
expected
bankruptcy
cost.
EsImaIng
Expected
Bankruptcy
Cost
Probability
of
Bankruptcy
EsImate
the
syntheIc
raIng
that
the
rm
will
have
at
each
level
of
debt
EsImate
the
probability
that
the
rm
will
go
bankrupt
over
Ime,
at
that
level
of
debt
(Use
studies
that
have
esImated
the
empirical
probabiliIes
of
this
occurring
over
Ime
-
Altman
does
an
update
every
year)
Cost
of
Bankruptcy
The
direct
bankruptcy
cost
is
the
easier
component.
It
is
generally
between
5-10%
of
rm
value,
based
upon
empirical
studies
The
indirect
bankruptcy
cost
is
much
tougher.
It
should
be
higher
for
sectors
where
operaIng
income
is
aected
signicantly
by
default
risk
(like
airlines)
and
lower
for
sectors
where
it
is
not
(like
groceries)
RaIngs
and
Default
ProbabiliIes:
Results
from
Altman
study
of
bonds
RaIng
AAA
AA
A+
A
A-
BBB
BB
B+
B
B-
CCC
CC
C
D
Likelihood
of
Default
0.07%
0.51%
0.60%
0.66%
Altman estimated these probabilities by
2.50%
looking at bonds in each ratings class ten
7.54%
years prior and then examining the
16.63%
proportion of these bonds that defaulted
25.00%
over the ten years.
36.80%
45.00%
59.01%
70.00%
85.00%
100.00%
6
Disney:
EsImaIng
Unlevered
Firm
Value
Current
Value
of
rm
=
$121,878+
$15,961
=
$
137,839
-
Tax
Benet
on
Current
Debt
=
$15,961
*
0.361
=
$
5,762
+
Expected
Bankruptcy
Cost
=
0.66%
*
(0.25
*
137,839)
=
$
227
Unlevered
Value
of
Firm
=
=
$
132,304
Cost
of
Bankruptcy
for
Disney
=
25%
of
rm
value
Probability
of
Bankruptcy
=
0.66%,
based
on
rms
current
raIng
of
A
Tax
Rate
=
36.1%
Disney:
APV
at
Debt
RaIos
Debt
Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Unlevered
Firm
$ Debt
Tax Rate
Value
Tax Benefits
$0
36.10%
$132,304
$0
$13,784
36.10%
$132,304
$4,976
$27,568
36.10%
$132,304
$9,952
$41,352
36.10%
$132,304
$14,928
$55,136
36.10%
$132,304
$19,904
$68,919
36.10%
$132,304
$24,880
$82,703
36.10%
$132,304
$29,856
$96,487
32.64%
$132,304
$31,491
$110,271
26.81%
$132,304
$29,563
$124,055
22.03%
$132,304
$27,332
Bond
Probability
Rating
of Default
AAA
0.07%
Aaa/AAA
0.07%
Aaa/AAA
0.07%
Aa2/AA
0.51%
A2/A
0.66%
B3/B-
45.00%
C2/C
59.01%
C2/C
59.01%
Ca2/CC
70.00%
Caa/CCC
85.00%
Expected
Bankruptcy
Cost
$23
$24
$25
$188
$251
$17,683
$23,923
$24,164
$28,327
$33,923
Value of
Levered
Firm
$132,281
$137,256
$142,231
$147,045
$151,957
$139,501
$138,238
$139,631
$133,540
$125,713
The optimal debt ratio is 40%,
which is the point at which firm
value is maximized.
8
II.
RelaIve
Analysis
The
safest
place
for
any
rm
to
be
is
close
to
the
industry
average
SubjecIve
adjustments
can
be
made
to
these
averages
to
arrive
at
the
right
debt
raIo.
Higher
tax
rates
->
Higher
debt
raIos
(Tax
benets)
Lower
insider
ownership
->
Higher
debt
raIos
(Greater
discipline)
More
stable
income
->
Higher
debt
raIos
(Lower
bankruptcy
costs)
More
intangible
assets
->
Lower
debt
raIos
(More
agency
problems)
Comparing
to
industry
averages
Debt to Capital
Ratio
Book
Market
Company
value
value
Disney
Vale
22.88%
39.02%
11.58%
35.48%
Net Debt to Capital
Ratio
Book
Market
value
value
Comparable
group
US
Entertainment
17.70%
8.98%
34.90%
Global
Diversified
31.38% Mining & Iron
Ore (Market
cap> $1 b)
Tata
Motors
58.51%
29.28%
22.44%
Baidu
32.93%
5.23%
20.12%
Global Autos
19.25% (Market Cap> $1
b)
2.32% Global Online
Advertising
Debt to Capital
Ratio
Book
Market
value
value
Net Debt to Capital
Ratio
Book
Market
value
value
39.03%
15.44%
24.92%
9.93%
34.43%
26.03%
26.01%
17.90%
35.96%
18.72%
3.53%
0.17%
6.37%
1.83%
-27.13% -2.76%
10
Gejng
past
simple
averages
Step
1:
Run
a
regression
of
debt
raIos
on
the
variables
that
you
believe
determine
debt
raIos
in
the
sector.
For
example,
Debt
RaIo
=
a
+
b
(Tax
rate)
+
c
(Earnings
Variability)
+
d
(EBITDA/Firm
Value)
Check
this
regression
for
staIsIcal
signicance
(t
staIsIcs)
and
predicIve
ability
(R
squared)
Step
2:
EsImate
the
values
of
the
proxies
for
the
rm
under
consideraIon.
Plugging
into
the
cross
secIonal
regression,
we
can
obtain
an
esImate
of
predicted
debt
raIo.
Step
3:
Compare
the
actual
debt
raIo
to
the
predicted
debt
raIo.
11
Applying
the
Regression
Methodology:
Global
Auto
Firms
Using
a
sample
of
56
global
auto
rms,
we
arrived
at
the
following
regression:
Debt
to
capital
=
0.09
+
0.63
(EecIve
Tax
Rate)
+
1.01
(EBITDA/
Enterprise
Value)
-
0.93
(Cap
Ex/
Enterprise
Value)
The
R
squared
of
the
regression
is
21%.
This
regression
can
be
used
to
arrive
at
a
predicted
value
for
Tata
Motors
of:
Predicted
Debt
RaIo
=
0.09
+
0.63
(0.252)
+1.01
(0.1167)
-
0.93
(0.1949)
=
.1854
or
18.54%
Based
upon
the
capital
structure
of
other
rms
in
the
automobile
industry,
Tata
Motors
should
have
a
market
value
debt
raIo
of
18.54%.
It
is
over
levered
at
its
exisIng
debt
raIo
of
29.28%.
12
Extending
to
the
enIre
market
Using
2014
data
for
US
listed
rms,
we
looked
at
the
determinants
of
the
market
debt
to
capital
raIo.
The
regression
provides
the
following
results
DFR
=
0.27
-
0.24
ETR
-0.10
g
0.065
INST
-0.338
CVOI+
0.59
E/V
(15.79)
(9.00)
(2.71)
(3.55)
(3.10)
(6.85)
DFR
=
Debt
/
(
Debt
+
Market
Value
of
Equity)
ETR
=
EecIve
tax
rate
in
most
recent
twelve
months
INST
=
%
of
Shares
held
by
insItuIons
CVOI
=
Std
dev
in
OI
in
last
10
years/
Average
OI
in
last
10
years
E/V
=
EBITDA/
(Market
Value
of
Equity
+
Debt-
Cash)
The
regression
has
an
R-squared
of
8%.
13
Applying
the
Regression
Disney
had
the
following
values
for
these
inputs
in
2008.
EsImate
the
opImal
debt
raIo
using
the
debt
regression.
ETR
=
31.02%
Expected
Revenue
Growth
=
6.45%
INST
=
70.2%
CVOI
=
0.0296
E/V
=
9.35%
OpImal
Debt
RaIo
=
0.27
-
0.24
(.3102)
-0.10
(.0645)
0.065
(.702)
-0.338
(.0296)+
0.59
(.0935)
=
0.1886
or
18.86%
What
does
this
opImal
debt
raIo
tell
you?
Why
might
it
be
dierent
from
the
opImal
calculated
using
the
weighted
average
cost
of
capital?
14
Summarizing
the
opImal
debt
raIos
Actual Debt Ratio
Disney
Vale
Tata Motors Baidu
11.58%
35.48%
29.28%
35.00%
5.23%
Optimal
I. Operating income
II. Standard Cost of capital 40.00% 30.00% (actual)
20.00% 10.00%
50.00% (normalized)
III. Enhanced Cost of Capital 40.00% 30.00% (actual)
10.00% 10.00%
40.00% (normalized)
IV. APV
40.00%
30.00%
20.00% 20.00%
To industry
28.54%
26.03%
18.72%
To market
18.86%
V. Comparable
1.83%
15
Task
RelaIve
to
the
sector
in
which
your
company
operates,
examine
where
it
has
too
much
or
too
liOle
debt.
16
Read
Chapter
8
