VII Ways to Enhance Value

Overview:

Value of a firm =

value of expected cash flows from existing operations

+ value of expected cash flows from future growth

discounted at the cost of capital (WACC)

What are some of the ways to enhance value of cash flows from existing operations?

What are some of the ways to enhance value of cash flows from future growth?

What are some of the ways to reduce the cost of capital (WACC)?

What is a necessary in an organization to accomplish all of the above?

Example:Analyzing impact of operating efficiency vs. future growth on value

How does capital structure (debt-equity mix) affect WACC?

How can we minimize WACC?

How are components of WACC affected by increasing debt in the capital structure?

Conclusion:

Some useful formulas when debt is risky

When debt is risky, beta of debt ≠ 0. i.e. Bd ≠ 0

Kd = Rf + MRP x Bd

Bd = (Kd – Rf) / MRP

Notice that CAPM formula applies to risky debt as well

Also, for levering/unlevering equity beta:

Be = Bu + (Bu – Bd) (1 – T) D/E

And

Bu = [Be + Bd(1 – T)D/E] / [1 + (1 - T)D/E]

Notation:

Kd = cost of debt

Rf = risk free rate

Bd = beta of (risky) debt

Bu = beta of unlevered equity

Be = beta of levered equity

T = marginal tax rate

D/E = debt-equity ratio (market values)

Case 1: Debt is risk-free, T = 0

Assumptions:Bu Rf MRP T0.9 5% 6% 0%

D/V E/V D/E Bd Kd Be Ke WACC0 1 0.00 0.00 5.00% 0.90 10.4% 10.40%

0.1 0.9 0.11 0.00 5.00% 1.00 11.0% 10.40%0.2 0.8 0.25 0.00 5.00% 1.13 11.8% 10.40%0.3 0.7 0.43 0.00 5.00% 1.29 12.7% 10.40%0.4 0.6 0.67 0.00 5.00% 1.50 14.0% 10.40%0.5 0.5 1.00 0.00 5.00% 1.80 15.8% 10.40%0.6 0.4 1.50 0.00 5.00% 2.25 18.5% 10.40%0.7 0.3 2.33 0.00 5.00% 3.00 23.0% 10.40%0.8 0.2 4.00 0.00 5.00% 4.50 32.0% 10.40%0.9 0.1 9.00 0.00 5.00% 9.00 59.0% 10.40%

What can we conclude from above?

Case 2: Debt is risky, T = 0

  Assumptions:    Bu Rf MRP T0.9 5% 6% 0%

D/V E/V D/E Bd Kd Be Ke WACC0 1 0.00 0.00 5.00% 0.90 10.4% 10.40%

0.1 0.9 0.11 0.03 5.20% 1.00 11.0% 10.40%0.2 0.8 0.25 0.08 5.50% 1.10 11.6% 10.40%0.3 0.7 0.43 0.15 5.90% 1.22 12.3% 10.40%0.4 0.6 0.67 0.23 6.40% 1.34 13.1% 10.40%0.5 0.5 1.00 0.32 6.90% 1.48 13.9% 10.40%0.6 0.4 1.50 0.45 7.70% 1.58 14.5% 10.40%0.7 0.3 2.33 0.58 8.50% 1.64 14.8% 10.40%0.8 0.2 4.00 0.63 8.80% 1.97 16.8% 10.40%0.9 0.1 9.00 0.73 9.40% 2.40 19.4% 10.40%

What can we conclude from above?

Case 3: Debt is risky, T ^= 0

  Assumptions:  Bu Rf MRP T0.9 5% 6% 35%

D/V E/V D/E Bd Kd Be Ke WACC0 1 0.00 0.00 5.00% 0.90 10.4% 10.40%

0.1 0.9 0.11 0.03 5.20% 0.96 10.8% 10.22%0.2 0.8 0.25 0.08 5.50% 1.03 11.2% 10.06%0.3 0.7 0.43 0.15 5.90% 1.11 11.7% 9.93%0.4 0.6 0.67 0.23 6.40% 1.19 12.1% 9.84%0.5 0.5 1.00 0.32 6.90% 1.28 12.7% 9.79%0.6 0.4 1.50 0.45 7.70% 1.34 13.0% 9.83%0.7 0.3 2.33 0.58 8.50% 1.38 13.3% 9.93%0.8 0.2 4.00 0.63 8.80% 1.59 14.6% 9.95%0.9 0.1 9.00 0.73 9.40% 1.88 16.3% 10.09%

What can we conclude from above?

Benefits and costs tradeoffs of higher debt and leverage

a. Taxes:

Interest on debt is tax deductible

If annual interest is

Kd x D

then

annual tax savings is Kd x D x T

If a firm maintains a constant $D of debt in perpetuity

PV of Interest Tax Shield = (Kd x D x T) / Kd

= D x T

Why is Kd the appropriate rate to discount interest tax shield perpetuity?

ExampleThe firm’s assets will generate an expected EBIT of $800,000 per year (beginning one year from today) in perpetuity. The firm will make no new investments. The assets have a beta of 1.5, the risk-free rate is 5%, and the market risk premium is 10%. You can issue bonds paying an annual coupon at a yield of 5% per year. The tax rate is 50%. The firm has 100,000 shares outstanding.

What is the value of the firm? What is the stock value per share? 

V = (800,000*.5)/(.20) = $2,000,000

P = 2,000,000/100,000 = $20

What is the value of the firm if it issues $1.5 million of debt and uses the proceeds to repurchase 75,000 shares for $20 (75,000*$20=$1.5 million)?

What is the value of the interest tax shield (ITS)?

Value of ITS = [1,500,000(.05)(.5)/.05] = $750,000

Who benefits from this interest tax shield?

What is the firm value?

V = 2,000,000 + [1,500,000(.05)(.5)/.05] = $2,750,000

What is the stock price?

P = (2,750,000 – 1,500,000)/(100,000 – 75,000)= $50

b. Financial Distress Cost

Higher leverage leads to increased probability of financial distress

Being in or close to financial distress is costly because of

direct costs : court, lawyers, etc.

indirect costs : opportunity costs of managerial time to resolve bankruptcy, lost sales, inability to get trade credit etc.

Probability of distress and incurring these costs increases with debt level

Example (continued):

What is the value of the firm if, by issuing the $1.5 million of debt, the firm now has a 10% probability of incurring $100,000 in bankruptcy costs in any given year? What is the stock value per share? Should the firm issue the debt? 

V = 2,750,000 – [(.10)(100,000)/.05] = $2,550,000

P = (2,550,000 – 1,500,000)/(25,000) = $42

c. Good incentives created by debt

Higher debt level leads to fixed commitment to pay interest

Committing free cash flow disciplines managers who would otherwise spend the money on wasteful projects and perks.

Implies that firms with high FCFs should return the money to its Shareholder

Debt is a disciplining device

d. Bad incentives created by debt

Managers have incentive to (especially when firm is close to distress situation)

Take too risky projects

Avoid profitable but low value/risk projects

Example:pets.com owes its creditors $50 million, due in six months. The firm has liquidated its assets because it could not operate profitably. Its remaining asset is $30 million cash.

CEO Navi Singh, who owns 50% of the outstanding shares, is considering two possible investments. (1) Buy six month T-bills to earn 3% interest.(2) Go to Vegas and wager the entire $30 million on a single spin of the roulette wheel.

Why might Navi consider the second “investment”?

Would he have considered it in the absence of leverage?

Adjusted Present Value (APV) approach to firm value

Steps to estimate Firm Value

1. Firm Value without Leverage2. Present Value of Tax Shields3. Present Value of Expected cost of Financial Distress4. Present Value of other effects of financing or debt

Firm Value (VL) = Firm Value without Leverage (VU)+ PV of interest tax shields (ITS)- PV of expected cost of financial distress± PV of other financing effects

1. Firm Value without leverage

Value of Unlevered Firm = PV of CF to all investors discounted at unlevered cost of equity

o Cash flows to all investors estimated same as the Indirect Model (FCFF)

o Unlevered cost of equity estimated using CAPM and unlevered equity beta

2. PV of Interest Tax Shields

There are 3 possible debt scenarios

i) Constant dollar amount of debt in perpetuityii) Constant D/V (or D/E) ratioiii) Debt is explicitly forecast

i) If the level of debt D is a constant dollar amount,

PV of Interest Tax Shield = (Kd x D x T) / Kd

= D x T

Assumes that interest tax shield is as risky as the interest generating them

ii) if D/V ratio is constant

The amount of debt varies with the value of the firm

Hence interest tax shield is as risky as the firm

Therefore,

PV of Interest Tax Shield = (Kd x D x T) / WACC

Implications:

iv) Debt is explicitly forecast

We will apply APV method to a simplified real world example:

Example: RJR-Nabisco’s Leveraged Buyout (LBO):

1989 1990 1991 1992 91993Op Inc 2620 3410 3645 3950 4310Tax 891 1142 1222 1326 1448Aft Tax OI 1929 2268 2423 2624 2862+Depr 449 475 475 475 475- CapExp 522 512 525 538 551-ChgNWC (203) (275) 200 225 250+Asset Sales 3545 1805FCFF 5404 4611 2173 2336 2536

Int Exp 3384 3004 3111 3294 3483ITS(T=34%) 1191 1021 1058 1120 1184

Other data:Unlevered Ke = 14%Post 1993 D/V = 25%Kd = 13.5%Post 1993 growth = 3%Pre buyout market value of debt = $5 billionPre buyout stock price = $55Pre buyout # of shares = approx. 229 millionBuyout offer price $109

Note: A direct way to obtain cost of levered equity (Ke,L) from cost of unlevered equity (Ke,U) is

Ke,L = Ke,U + (Ke,U – Kd) (1 – T) D/E

This formula will give the same result as with unlevering/relevering beta and using CAPM formula to get cost of levered equity.

Step 1: Calculate PV of unlevered cash flows for 1989-93

Step 2: Calculate PV of unlevered CF beyond 1993

Step 3: Calculate PV of interest tax shield 1989-93

Step 4: Calculate WACC to estimate terminal value

Step 5: Calculate PV of interest tax shields beyond 1993