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 )
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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
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
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:
50. The S&P Model Worked Example with One Ratio – Cont’d… Curve Fit for Spread vs Rating
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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
63. Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure
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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
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
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97. Finding the OCS under “Constraints” Generalization OCS occurs at min V U / FV OCS FV = constant
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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
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
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
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
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.
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
