Prof Dr Catherine Ho

13 .1

Components of Capital
Permanent Short-Term Debt Long-Term Debt And Leases

Preferred Stock

Common Stock
13 .2

Table 13.1

Summarized Balance Sheet

December 31, 2005 - $ Millions Current Assets Net, Plant, Property, & Equipment Goodwill Other Assets Total Assets $1,409 1,659 487 740 $4,295 Current Liabilities* Long-Term Debt Deferred Taxes Other LT Liabilities Stockholders Equity $1,518 943 400 413 1,021

Total Liabilities and Stockholders Equity $4,295

* Current Liabilities includes a total of $819 million of permanent short-term debt.

13 .3

Cost of Capital Overview

Weight X Debt Preferred Stock Common Stock Total WD% WPS% WCS% 100% Cost KD% KPS% KCS% = WACC WD KD WPS KPS WCS KCS WACC

13 .4

Cost of Capital Topics

Cost of Individual Components
Cost of Debt Cost of Preferred Stock Cost of Equity

Weighting Approaches
Book vs. Market Weights Current vs. Target

Weighted Average Cost of Capital Capital Structure Theory Hurdle Rates

13 .5

Cost of Debt
After-Tax Cost of Debt = Before Tax X (1 Tax Rate) Cost of Debt
Financial Structures Debt No Debt Debt Interest Rate Interest Sales Cost of Goods Sold Operating Income Interest Expense Pre-Tax Income Income Taxes Net Income Pre-Tax Cost of Debt = After-Tax Cost of Debt = After-Tax Cost of Debt $1,000 10% $100 $1,000 800 200 100 100 40 $ 60 $100 60 $0 10% $0 $1,000 800 200 0 200 80 $ 120

= =

10% 6%

(1- 40% )
13 .6

Historical or Book Cost of Debt

Cost of existing debt the company has outstanding

Current or Market Cost of Specific Debt

Current yield on specific debt But many bonds do not trade regularly or at all

Current or Market Cost of Similar Debt

Todays interest rates only similarly rated debt

Of course, any of the costs must be aftertax

13 .7

Table 13.6

Hershey's Cost of Debt Historical Technique

Balance 12/31/05 $819.1 Interest Rate 4.30% Weighted Cost 2.00%

$ Millions Short-Term Debt Debentures Due 2021 Due 2027 Notes Due 2007 Due 2012 Due 2015 Other

Weight 46.49%

100.0 250.0

5.68% 14.19%

8.80% 7.20%

0.50% 1.02%

151.2 150.0 250.0 41.6 $1,761.9

8.58% 8.51% 14.19% 2.36% 100.00%

6.95% 6.95% 4.85% 6.70%

0.60% 0.59% 0.69% 0.16% 5.55% 63.8% 3.54%

X (1 Tax Rate) After-Tax Cost of Debt

13 .8

Table 13.4

Current Market Cost of Debt

PV Yr 0 Yr 1 ($1,070) $1,070 $72 X% Yr 2 $72 X% Yr 3 . $72 X% $72 X% Yr 12 .. $72 $1,000 X% Yr 21

Where: X% = Current or Market Cost of Debt = 6.60%

13 .9

Table 13.5

Current Market Interest Rates

Yield Comparisons
Based on Merrill Lynch Bond Indexes, priced as of midafternoon ET.

5/15 Treasury 1-10 Yr 10+ Yr Agency 1-10 Yr 10+ Yr Corporate 1-10 yr High Quality Medium Quality 10+ yr High Quality Medium Quality High Yield Corporate 5.03 5.35 5.34 5.71 5.61 5.91 6.29 6.61 8.09

5/12 5.06 5.40 5.37 5.76 5.64 5.95 6.33 6.64 8.08

52-week High Low 5.06 5.40 5.37 5.76 5.64 5.95 6.33 6.64 8.51 3.57 4.18 3.84 4.49 4.21 4.62 5.08 5.48 7.47
13 .1 0

Source: Wall Street Journal, May 16, 2006, p. C-8

Cost of Debt Issues

Book (or Historical) vs. Market Cost of Debt Market Cost of Debt
Specific cost of a bond vs. general market cost Often bonds do not trade regularly or trade at all

Recommendation is Market (or Current) Cost of Debt

When specifics are not available, use general rates

Summary:
Historical Market - Specific Market - General

Cost of Debt Pre-Tax After Tax 5.55% 3.54% 6.60% 4.21% 6.29% 4.01%
13 .1 1

Preferred Stock
Special form of ownership that has a fixed periodic dividend payment which must be paid before any payment of common stock dividends Hybrid Security
Characteristics of Debt, but Considered Equity

Limited Participation in the Growth of the Firm Dividends Are Not Tax Deductible
Unlike Tax Deductible Interest

Popular with Utility Companies or Start-Up Companies

13 .1 2

Cost of Preferred Stock

Cost of = Preferred Stock Preferred Stock Dividend Price of Preferred Stock

13 .1 3

Figure 13.2

Cost of Preferred Stock

PV Yr 0 Yr 1 ($48.00) $48.00 $4.00 X% Yr 2 $4.00 X% Yr 3 . $4.00 X% $4.00 X% Yr 50 . $4.00 X% Yr 100

Where: X% = Cost of Equity = 8.33%

13 .1 4

Preferred Stock Issues

What Price for the Preferred Shares?
Par Value
Value When Issued Related to Book (or Historical) Value Related to Book (or Historical) Cost of Preferred Stock

Market Value
Current Value in the Market Related to Market Value Related to Market Cost of Preferred Stock

Our recommendation: Market Value

13 .1 5

Cost of Equity
Cost of Equity Includes:
All Stockholder Equity Components
Common Stock Paid in Excess Retained Earnings Miscellaneous

Shareholders Required Return Three Techniques

Gordon Dividend Growth Model Capital Asset Pricing Model
William Sharpe Won Part of a Nobel Prize

Arbitrage Pricing Theory

13 .1 6

Gordon Dividend Growth Model

Dividend Growth Model uses the concepts of a no growth perpetuity and solves for the discount rate. D0 = D1 = D2 = DKNY
R e q u ir e d R e tu r n = C o st o f E q u ity

R e q u ir e d R e tu r n

= =

D iv id e n d Y ie ld D iv id e n d 1 S to c k P r ic e 0

+ +

G r o w th G r o w th

13 .1 7

Table 13.8

Interpretation of Gordon Dividend Growth Model

PV Yr 0 Yr 1 ($55.25) $55.25 $0.93 X% Yr 2 $1.00 X% Yr 3 $1.07 X% $26.80 X% Yr 50 . $827 X% Yr 100

Where: X% = Cost of Equity = 8.8%

Note: Dividends are assumed to grow at 7.1% annually. This is our assumption . Do NOT buy stock in Hershey based upon this illustrative growth rate. The stock price in December 2005 was $55.25.
13 .1 8

Cost of Hersheys Equity: Dividend Growth Model

Cost of Equity = Dividend1 Stock Price0 $0.93A $55.25B 1.7% 8.8% + Growth

= = =

+ +

7.1%C 7.1%

ABC-

Projected dividend assuming 7.1% growth from current dividend of $0.8650. December 2005 Stock Price. The expected growth of dividends is the anticipated growth rate of future dividends and can be ascertained from the strategic plan. The growth rate of 7.1% is only a representative rate for illustrative purposes. Do NOT buy Hershey stock based on this example.

13 .1 9

Dividend Growth Model Issues

For most effective use, company needs to pay dividend with steady stable growth Can be used for zero dividend companies by estimating first dividend payment (when and how much) and the subsequent growth rate Difficulty in defining growth
Long-term, perpetual growth rate

13 .2 0

Capital Asset Pricing Model (CAPM)

Graphical Overview
200% 150% Stock Excess Return 100% 50% 0% -200% -150% -100% -50% -50% 0% -100% -150% -200% Market Excess Return 50% 100% 150% 200%

Stock Return = Risk-Free Rate + Beta (Excess Market Return) Excess Return = Capital Appreciation + Dividend Yield - Risk Free Rate
13 .2 1

CAPM Three Different Stocks

400% 300% Stock Excess Return 200% 100% 0% -200% -150% -100% -50% -100% 0% -200% -300% 50% 100% 150% 200%

Beta = 2.0 Beta = 1.0 Beta = 0.5

Stock C Stock B

Stock A

-400% M arket Excess Return

Stock A B C

Alpha 0.0 0.0 0.0

Beta 2.0 1.0 0.5

13 .2 2

CAPM: Application
Kcs Rf (Km - R R) f) Kcs Kcs = = = = = = Rf 5.35% 0.70 4.89% 5.35% + 8.77% 0.70 (4.89%) + (Km - Rf) (13.6A) (May 15, 2006, from above) (Value Line, December 2005) (Trend since 1926)

13 .2 3

Figure 13.4

CAPM: Hershey Foods vs. Market

The Hershey Company Beta Analysis
10%

5%

Hershey Returns

0% -10% -5% 0% 5% 10%

-5%

y = 0.4551x + 0.0127 R2 = 0.2218

-10%
Market Returns

Note: Beta is 0.4551 in this specific calculation.

R2 in this example is about 0.22. Rarely does the R2 exceed 0.25.

13 .2 4

Market Risk Premium

Excess Returns (Large Company Stocks less ) Bonds Average CAGR 1926-2005 1976-2005 1986-2005 1996-2005 6.46% 3.69% 2.91% 2.76% 4.89% 3.23% 2.19% 1.48% Bills Average CAGR 8.55% 7.73% 8.55% 7.09% 6.65% 6.67% 7.33% 5.45%

13 .2 5

CAPM Issues
Maintains its conceptual appeal, but . Portfolio technique with limited statistical properties for single company application Determining market risk premium Specific CAPM calculation:
Monthly, weekly, daily One year, three years, five years

CAPM rejected theoretically:

Alpha term 0 Other things explain return

Lead to Arbitrage Pricing Theory

13 .2 6

Arbitrage Pricing Theory

Multiple Regression Model Factors May Include
Inflation GNP Growth Interest Rates
Difference Between Long and Short-Term Rates Difference Between High Quality (AA) and Lower Quality (BB) Rates

Others

Focussed on Surprise in the Factors

13 .2 7

Cost of Equity Issues

Three Techniques - With Limitations
Dividend Growth Model Capital Asset Pricing Model Arbitrage Pricing Theory

Systematic Estimation Largest Cost Component Not Tax Deductible Our recommendation: CAPM
13 .2 8

Cost of Capital Components

Cost of Debt
Historical vs. Marginal

Cost of Preferred Stock

Par Value vs. Current Market Price

Cost of Equity
Dividend Growth Capital Asset Pricing Model Arbitrage Pricing Theory

13 .2 9

Table 13.6

Hersheys Cost of Capital Market Based Weights

% of Total Debt A $1,762 Equity B $13,288 After-Tax Cost Weighted Cost

11.70% 88.30%

4.01% 8.77%

0.47% 7.74% 8.21%

Total 100.00%

A - The market value of the debt is assumed to be the same as the book value of the debt. B - The market value of the equity is calculated as $55.25 (price per share December 31, 2005) times 240.5 million shares outstanding.
13 .3 0

Hersheys Cost of Capital Book Based Weights

% of Total Debt $1,762 Equity $1,021 63.31% 36.69% After-Tax Cost 4.01% 8.77% Weighted Cost 2.54% 3.22% 5.76%

Total 100.00%

This approach understates the proportion of equity and results in a significantly lower cost of capital.

This is offered for comparison only. It is not an appropriate weighting technique.

13 .3 1

Based on:
Best Practices in Estimating the Cost of Capital: Survey and Synthesis, Bruner, Robert F., Kenneth M. Evades, Robert S. Harris, and Robert C. Higgins, Financial Practice and Education, Volume 8, Number 1, Spring/Summer 1998.

Selected topics:
Cost of Debt Cost of Equity Capital Weights

13 .3 2

Percent of respondents in using each approach. Financial Advisors 60 30 10

Corporations Cost of Debt Market Current (or historical) Other 52 37 11

13 .3 3

Percent of respondents in using each approach. Financial Advisors 80 20 10 10 70 10 10 0 50 40

Strategic 13 .3 4

Corporations Cost of Equity CAPM Other Risk free rate 90-day T-bill 3 to 7-year treasury 10 to 30-year treasury Other Equity risk premium Fixed rate of 4% to 5% Fixed rate of 5% to 6% Fixed rate of 7% to 7.4% Other (9 techniques) 81 19 4 7 70 23 11 37 0 52

Percent of respondents in using each approach. Financial Advisors 90 10 10 90 10 10

13 .3 5

Corporations Weights Market Book Other Weights Target Current Other 59 15 23 52 15 23

Weighting Basis
Book Basis Market Basis (Recommended)

Time Focus
Historical Current (Partially Recommended) Projected (Partially Recommended)

Related Topics
Capital Structure Hurdle Rates

13 .3 6

13 .3 7

25% After-Tax Cost of Capital

Cost of Equity

20% 15% 10% 5% 0% 0% 10% 20% 30% Debt / Capital 40% 50% 60%
Cost of Capital Cost of Debt

13 .3 8

% of Total Structure 1 Debt Equity Capital Structure 2 Debt Equity Capital Structure 3 Debt Equity Capital 0% 100% 100% 35% 65% 100% 50% 50% 100%

After-Tax Cost 4.0% 11.0%

Weighted Cost 0.0% 11.0% 11.0% 1.6% 8.4% 10.0% 3.0% 9.0% 12.0%

4.5% 13.0%

6.0% 18.0%

13 .3 9

All organizations employ cost management programs to moderate all expenses. Capital is the most used commodity, and many firms are to the left of the minimum cost of capital. By reducing the cost of capital, the firm increases its value:
Recall the examples from Chapter 12

13 .4 0

12%

Cost of Equity
10% 8%

Cost of Capital

Cost of Capital
6% 4%

Cost of Debt
2% 0% 0% 10% 20% 30% 40% 50%

Current Market - Debt % of Total Capital

13 .4 1

11%

Cost of Capital
10%

Cost of Capital

y = -0.0552x + 0.0984 R = 0.7517

9%
2

8%

Hershey

7% 0% 10% 20% 30% 40% 50%

Current Market - Debt % of Total Capital

13 .4 2

Hershey can reduce its cost of capital by taking on more debt. By taking on a moderate amount of debt, the value of the Hershey should increase.

13 .4 3

Consider Risk vs. Return Analogous to mutual fund scoring Cost of capital based Aligned to project classifications Integral to capital investment process Similar to discussions in chapter 6

13 .4 4

14 .4 5

Financing a Business
Sources of Capital Direct Investment

Role of the Investment Banker Long-Term and Short-Term Debt Preferred Equity Common Equity

14 .4 6

Table 14.1

Financing Sources Through a Firms Development

Organization Life Organization Development Stage Financing Sources Start-Up
Personal Savings Personal Loans Governmental Agencies

Rapid Growth
Internal Financing Bank Credit Venture Capital

Growth to Maturity
Going Public Money M arket Capital Market

Maturity
Internal Financing Debt Repayment Share Repurchase

14 .4 7

Life Cycle Stage

Development

Financing Type
Seed Financing

Major Sources
Entrepreneur Family and Friends

Start Up

Start Up Financing

Entrepreneur Family and Friends Business Angels Venture Capitalists

Survival

First Round Financing

Operations Venture Capitalists Government Commercial Banks

Rapid Growth

Second Round Financing Operations Commercial Banks Investment Banks

14.48

Direct Financing Venture Capital Staged Capital Commitment Going Public & Initial Public Offerings (IPOs)
Investment Banking Firm Commitment Best Efforts

14 .4 9

Direct financing is raising funds directly from an investor such as a commercial bank. Advantages
Facilitates short-term seasonal borrowing No SEC costs Requires less time May be able to modify loan agreement

Disadvantages
Interest may be higher. Cash drain is large. Required to make payments that include interest and principal. Long-term loans are restricted to only high quality companies. Long-term loan has restrictions that commercial paper would not. Investigation costs can be high.
14 .5 0

Underwriting Distributing Advice & Counsel Operations

Pre-Underwriting Consultation Registration Statement
Including Pricing

Investment Banking Syndicate

14 .5 1

Table 14.2

Investment Banking Syndicate

Security Issuer Business Firm

Managing Investment Banker

Investment Banker

Investment Banker

Investment Banker

Underwriting Syndicate: Manager plus 10-60 Investment Bankers

Ultimate Investors

Strategic Financial Management: Applications of Corporate Finance Samuel C. Weaver and J. Fred Weston

14 .5 2

Advantages
Raise additional funds Easier to raise next round Public price is established
Also for tax purposes

Disadvantages
Loss of control Cost Disclosure of activities More formal reporting May have inactive stock market Outsiders push for shortterm results Disclosures may contain competitive information Cost to service stockholders Can not act as quickly
14 .5 3

Increased liquidity

Secured
Mortgage
Similar to Home Mortgage or Car Loan Applied to business

Unsecured
Debenture
Credit Card Debt, as a personal example

Provisions
Priority of Claims Right to Issue Additional Securities Scope of Lean Specific vs. Blanket

Subordinated Debentures

Other Types
Income Bonds Zero Coupon Bonds Floating Rate Notes
14 .5 4

Debt Characteristics
Sinking Fund Callable Convertible
Usually Equity Can be Commodity

Protection to Creditors
Trustee
certifies issue of bond, polices firms behavior, takes action on behalf of the bondholders

Indexed Bond

Indenture
Restricts Restricts Restricts Restricts assets new debt dividends M&A disposition of

Strategic Financial Management: Applications

14 .5 5

Advantages
Limited cost Lower required return No sharing of control Interest is tax deductible Flexibility is increased by inserting a call feature

Disadvantages
Fixed charges Non-payment is default Higher leverage, higher cost of equity Fixed maturity Long-term risk Stringent indenture Provisions Limited amount of funds

Strategic

14 .5 6

Personal home mortgage refinancing:

Went from 25 years @6.25% to 15 years @4.5% Payments from $1400 to $1600 a month Total payments for life of loan
Old: 25 Years X $1400/month = $420,000 New: 15 Years X $1600/month = $288,000 Savings = $132,000.Right??

Need to include cost of refinancing, tax impact, and time value of money (@ new rate, 4.5% after tax).
14 .5 7

Existing Bond
$200 million, 15-year bond five years ago at 8.00% Cost of issuing: $6.0 million Discount: $0.3 million $200.0 million at 6.50% for ten years Cost of issuing: $6.0 million (3%) Discount: None Call premium: 5.0% or $10 million

New Bond

Cost to Refinance Tax Rate: 40.0%

14 .5 8

The question is simply: should the company incur the $16.0 million of cost to reduce its interest expense by $3.0 million each year? The analysis can best be framed by comparing the present value of the savings versus the present value of the cost. If savings exceed the cost, the original bond should be called and refinanced. But as with any analysis, important details need to be examined and after-tax cash flow amounts considered.
14 .5 9

Table 14.5

Bond Refinancing Analysis

($000's)

A. Initial Cost (or Benefit) - Year 0

New or Existing Bond 1. New Pre-Tax Cost (Savings) $ Year 0 Impact After Tax Tax Cost Consequence (Savings) After Tax Calculation (40% Tax Rate)

Item Refinancing or Floatation Cost

6,000.0 Tax savings over bond's life. $ 6,000.0 No Immediate Tax Impact 10,000.0 Immediately tax deductible. 6,000.0 $10,000 (1-Tax Rate)

2. Existing Call Premium

3. Existing Tax Savings on Existing Bond's: Floatation Cost: Unamortized Portion: $4,000 ($6,000 X 2/3) Existing Bond Price Discount: Unamortized Portion: $200 ($300 X 2/3) Total After-Tax Year 0 Investment Amount

Immediate tax savings. Immediate tax savings.

(1,600.0) $4,000 (Tax Rate) (80.0) $200 (Tax Rate) $ 10,320.0

14 .6 0

Table 14.5

Bond Refinancing Analysis

($000's)

B. On-Going Benefit (or Cost) - Years 1-10

New or Existing Bond 1. Pre-Tax Cost (Savings) Years 1 - 10 Impact After Tax Tax Cost Consequence (Savings) After Tax Calculation (40% Tax Rate)

Item

Interest Payments Existing 8.00% Interest on $200,000.0 New 6.50% Interest on $200,000.0 Net Savings

$ 16,000.0 Deductible when paid. (13,000.0) Deductible when paid. 3,000.0

$ 9,600.0 $16,000 (1-Tax Rate) (7,800.0) $13,000 (1-Tax Rate) 1,800.0

2.

Tax Shield from Refinancing Costs Paid in Initial Year Existing Amortization of $6,000 over 15 years = $400/yr New Amortization of $6,000 over 10 years = $600/yr Tax Shield from Bond Discount Incurred in Initial Year Existing Amortization of $300 over 15 years = $20/yr New None Anticipated so no Amortization Expense

(160.0) $400 (Tax Rate) 240.0 $600 (Tax Rate) 80.0 (8.0) $20 (Tax Rate) $0 (Tax Rate) (8.0) $ 1,872.0

3.

Total After-Tax Savings - Years 1-10

14 .6 1

Table 14.6

Net Present Value of Bond Refinancing

($000s) Value Period Years 1-10 Year 0 After Tax Impact Annual After-Tax Impact (Cash Flow) Initial Year After-Tax Investment (Cash Flow)
(Table 14.5)

Present Value* $ 15,259.5 (10,320.0) $ 4,939.5

1,872.0 (10,320.0)

Net Present Value of Bond Refinancing

* The present value is calculated at the after tax cost of the new debt or 3.9% (6.5% * 0.60).

Refinance the bond.

14 .6 2

Hybrid security that pays a fixed dividend similar to debt, but it is classified as equity. Perpetuity with claims and rights with priority ahead of common stock but behind all bonds. Typical feature is cumulative dividends
If a dividend is skipped, must repay all skipped dividends before a common dividend.

Often convertible to common equity.

Strategic Financial Management: Applications of Corporate Finance Samuel C. Weaver and J. Fred Weston

14 .6 3

Preferred stock can have creative features On occasion those features can include:
Voting rights Participating Sinking fund Maturity Call provisions Adjustable rate preferred stock Auction-rate preferred stock

Strategic Financial Management: Applications of Corporate Finance Samuel C. Weaver and J. Fred Weston

14 .6 4

Advantages
Could miss a dividend payment Limited return to holders No participation in earnings No sharing control via voting Conserves mortgageable assets No maturity and no sinking fund provided for greater flexibility than debt

Disadvantages
Higher yield than bonds Dividends are not tax deductible After tax cost is therefore the full portion

14 .6 5

Collective Rights
Amend the charter Amend bylaws Elect directors Authorize sale of fixed assets Authorize mergers Right to change amount of authorized common stock Right to issue preferred stock, bonds, and other securities

Voting rights and proxies

Absentee voting mechanism

Cumulative voting
A stockholder can pool all of their votes for one board member

Preemptive rights
Before issuing new shares, existing shareholders must be given the offer to purchase proportionally.

14 .6 6

Advantages
No fixed charges No maturity Increase creditworthiness Can, at times, be sold more easily than debt Returns from common stock, in the form of capital gains, may be taxed preferentially Employee stock programs can be effective alignment mechanisms

Disadvantages
Dilution of control Dilution of earnings vs. fixed cost of debt Costs of issuing usually higher than debt Cost of equity higher than debt or preferred stock Common dividends are not tax deductible

14 .6 7