AFM Quiz 3

When ERP rises relative to default spreads, firms will borrow ____.

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Assume project A ($1 mil) has a higher IRR and project B ($10 mil) has a higher NPV. What is your biggest concern given each choice?

Project A) Biggest risk is that no other projects come along during the course of the period, and the funds stay uninvested (NPV of zero) Project B) Biggest risk is that lots of very good projects earning higher returns come along but you don't have the funds to accept them.

Assume project A ($1 mil) has a higher IRR and project B ($10 mil) has a higher NPV. What is the rationale for choosing either?

Project A) Choose if you have a more serious capital rationing constraint Project B) Choose if you do not have capital rationing

Relative Analysis

The "safest" place for any firm to be is close to the industry average

Three transitional periods

(1) Going from being a private business entirely funded by the owner to accessing the private equity markets (venture capital) (2) Going from private to public with an initial public offering and (3) Public companies making seasoned offerings of debt and equity.

costs of rating constraints

- The cost of a rating constraint is the difference between the unconstrained value and the value of the firm with the constraint. - Managers need to be made aware of the costs of the constraints they impose.

Downside risk of buying back shares: sensitivity to assumptions

*"What if" analysis* - The optimal debt ratio is a function of our inputs on operating income, tax rates and macro variables. We could focus on one or two key variables - operating income is an obvious choice - and look at history for guidance on volatility in that number and ask what if questions. *"Economic Scenario" Approach* - We can develop possible scenarios, based upon macro variables, and examine the optimal debt ratio under each one. For instance, we could look at the optimal debt ratio for a cyclical firm under a boom economy, a regular economy and an economy in recession.

US Tax reform act of 2017: effects on the optimal debt ratio

*Change in marginal tax rate*: The marginal federal tax rate for US companies on US income has been lowered from 35% to 21%. Holding all else constant, that will lower the optimal debt ratio for all firms. *Limits on interest tax deduction*: Companies can deduct interest expenses only up to 30% of EBITDA (until 2022) and 30% of EBIT (after 2022). That will add a constraint to the tax savings from debt.

enhanced cost of capital approach

*Distress costs affect operating income*: In the enhanced cost of capital approach, the indirect costs of bankruptcy are built into the expected operating income. As the rating of the firm declines, the operating income is adjusted to reflect the loss in operating income that will occur when customers, suppliers and investors react. *Dynamic analysis*: Rather than looking at a single number for operating income, you can draw from a distribution of operating incomes (thus allowing for different outcomes).

Limitations of the cost of capital approach

*It is static*: The most critical number in the entire analysis is the operating income. If that changes, the optimal debt ratio will change. *It ignores indirect bankruptcy costs*: The operating income is assumed to stay fixed as the debt ratio and the rating changes. *Beta and Ratings*: It is based upon rigid assumptions of how market risk and default risk get borne as the firm borrows more money and the resulting costs.

Will the optimal be different if you invested in projects instead of buying back stock?

*No.* As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change significantly. *Yes*, if the projects are in entirely different types of businesses or if the tax rate is significantly different

NPV vs. IRR: small, large, and growing firms

- If a business has limited access to capital, has a stream of surplus value projects and faces more uncertainty in its project cash flows, it is much more likely to use IRR as its decision rule. Small, high-growth companies and private businesses are much more likely to use IRR - If a business has substantial funds on hand, access to capital, limited surplus value projects, and more certainty on its project cash flows, it is much more likely to use NPV as its decision rule. - As firms go public and grow, they are much more likely to gain from using NPV.

Tax benefits of debt & implications

- You can deduct interest payments as long as you have the income to cover interest payments to get the tax benefit - Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure - Debt ratios for firms should go up as corporate tax rates increase. - Debt ratios of firms incorporated in high-tax locales should be higher than debt ratios of firms in low-tax or tax exempt locales.

Side cost and benefit examples

- costs: costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have - benefits: project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay or abandon a project).

two categories for why the actual cash flows can be grater than or less than originally forecasted

1) *chance*: The nature of risk is that actual outcomes can be different from expectations. Even when forecasts are based upon the best of information, they will invariably be wrong in hindsight because of unexpected shifts in both macro (inflation, interest rates, economic growth) and micro (competitors, company) variables. Should be symmetry in the errors. 2) *bias*: If the original forecasts were biased, the actual numbers will be different from expectations. The evidence on capital budgeting is that managers tend to be over-optimistic about cash flows and the bias is worse with over-confident managers. Errors will tend to be in one direction.

two choices in how we deal with synergies

1) Assume that they exist and will be large enough to offset any negatives associated with the investment. (Common in big investments, where companies fall back on the "strategic benefits" argument to overwhelm financial considerations) 2) Try to quantify the benefits and bring them into the cash flows and returns and make sure that the project meets its financial hurdles

Subjective adjustments can be made to these the relative analysis to arrive at the right debt ratio: 1) higher tax rates 2) lower insider ownership 3) more stable income 4) more intangible assets

1) Higher debt ratios (Tax benefits) 2) Higher debt ratios (Greater discipline) 3) Higher debt ratios (Lower bankruptcy costs) 4) Lower debt ratios (More agency problems)

Framework for assessing the cost of using excess capacity

1) If I do not add the new product, when will I run out of capacity? 2) If I add the new product, when will I run out of capacity? 3) When I run out of capacity, what will I do? ¤Cut back on production: cost is PV of after-tax cash flows from lost sales ¤Buy new capacity: cost is difference in PV between earlier & later investment

1) An article in a business magazine argued that equity was cheaper than debt because dividend yields are much lower than interest rates on debt. Do you agree with this statement? a.Yes b.No 2) Can equity ever be cheaper than debt? a.Yes No

1) No. Dividend yields are only a portion of what you have to deliver to equity investors to keep them satisfied 2) Equity can never be cheaper than debt for any firm at any stage in its life cycle, since equity investors always stand behind debt holders in line when it comes to claims on cash flows (each year) and on assets (on liquidation). An exception to this is a company with a negative or very low beta that is lower than the default-risk adjusted cost of debt.

The expected bankruptcy cost is a function of two variables:

1) The *probability of bankruptcy*, which will depend upon how uncertain you are about future cash flows 2) The *cost of going bankrupt*: - Direct costs: Legal and other Deadweight Costs - Indirect costs: Costs arising because people perceive you to be in financial trouble

1) Assume that in the Disney theme park example, 20% of the revenues at the Rio Disney park are expected to come from people who would have gone to Disney theme parks in the US. In doing the analysis of the park, you would a.Look at only incremental revenues (i.e. 80% of the total revenue) b.Look at total revenues at the park c.Choose an intermediate number 2) Does Disney have a competitive advantage in theme parks? Why would this matter?

1) The answer will depend upon whether the cannibalization would occur anyway (to a competitor, if Disney does not take the project). The greater the barriers to entry or the competitive advantage that Disney has over its competitors, the less likely it is that cannibalization would occur anyway. In that case, it should be treated as an incremental cost. If not, it should be treated as non-incremental and ignored. 2) I would argue that Disney has far greater competitive advantages at its theme parks, than it does in TV broadcasting. Therefore, I would look at only the incremental revenue for the theme park, and the total revenues for the TV show.

Costs incurred by existing owners in each transition:

1) When venture capitalists enter the firm, they will demand their fair share and more of the ownership of the firm to provide equity. 2) When a firm decides to go public, it has to trade off the greater access to capital markets against the increased disclosure requirements (that emanate from being publicly lists), loss of control and the transactions costs of going public. 3) When making seasoned offerings, firms have to consider issuance costs while managing their relations with equity research analysts and ratings agencies

1) When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Stockholders' interests are different from your interests, because: 2) In some cases, the clash of interests can lead to stockholders:

1) You (as lender) are interested in getting your money back. Stockholders are interested in maximizing their wealth. 2) Investing in riskier projects than you would want them to. Paying themselves large dividends when you would rather have them keep the cash in the business.

1) Firms with more volatile earnings and cash flows will have ____ probabilities of bankruptcy at any given level of debt and for any given level of earnings. 2) Other things being equal, the greater the indirect bankruptcy cost, the ___ debt the firm can afford to use for any given level of debt. 3) Other things being equal, the greater the agency problems associated with lending to a firm, the ___ debt the firm can afford to use 4) Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the ____ debt the firm will use for financing current projects.

1) higher 2) less 3) less 4) less

three factors driving rating constraint

1) it is one way of protecting against downside risk in operating income (so do not do both) 2) a drop in ratings might affect operating income 3) there is an ego factor associated with high ratings

What should you do if: 1) new forecast < 0 2) new forecast < salvage value 3) new forecast < divestiture value 4) new forecast > 0 > divestiture value

1) liquidate 2) terminate (doesn't mean you will get the capital you originally invested in it back) 3) divest (may be worth if someone is willing to pay a much higher price for them than what you would make from continuing the investment) 4) continue

pathways to the optimal capital structure

1. *The Life Cycle Approach*: The optimal debt ratio is the one that best suits where the firm is in its life cycle. 2. *The Cost of Capital Approach*: The optimal debt ratio is the one that minimizes the cost of capital for a firm. 3. *The Enhanced Cost of Capital Approach*: The optimal debt ratio is the one that generates the best combination of (low) cost of capital and (high) operating income. 4. *The Adjusted Present Value Approach*: The optimal debt ratio is the one that maximizes the overall value of the firm. 5. *The Sector Approach*: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of financing mix.

Mechanics of Cost of Capital Estimation

1. Estimate the Cost of Equity at different levels of debt: - Equity will become riskier -> Beta will increase -> Cost of Equity will increase. - Estimation will use levered beta calculation 2. Estimate the Cost of Debt at different levels of debt: - Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. - To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense) 3. Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price.

project options

1: Option to delay taking a project until a later date. 2: Option to expand successful projects. 3: Option to abandon a project, if the cash flows do not measure up.

Determinants of the optimal debt ratio

1: The marginal tax rate - The primary benefit of debt is the tax benefit. The higher the marginal tax rate, the greater the benefit to borrowing. 2: Pre-tax cash flows - Higher cash flows, as a percentage of value, give you more debt capacity 3: Operating risk - Firms with more variable operating incomes will have higher betas and lower bond ratings, and therefore lower optimal debt ratios 4: Macro determinants - Changes in the ERP relative to bond default spreads will affect the relative attractiveness of equity versus debt

Exceptions on hedging commodities

A commodity company that prides itself on its operating prowess may choose to isolate that strength by hedging against commodity price risk. Thus, an oil company that is consistently more efficient about finding and exploiting new oil reserves may hedge against oil price to show the market its strength.

project synergies & example using Disney

A project may provide benefits for other projects within the firm Example: A Disney animated movie costs $50 mil to produce and promote. The movie, in addition to theatrical revenues, also produces revenues from the sale of merchandise, increased attendance at theme parks, stage shows, and TV series based on the movie.

Downside risk of buying back shares: constraint on bond ratings/book debt ratios

Alternatively, we can put constraints on the optimal debt ratio to reduce exposure to downside risk. Thus, we could require the firm to have a minimum rating, at the optimal debt ratio or to have a book debt ratio that is less than a "specified" value.

benefits vs. costs of debt

Benefits: - *Tax Benefits*: The tax code is tilted in favor of debt, with interest payments being tax deductible in most parts of the world, while cash flows to equity are not. - *Adds discipline* to management: When managers are sloppy in their project choices, borrowing money may make them less so Costs: - *Bankruptcy Costs*: Borrowing money will increase your expected probability and cost of bankruptcy. - *Agency Costs*: What's good for stockholders is not always what's good for lenders and that creates friction and costs. - *Loss of Future Flexibility*: Using up debt capacity today will mean that you will not be able to draw on it in the future.

exclusive rights

Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. - The value of these rights increases with the volatility of the underlying business. - The cost of acquiring these rights (by buying them or spending money on development or R&D, for instance) has to be weighed off against these benefits - Firms should be willing to pay large amounts for the rights to tech in areas where there is tremendous uncertainty about what the future will bring and much less in sectors where there is more stability

Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs: a. A Grocery Store b. An Airplane Manufacturer c. A High Tech Company

I would expect a grocery store to have the lowest bankruptcy costs. Customers generally do not consider the rating or default risk of grocery stores when they shop, but they definitely do consider both when placing an order for an airplane. Technology companies can have high bankruptcy costs, but the costs will vary depending upon what type of product they produce. A PC manufacturer might be affected more than someone who manufacturers software; a company which serves businesses might be affected more than one which creates games for children.

Value per share: rational investor solution

Implicit in this computation is the assumption that the increase in firm value will be spread evenly across both the stockholders who sell their stock back to the firm and those who do not and that is why we term this the "rational" solution, since it leaves investors indifferent between selling back their shares and holding on to them.

Should you hedge oil companies?

Investors who believe that oil prices will go up often buy oil companies. If these companies then hedge against oil price variability, they are undercutting that rationale. On an empirical basis, there have been studies that have compared commodity prices that hedge against commodity price movements against companies that do not, as investments. The general consensus seems to be that companies that do not hedge are much better investments, even on a risk adjusted basis, than companies that do.

Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs? a.A Technology Firm b.A Large Regulated Electric Utility c.A Real Estate Corporation

Lenders will probably perceive less agency costs in the regulated utility because: a. The assets are tangible and easy to monitor (much easier to monitor a power plant than R&D) b. The regulatory authorities will operate as brake on the investment activities of the utility and thus do the lender's work for them.

NPV vs IRR biases

NPV is biased towards larger investments. IRR is biased towards smaller investments

In the mine example, assume that the firm will use its existing distribution system to service the production out of the new iron ore mine. The mine manager argues that there is no cost associated with using this system, since it has been paid for already and cannot be sold or leased to a competitor (and thus has no competing current use). Do you agree?

No, using that excess capacity will create a cost down the road for the firm

In markets where there is no choice and you have to borrow from a bank, would you expect see lower debt ratios? Higher interest rates?

Not necessarily, but access to debt may be available only to well established firms that have long-standing relationships with banks. Smaller and younger firms may find themselves shut out of the process.

Are US companies de-levering in response to the 2017 tax reform?

US companies actually have more dollar debt now than they did in 2017, the year the tax law was passed towards the end. However, the debt to EBITDA has dropped fairly significantly in 2019.

If you can issue bonds, why would you use bank loans instead?

You may be able to supply proprietary information to a bank that you could not make public.... Special relationships with banks...)

opportunity cost

a project uses a resource that may already have been paid for by the firm (includes land, buildings, equipment, individuals who already work on other projects, or excess capacity in computer systems, distribution systems, etc.) - When a resource that is already owned by a firm is being considered for use in a project, this resource has to be priced on its next best alternative use, which may be ¤a sale of the asset, in which case the opportunity cost is the expected proceeds from the sale, net of any capital gains taxes ¤renting or leasing the asset out, in which case the opportunity cost is the expected present value of the after-tax rental or lease revenues ¤use elsewhere in the business, in which case the opportunity cost is the cost of replacing it

You are comparing the debt ratios of real estate corporations, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt ratios? a. The real estate corporations b. The real estate investment trusts c. Cannot tell, without more information

a. The forced payout of 95% of earnings as dividends by REITs to their stockholders may expose their investors to substantial personal taxes, but the absence of taxes at the entity level will make debt a less attractive option.

We would expect indirect bankruptcy costs to be higher at the following types of firms:

a. Firms that sell durable products with long lives that require replacement parts and service b. Firms that provide goods or services for which quality is an important attribute but is difficult to determine in advance. c. Firms producing products whose value to customers depends on the services and complementary products supplied by independent companies

At the end of 2017, the United States had one of the highest marginal corporate tax rates in the world (about 40%). Most companies had effective tax rates well below this, with the average effective tax rate closers to 22%. Which tax rate drives the tax benefit of debt and why? a.Marginal tax rates b.Effective tax rates

a. It is the marginal tax rate that drives the tax benefits because interest saves you taxes on your marginal dollar of income. Put simply, even companies that have low effective tax rates have some income taxed at higher rates, and will borrow against that income.

Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline? a. Conservatively financed (very little debt), privately owned businesses. b. Conservatively financed, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock. c. Conservatively financed, publicly traded companies, with an activist and primarily institutional holding.

b. Conservatively financed (Equity financed), publicly traded firms with a wide and diverse stockholding should be the best candidates for debt (with discipline as the argument) Private firms should have the incentive to be efficient without debt, because the owner/manager has his or her wealth at stake. Publicly traded firms with activist stockholders (like Michael Price) might not need debt to be disciplined. Investors looking over managers' shoulders will keep them honest.

Assume that Disney owns land in Rio already. This land is undeveloped and was acquired several years ago for $5 million for a hotel that was never built. It is anticipated, if this theme park is built, that this land will be used to build the offices for Disney Rio. The land currently can be sold for $40 million, though that would create a capital gain (which will be taxed at 20%). In assessing the theme park, which of the following would you do: a) Ignore the cost of the land, since Disney owns its already b) Use the book value of the land, which is $5 million c) Use the market value of the land, which is $40 million d) Other

d) Use the market value of the land, net of capital gain taxes $40 million - 0.2(30 - 5) = $33 million This is the cash flow you would have generated if the project was not taken

Why would there be two internal rates of return on a project?

there are two sign changes in the cash flows

agency cost

whenever you hire someone else to do something for you. It arises because your interests(as the principal) may deviate from those of the person you hired (as the agent).