13 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Capital and Capital Structure Choosing between debt

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

Cost of Capital and Capital Structure

Choosing between debt and equityCost of capital conceptsEstimating the cost of capital“Optimal” capital structure determination

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Cost of Capital Basics

Sources of organizational capitalDebt -- bonds, term loans, debenturesEquity -- retained earnings, stock

Capital structure defined -- “mix” of debt/equity capital utilized

Cost of capital definedDebt -- interest/coupon rateEquity -- dividends, opportunity costs

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The corporate cost of capital is a blend (weighted average) of the costs of the financing components. (WACC)

WACC Equation: WACC = [(Wd)*(Kd)*(1-T)] + [(We)*(Ke)]

WACC assumption -- Optimal structure implied by weights (Wd, Kd)

Interpretation of WACC estimateUse of historical vs. marginal costs

Cost of Capital Basics

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Estimating the WACC:Cost of Debt (Kd)

Discuss current debt cost with banker:Investment banker if bonds are used.Commercial banker if loan is used.

Look at YTM on outstanding issues if actively traded (PV, maturity, coupon)

Look to the debt markets for guidance. Find the interest rate on recent issues:By companies with same debt rating.By companies that are similar (size, risk)

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Cost of Debt (Kd)

For a not-for-profit organization, the component cost of debt is the interest rate on a new issue.

An investor-owned organization must consider the tax benefits of debt:Assume that Valley Clinic (VC) has a 40% tax rate.

According to its bankers, a new bank loan would have an interest rate of 10%.

Its effective cost of debt (Kd) would be 10% x (1 - T) = 10% x 0.6 = 6.0%.

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Cost of Debt (Kd)

Not-for-profit organization KdTax exempt municipal bond financingKd comparisons with FP organizations

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Cost of Equity Capital (Ke)

The effective cost of debt (Kd) is the return required by debt suppliers, and the effective cost of equity (Ke) is defined similarly.

For investor-owned businesses the primary sources of equity are:Retained earnings. (Kre)New common stock sales. (Ks)

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The cost of new common stock (Ks) is the rate of return that investors require on that stock.

The cost of retained earnings as an opportunity cost of capital:If earnings are retained rather than paid

out as dividends, the stockholders bear an opportunity loss.

These funds could be reinvested in alternative investments of similar risk.

Cost of Equity (Ke)

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Thus, retained earnings have roughly the same cost as does similar forms of common stock.

There are three primary methods used to estimate the component cost of equity in FP businesses:Capital Asset Pricing Model (CAPM)Discounted cash flow (DCF) modelDebt cost plus risk premium model

Cost of Equity (Ke)

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CAPM Method (Ke estimation)

The Capital Asset Pricing Model (CAPM) is a equilibrium model that relates market risk to required rate of return.

The equation used is the Security Market Line (SML):

R(Ri) = RF + [R(RM) - RF] x bi.

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CAPM Method (Cont.)

Input values to CAPM estimate“Risk free” rate (RF) estimation --

matching to avg. stock holding period Required market returns (R(Rm))

• Sources of data

• Choice of observation period(s)

Market beta value of stock• Definition/different types of betas

• Regression estimate

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Some Recent (1998) Beta Estimates

Alza Drug delivery systems 1.40 Baxter Medical Supplies 1.10 Beverly Enterprises Nursing homes 1.20 Glaxo Wellcome Diversified drugs 1.00 HEALTHSOUTH Rehabilitative care 1.35 Humana Managed care 1.55 Phycor Practice management 1.35 Tenet Healthcare Acute care hospitals 1.00 U.S. Surgical Medical Equipment 1.30 Valley Clinic (VC) Outpatient care 1.10

Source: Value Line

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R(Ri) = RF + [R(RM) - RF ] x bi

= 8.5% + (13.5% - 8.5%) * 1.1 =14.0%.= Estimate of Ke for common stock(Limitations of CAPM estimates for Ke)

CAPM Method (Cont.)

What is Valley Clinic’s cost of equity (Ke) if RF = 8.5%, R(Rm) = 13.5%, and bi = 1.1?

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DCF Method (Ke estimation)

The discounted cash flow (DCF) approach assumes that stock price is the present value of the expected dividend stream.

The DCF method can be used both with constant and nonconstant growth, but the calculations are more complicated when growth is nonconstant.

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DCF Method (Cont.)

Under constant growth assumptions, the DCF model is as follows:

E(Ri) = R(Ri) = + E(g).E(D1)

P0

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DCF Method (Cont.)

Where do we get the input values?P0 comes from the Wall Street Journal

(or many other sources).E(D1) can come from:

• Analyst’s estimates

• Historical growth rates

• Retention growth model estimates

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DCF Method (Cont.)

Assume that P0 = $40, E(D1) = $2.72, and E(g) = a constant 7.0% for Valley Clinic. Then,

R(Ri) = + E(g) = + 7.0% E(D1)

P0

$2.72

$40

= 6.8% + 7.0% = 13.8%

= Ke estimate

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Equity Issuance Costs

Issuance costs on equity sales are larger than on debt sales.

Two methods are used to adjust the cost of equity for issuance costs:Adjust project cost (add-on cost)Adjust cost of equity, which produces two

costs: one for retained earnings and one for new stock sales.

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Debt cost plus risk premium method (Ke estimation)

Ke as a function of Kd and a stock’s risk premium (Ke = Kd + RPs)

RPs ranges from 4-7% above Kd based on historical data

Effect of interest rates on Kd and stock risk premiumsHigh interest rates -- low RPsLow interest rates -- high RPs

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Ke estimation methods (comparison)

When CAPM, DCF, & DCPRP estimates for the cost of equity (Ke) differ, judgment must be applied.

For our provider, the CAPM estimate is 14.0% and the DCF estimate is 13.8%.

A reasonable final estimate is 13.9%.

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Cost of retained earnings (Ke)

Opportunity cost to organizational shareholdersApplicable to FP and NFP organizationsConceptual challenge of Ke estimation (missing

market for retained earnings)

Approaches to estimating KeReplacement cost estimate (estimated growth in fixed

assets over time)Opportunity cost estimate (Ke for stock of similar

investment risk and size)

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Assume target weights of 35% debt and 65% equity. What is Valley Clinic’s

Weighted Avg. Cost of Capital?

WACC= [Wd x Kd x (1 - T)] + [We x Ke]

= (0.35 x 10% x 0.6) + (0.65 x 13.9%)

= (0.35 x 6.0%) + (0.65 x 13.9%)

= 2.1% + 9.0%

= 11.1%.

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Interpretation of WACC estimate

“True” opportunity cost of capitalNormative economic implications

“Hurdle” rate for proposed capital investments (minimum acceptable)

Technical issues with WACCDeviations from optimal structure -- effect on

WACCApplies only to average risk

assets/investments

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What factors influence a company’s corporate cost of capital?

Market conditionsInterest rates (effect on Kd and Ke)Tax rates (effect on Kd)

Firm conditionsCapital structure policy Capital investment policy (business

risk, use of financial and operational leverage

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Risk and the Cost of Capital

Low

Cost ofCapital (%)

Corporate

RiskHighAverage

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The Capital Structure Decision

The funds used to finance a business’ assets are called capital.

Capital structure is the financing mix on the right side of the balance sheet.

The capital structure decision revolves around this question: Is there an optimal mix of debt and equity

(as implied in WACC equation) that will maximize the value of the firm?

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Risk and Return Implications of Capital Structure Decisions

Consider a new for-profit ambulatory care clinic that needs $200,000 in assets to begin operations.

The business is expected to produce $50,000 in operating income.

It has two capital structure alternatives:No debt financing (all equity).$100,000 of 10% interest debt (50/50 mix).

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Pro Forma Balance Sheets

Stock Stock/Debt

Current assets $100,000 $100,000 Fixed assets 100,000 100,000

Total assets $200,000 $200,000

Bank loan (10% cost) $ 0 $100,000 Common stock 200,000 100,000

Total claims $200,000 $200,000

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Pro Forma Income Statements

Revenues $150,000 $150,000Operating costs 100,000 100,000 Operating income $ 50,000 $ 50,000Interest expense 0 10,000Taxable income $ 50,000 $ 40,000Taxes (40%) 20,000 16,000

Net income $ 30,000 $ 24,000

ROE 15% 24%

Total to investors $ 30,000 $ 34,000

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Conclusions

Debt financing levers up (increases) the rate of return (ROE) to owners. Thus, the use of debt financing is called financial leverage.

But, with uncertainty, the use of debt financing also increases owner’s risk.

Thus, the decision is not clear cut. The capital structure decision involves a classical risk/return trade-off.

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Business risk is the uncertainty inherent in a business’s operating income; that is, how well can managers predict operating income?

Business risk does not consider financing.

Business Risk

Probability

EBITE(EBIT)0

Low risk

High risk

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Factors that Influence Business Risk

Uncertainty about utilization rates

Uncertainty about reimbursement

Uncertainty about costs

Liability uncertainty

The degree of operating leverage (% of fixed to total costs) -- synergy with financial leverage

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Financial Risk

Financial risk is the additional risk placed on owners when debt financing is used (default risk)

The greater the proportion of debt financing, the greater the financial (default) risk

Diff. between ROE(U) and ROE(L)

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Capital Structure Theory

Capital structure theory attempts to define the relationship between debt financing and firm/equity value for investor-owned businesses.

Tradeoff models of capital structureDeveloped by Modigliani and MillerOrganizational “trade off” between costs

(increased risk) and benefits (increased returns) of debt capital

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Tradeoff Models of Capital Structure

VL = VU + (T x D) - PVDVL = equity value of unleveraged firmVU = equity value of leveraged firmT = firm’s marginal tax rateD = amount of debt capital usedPVD = PV of financial distress costs

Bimodal relationship between VL and level of debt capital utilized

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%

15

D/A

Cost of Equity

Corporate Cost of Capital

Cost of Debt

$

D/A

Equity Value

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Tradeoff Theory Limitations

Minimal power to explain actual capital structure preferences of different firmse.g. emerging firm reliance on retained

earnings, mature firms reliance of debt, large differences in capital structure among similar industries/firms

Inconsistency of tax-related effects on capital structure decisions for investor-owned firms

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Asymmetric Information Model

Model assumptionsInformation asymmetry between

managers and investorsManagers exist to maximize equity value

Model predictions“Pecking order” of preferences for capitalDependent on magnitude of information

asymmetry present , perceived future growth prospects of the firm, presence of tangible vs. intangible assets

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Asymmetric Information Model

Emerging firmsLow level of tangible assets (equity)High growth prospects (equity/debt)Significant information asymmetry (debt)

Mature firmsHigh level of tangible assets (debt)Low growth prospects (debt/equity)Low information asymmetry (debt)High information asymmetry (equity)

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Summary Implications of Various Capital Structure Theories

Tax-related benefits of debt financing increase equity value of firm

Costs of financial distress (bankruptcy costs) variably offset the benefits of debt financing as debt level increases

Due to information asymmetries, firms will use variable amounts of debt vs. equity capital based on several factors.

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Implications of Capital Structure Theory

There is an optimal, or target, capital structure for every investor-owned business that balances the costs and benefits of debt financing.

Unfortunately, capital structure theory can not be used in practice to find a business’s optimal structure.

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Factors That Influence CapitalStructure Decisions In Practice

Organizational viability considerationOrganizational financial risk prefsLender/rating agency risk prefsLevel of reserve borrowing capacityIndustry benchmarks for riskShareholder control issuesOrganizational asset structureProjected growth rate/profitabilityOrganizational taxation issues

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Not-For-Profit Businesses

The same general concepts apply to not-for-profit businesses:There is a benefit to debt financing (tax-

exempt bond financing)There also are costs

However, not-for-profit firms do not have the same financial flexibility as do investor-owned businesses.

Implications for capital structure

Documents

13 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cost of Capital and Capital Structure Choosing between debt