1. Capital Structure Theory & Applications Ruben D. Cohen ruben . cohen @ citi .com 0207 500 5793 Risk Architecture Citigroup, London

2. 1. Introduction Background, Scope and Outline 3. Background

What is capital structuring?

• Process of interchanging debt, equity and assets

Why is it important?

• Enables one to optimize the value of a firm or itsWACCby finding the best mix for the amounts of debt and equity on the balance sheet

• Provides a signal that the firm is following proper rules of corporate finance to improve its balance sheet.This signal is central to valuations provided by market investors and analysts

Who is interested in it?

• Academics, because it is controversial and open ended

• Practitioners, because they use it for v aluation, advisory and development and marketing of financial products & strategies

4. Scope 5. Outline

Introduction

Modigliani & Miller ( M&M ) ( paper 1 )

• Derivation

• Implementation

Beta ( paper 3 )

• Definition

• Implementation withinM&M(Hamada Equation)

Default risk & credit rating models

Incorporating default risk to locate the optimal capital structure ( OCS)( paper 2 )

Incorporating default risk into beta ( paper 3 )

Extending theOCSmethodology to more ratios

Application to different scenarios

• M&A s

• Divestitures

• Share and debt issues and buybacks

Applying constraints ( paper 4 )

Case studies

Depository institutions ( paper 5 )

6. End Part 1 7. 2. The Modigliani-Miller ( M&M ) Theorems Motivation & Methodology 8. Motivation Key Observation 1 Equity, E Debt, D Balance Sheet EBIT EBIT x(1- T ) Income Statement What ifT= 100%? Discounted value of cash flows to bond and equity holders will be zero.Therefore, value implicit withinISwill be ZERO!Doesnotmatch the firms value ofE + Dfrom theBS . or NOPAT To debt holders To equity holders Firms Value, D+E Tax 9. Total Discounted Value derived from Income Statement Effectively, a capital of 100 is being used to operate a firm thats 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 ) 10. Theory

Key observations create a need to:

• Reconcile the difference in valuations between theISand theBS

• Exploit the notion of efficiency in capital structure

M&Machieves the 2 objectives

Main assumptions - Aside from the typical, there are 3:

• Simple corporate firm able to freely exchange generic debt, equity and assets

• EBIT& Tax rate held constant as firm exchanges debt, equity and assets

• No default risk, so that credit spread = 0 at all levels of leverage

11. TheM&MMethodology 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 12. TheM&MMethodology Proposition I This difference is attributed to tax and debt.In the absence of taxes, there are no benefits, in terms of value, to increasing leverage.In the presence of taxes, such benefits, by way of the interest tax shield, do accrue when leverage is introduced and/or increased. Leads toM&M sProposition I Could be exploited to increase the efficiency of the firm e.g. increase Tax, Debt or the productDT .Tax is difficult to control, but debt could be increased.

Value implicit in theIS=Dx(1-T) + E( operating capital )

Total Firms Value ( FV ) =D + E

Reconciling Difference=DxT 13. TheM&MMethodology Proposition II

IfFV=D + E

And the value added due to debt =DxT

Then the remainder,D x (1- T )+ E , must represent the unlevered value of the firm and is aconstant , equal toE 0= V U

Defining= D/E& solving forR EgivesM&M sProposition II Operating capitalR U Recall:EBIT (1- T ) =R D D (1- T ) +R E E 14. TheM&MMethodology in Practice Creating the FV Curve Step 1

Question:Consider the firm hasD= 80 andE= 52.It wants to issue enough equity to buy back all debt and completely delever.

How is this done according toM&M ?

Answer:We know V = DxT = 80x40% = 32.Therefore to delever completely, the value of theall-equityfirm should be 132 32 = 100.

Achieved by issuing 48 in equity and selling off 32 in assets, totalling 80 - enough to buy back all debt.

15.

Question:The firm is now fully debt free.It wants to borrow 20 to buy back some of its shares and, at the same time, purchase some assets.

How is this done according toM&M ?

Answer:We know V = DxT =20 x 40% = 8, which raises the firms value from 100 to 108.

Therefore, with additional debt of 20 buy back 12 in equity and purchase 8 in assets.

TheM&MMethodology in Practice Creating the FV Curve Step 2 16. TheM&MMethodology in Practice A More Methodical approach

Begin with the original financial statement

Create table similar to the one below

• Insert debt in increments

• Populate with information thats readily available

17. TheM&MMethodology in Practice A More Methodical approach

Define

and populate relevant cells

18. TheM&MMethodology in Practice A More Methodical approach

Calculate parameters forD= 0

• Recall: atD= 0, all equity firm valueE 0= E + D (1- T ) = 52 + 80*(1-40%) = 100

Insert in the appropriate row

19. TheM&MMethodology in Practice A More Methodical approach

RecallE +(1- T ) D= 100 across all debt levels i.e. at

• D =20,E= 100-(1-40%)*20 = 88;

• D =40,E= 100-(1-40%)*40 = 76, etc.

Streamline and automate the process *to populate all cells at different increments ofD

*If preferred, this could be done using the beta approach (Hamadas Equation).Either way, the resultsmustbe identical 20. TheM&MMethodology Graphical Representation 0% 50% 100% 150% 200% 0 10 20 30 40 ROE Leverage, 21. TheM&MMethodology Effect of Tax Rate T > 0% T = 0 22. Spreadsheet Demo M&M Methodology 23. End of Part 2 24. 3. Beta 25. What is Beta?

Defined as:

It is a measure of relative risk

It depends on leverage.This comes throughR E

To obtain beta, plotR E-R fvsR M-R f

Slope of fitted straight line is the beta

Beta turns out to be independent ofR f

Market risk premium 26. What is Beta? Example with R f = 5% beta 27. What is Beta? Example with R f = 20% beta 28. What is Beta? Example with R f = 0 beta 29. Incorporating Hamadas Equation Alternative Approach to Capital Structure Analysis Using the Beta 30. Important Relationships Valid only when the cost of debt,R D , is constant, independent of leverage (seepaper 3 ) Hamada Equation CAPM Can be derived from definition ofWACC 31. Implementation 32. Implementation Populate E column usingE=V U D (1- T ) = 100 D (1-40%) 33. Implementation

PopulateD/Ecolumn

Compute

34. Implementation Populate rest of beta: 35. Implementation

PopulateROE :

PopulateWACC :

36. Comparison Beta approach Classical approach Identical Results 37. Spreadsheet Demo M&M Methodology via Beta 38. End of Part 3 39. 4. The Risk of Default and Credit Rating Methodologies 40. Credit Risk and Credit Spread Some Facts

The interest rate at which corporations can borrow money depends on the markets perception of theprobabilitythat they will not be able to pay back the debt

The premium for this rate above the risk-free interest rate is known as the credit spread

The credit spread, a direct measure of credit risk, is linked to

• theprobability of default

• therecovery rate and

• Theterm of the loan

The classification of credit risk into bands is known as credit rating.The banding follows AAA, AA, A, BBB, BB, B, CCC, CC, C and Default.

Pluses and minuses are, in addition, used to add granularity within the different bands (i.e. A+, A-, etc.)

41. Credit Rating Models

Credit agencies, the primary ones being S&P, Moodys and Fitch, use credit rating models to assess a firms credit worthiness.These ratings are then binned into categories tabulated below:

CRM s are generally complex and inputs to them are both statistical and subjective, involving historical, as well as forward-looking, elements

Weak No BB & Adequate Yes BBB Strong Yes A Very Strong Yes AA Extremely Strong Yes AAA Financial Capacity Investment Grade Rating 42. Assessing the Risk of Default Different Credit Rating Methodologies

There are three main classes of quantitativeCRM s, which are used most widely.They are derivatives of:

• Ratio-driven models

• • S&P

• • Fitch

• Z -Score

• Mertons model

There are also other types, which are hybrids

43. TheS&PModel Key Ratios 44. TheS&PModel Rating of the Key Ratios 45. TheS&PModel 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: 46. TheS&PModel Worked Example with One Ratio 47. TheS&PModelWorked Example with One Ratio

1. Given currentFS , we can calculate:

Interest rate

Interest cover

Effective rating from table

Credit Spread

Risk-free rate

2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage (this table is needed to create theWACCorFVcurves)

Assume the S&PCRMdepends on asingleratio, i.e. interest coverage ratio =EBIT /interest expense, 48. Necessary Data http://www2.standardandpoors.com/spf/pdf/fixedincome/corporateratings_2006.pdf?vregion=ap&vlang=en 49. Necessary Data http://www.bonds-online.com/Todays_Market/Corporate_Bond_Spreads.php 50. TheS&PModelWorked Example with One Ratio Contd Curve Fit for Spread vs Rating 51. TheS&PModelWorked Example with One Ratio Contd

1. Calculate:

Interest rate = 5/80 =6.25%

Interest cover = 20/5 =4.0

Effective rating from table =BBB-

Credit Spread =1.74%(from curve fit)

Risk-free rate = 6.25%-1.74% =4.51%

2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage

Assume the S&PCRMdepends on asingleratio, i.e.interest coverage ratio =EBIT /interest expense ,Curve fitted 52. TheS&PModelWorked Example with One Ratio Contd

ICR=4.0 , Interest rate =6.25% , spread =1.74%

Create table (this table is needed to create theWACCorFVcurves)

D spread(1) ICR Rating spread(2) Interestrate ImpliedRating 0 0.24% 10000.00 19 0.24% 4.75% AAA 8 0.24% 52.61 19 0.24% 4.75% AAA 16 0.24% 26.31 19 0.24% 4.75% AAA 24 0.53% 16.53 15 0.53% 5.04% AA- 32 0.78% 11.80 13 0.78% 5.30% A 40 0.78% 9.44 13 0.78% 5.30% A 48 0.95% 7.62 12 0.95% 5.47% A- 56 1.17% 6.29 11 1.17% 5.68% BBB+ 64 1.42% 5.26 10 1.42% 5.94% BBB72 1.73% 4.44 9 1.73% 6.25% BBB- 80 1.74% 4.00 9 1.74% 6.25% BBB- 88 2.12% 3.43 8 2.12% 6.63% BB+ 96 2.12% 3.14 8 2.12% 6.63% BB+ 104 2.58% 2.71 7 2.58% 7.10% BB 112 3.15% 2.33 6 3.15% 7.67% BB- 53. TheS&PModelWorked Example with One Ratio Contd

Populate row D = 0

54. TheS&PModelWorked Example with One Ratio Contd

Use iterative procedure

to populate row D = 8 55. TheS&PModelWorked Example with One Ratio Contd

Populate remainder of table using the same iterative procedure:

56. TheZ -Score Model

Based on regression analysis of ratios

Define:

57. TheZ -Score ModelImplementation 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. TheZ -Score ModelUS Bond Rating Equivalent Based on the Adjusted Model 59. Mertons Model Question:Borrow $ Dtoday 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 obligationstrike price Asset market value & volatilityShare price & volatilityProbability of defaultArea under curve behindD One year from today Today Asset Volatility 60. Comparison

Ratios/Scoring

Need calibration

Incorporate more variables

More dependent on historical information

Probability of default computed indirectly

Appear to involve more steps to get to the rating

Heavily dependent on financial statement inputs More easily applied to private firms.

Merton

May not need calibration

Incorporates less variables

Less dependent on historical information

Probability of default computed directly

Requires less steps and is more direct

Involves primarily market variables Difficult to apply to private firms.

61. End of Part 4 62. 5. Incorporating Default Risk 63. Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure 64. Impact of Default Risk

Leads to credit spread

Gives an optimal capital structure

Idea : tax benefits and default risk work against each other, takingFV - vs -leverage curve through a maximum or theWACCthrough a minimum

Approach identical to classicalM&M , but must take into account the credit spread due to default risk

65. Optimization of the Capital Structure

Objective is to locate the optimal capital structure

By classical definition, mi nimumWACCis where the optimal capital structure occurs

Recall:

SinceEBITx (1- T ) =constantby assumption, then max( E+D)and min( WACC)occur at exactly the same leverage

The rest is based on the principle of maximizing the firms value rather than minimizing theWACC

66. Procedure Requirements

Need a credit-rating model to calculate credit spreads along the curve

• Can use any

• This work utilizes theS&Papproach, which is based on ratios

Important to recall thatD * x(1- T ) +E= constant was derived based on the default-free scenario (classicalM&M ), whereD *is the default-free debt

Mustaccordingly adjust theBSdebt when there is credit risk.Adjustment is of the form:

With this adjustment, procedure becomes identical to classicalM&Ms

67. Procedure Flowchart Original Financial Statement : With default risk Convert to no-default scenario ApplyM&Mmethodology to obtainFVcurve Convert back to default case Final Output FVcurve with default 68. Procedure Begin with original financial statement:With default risk 69. Procedure Step-by-Step

Produce table in the following form

Fill in cells using the financial statement

70. Procedure contd Or use curve-fitted

Need CRM

Fill in remaining cells in the same row

• (Note: D* = 6.25%/4.51%80 =110.7 )

71. Procedure contd

CalculateV U=E 0=D * x (1- T )+ E= 110.7 (1 0.4) + 52 = 118.4

Populate first row at D = 0

72. Procedure contd

Populate next row via the following iteration scheme:

& Factors Ratios Implied Spread Calculated cost of Debt =R f + spread CRM Debt Cost of debt ImpliedRating 73. Procedure contd

And so on ...

74. Procedure Outcome 75. End of Part 5 76. 6. Incorporating Default Risk into Beta Generating the WACC Curve via the Modified Hamada Equation 77. Important Relationships Recall

Valid only when interest rates are constant, independent of leverage.

Therefore, must modifyD/Eto account for credit spread.

Hamada Equation 78. Procedure Step-by-Step

Create table with the following format

Fill in cells using information from financial statement

79. Procedure Step-by-Step

Calculate risk-free rate using earlier procedure

PopulateD* ,D*/E , ,ROE ,WACCusing formulas

• (Note:D*= 6.25%/4.51%80 =110.7 )

80. Procedure Step-by-Step

Compute uusingD * /Erather thanD/E

ComputeV u= E + D * (1-T) =52+110.7 (1-40%) =118.4

Populate row forD= 0

110.7 9.00 162.7 4.00 1.73% 81. Procedure Step-by-Step

Populate remaining rows using same methodology as before

82. Comparison WACCcomputed using beta WACCcomputed the direct way Shouldnt make any difference! 83. End of Part 6 84. 7. Incorporating More Ratios 85. How It Works Average raw rating = BBB+ Subjective inputs Final Rating Convert to Credit Spread 86. Spreadsheet Example

Note that the S&PCRMdepends on 8 or 9 ratios.

Previous example involved a single ratio -interest cover .

A working spreadsheet with 3 ratios:

• ICR ,

• Cash Flowand

• Leverage

87. End of Part 7 88. 8. Application to Scenarios

M&A(acquisition)

Divestiture

Share and debt issues and buybacks

89. Extension to Other Scenarios

Spreadsheet Demo for M&A

(Acquisition)

90. Extension to Other Scenarios 2. Spreadsheet Demo for Divestiture 91. Extension to Other Scenarios 3. Spreadsheet Demo for Share and Debt Issues and Buybacks 92. End of Part 8 93. 9. Applying Constraints 94. Applying Constraints

Question:What if no suitable assets were available for purchase or there was a preference instead for a 1:1 share buy back?Constrains the firm to followFV= const.

To get to theOCS(maxFV ) from current, issue43units inEto buy back32units of debt and purchase an additional11of assets.With no apparent maximum in the firms value, how is the optimal capital structure determined??? This moves the firm on theFVcurve, along whichV U= const, towards theOCS . 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 96. Finding theOCSunder Constraints Extending Along All Leverage

Every point along theE+D= const. line will have aunique V Uassociated with it (becauseV Uvaries with leverage)

Obtain the locus ofV U s and theOCSfalls where theratioV U /FVis minimized .

Unique unlevered values associated with eachFVpoint. 97. Finding theOCSunder Constraints Generalization OCSoccurs at minV U / FV OCS FV = constant 98. On the Side Recall

From Part 2 (derivation of classicalM&M )

Outcome:NOPAT operating capital

• i.e.EBIT (1- T ) =R u V uwhereR uis a proportionalityconstant(see Part 2)

R D D (1- T ) R E E D x(1- T ) E + Total Discounted Value derived from Income Statement operating capital = unlevered value =V u NOPAT EBIT x(1- T ) 99. On the Side Implications on the S&P CRM

TheS&P CRMcontains ratios that involve theEBIT

• EBIT interest cover and D-to-EBITDA, among others

Therefore in constrained cases, whereV uvaries with leverage , one must take into account the impact of this variation on theEBIT .

Once this is accounted for, the ratios containingEBITandEBITDAcould subsequently be adjusted.

EBITDA, EBIT, D, E, T, CRM spread V u Output Until convergence 100. Finding theOCSunder 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 followVu= const = 130, as perM&M s methodology. OCS @ D/E=51% OCS @ D/E=92% Current @ D/E=154% 101. Finding theOCSunder 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 theOCSunder Constraints Results Summary Capital Structure Curve In general, any type of constraint could be created by combining the above. 103. Finding theOCSunder Constraints Results Summary - Table 51% 1.54 4. ConstDat 80 57% 1.54 3. ConstFVat 132 92% 1.54 2. ConstEat 52 51% 1.54 1. ConstV uat 130 ( M&M ) Leverage atOCS Current leverage,D/E Scenario 104. Applying Constraints Spreadsheet Demonstration E = constant 105. Applying Constraints Spreadsheet Demonstration FV = constant 106. Applying Constraints Spreadsheet Demonstration D = constant 107. End of Part 9 108. 10. Case Studies 109. Dealing with theFinancial Statement Needed forM&ManalysisNeeded forM&ManalysisB.S. I.S. Needed for CRMequity (Market value) Interest-bearing liabilities (IB debt) Non-IB liabilities Liabilities & Equity Tax Profits EBT Gross interest on IB debt EBIT D&A EBITDA Costs & Expenses Revenues 110. Case Studies by Company

Procter & Gamble (USA)

Coca-Cola (USA)

Nestl Group (Switzerland)

Electrolux (Sweden)

Walt Disney Company (USA)

Telenor ASA (Norway)

Henkel (Germany)

Special Request : Grundfos (Denmark)

111. Company Analysis Procter & Gamble 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 RatioBV/MV= 0.33 115. Company Analysis Procter & Gamble Cash Flow Dep & Amort 116. Company Analysis Procter & Gamble Input into the Model 66,760 B Equity 23,375+12,039 =35,414(capital lease negligible) IB Debt 0.33 BV/MV 10,906 Profit 4,370 4,370/15,274= 28.6% Tax (Tax rate) 15,274 EBT -1,304(capital lease charge negligible) Interest 15,450+564= 16,014 EBIT+other income -3,130 D&A 16,014+3,130 =19,144 EBITDA 117. Company Analysis Procter & Gamble Model Output 118. Application Spreadsheets 119. PGComparison 120. Company Analysis The Coca-Cola Company 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 InterestOther 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 RatioBV/MV= 0.16 123. Company Analysis Coca-Cola Cash Flow Dep & Amort 124. Company Analysis Coca-Cola Input into the Model 21,744 B Equity 5,919+133+3,277 =9,329 IB Debt 0.16 BV/MV 5,981 Profit 1,892 1,892/7,873 =24% Tax (Tax rate) 7,873 EBT -456 Interest 7,252+ (236+668+173) EBIT+other income -1,163 D&A 7,252+1,163 =8,415 EBITDA 125. Company Analysis Coca-Cola Model Output 126. Application Spreadsheets 127. Company Analysis Nestl Group 128. Company Analysis Nestl Group Income Statement EBIT See Notes Other Income 129. Company Analysis Nestl Group Note 3 & 5 on Interest and Tax Interest* Tax * Negligible capital lease charge. 130. Company Analysis Nestl Group Liabilities * ST IB Debt LT IB Debt *Capital leases negligible. 131. Company Analysis Nestl Group Equity at Market Value MV of Equity BV of Equity RatioBV/MV= 0.28 132. Company Analysis Nestl Group Cash Flow Dep & Amort Unusual 133. Company Analysis Nestl Group Input into the Model Spreadsheet 195,661 MV Equity 24,541+6,129 =30,670 IB Debt 54,234/195,086 = 0.28 BV/MV 9,553 Profit 3,400 3,400/13,529 =25% Tax (Tax rate) 13,529 EBT -1,481 Interest 14434+576= 15,010 EBIT+other income 2,620+591=3,211 D&A 14,434+3,211 =17,645 EBITDA 134. Company Analysis Nestl Group Model Output 135. Application Spreadsheet 136. Company Analysis Electrolux 137. Income Statement Electrolux - P. 7 All figures inSEKm EBT EBIT+other income See notes for Interest See notes for tax 138. Income Statement Electrolux - Note 9 Interest Expense Interest 139. Income Statement Electrolux - Note 10 Tax 140. Balance Sheet Liabilities Electrolux - P. 11 All figures inSEKm BE LT debt ST debt 141. Other Useful Information Electrolux

Credit Rating (p. 37)

Market Cap (p. 76)

142. Company Analysis Electrolux Input into the Model 16,040 B Equity 4,887+,701 =10,588 IB Debt 16,040/34,000 =0.47 BV/MV 1,054 Profit 32.8% Tax rate 4,007 EBT -650 Interest 4,475 + 182 =4,657 EBIT+other income -2,738 D&A 4,475+2,738=7,213 EBITDA 143. Company Analysis Electrolux Model Output Compare 144. Spreadsheet Demo 145. Company Analysis The Walt Disney Company 146. Company Analysis Disney Income Statement EBT For tax see notes For interest expense, see notes 147. Company Analysis Disney D&A 148. Company Analysis Disney Gross Borrowings *Capital leases negligible 149. Company Analysis Disney Income Taxes Total tax paid EBT 150. Company Analysis Disney Gross Interest Expense *Capital lease charges, negligible 151. Company Analysis Disney Shareholders Equity BV of Equity MV of equity (market cap) = USD 65B 152. Company Analysis Disney Input into the Model 30,753 B Equity 15,172 IB Debt = 30,753/65,000 = 0.473 BV/MV 4,724 Profit 3,001 3,001/7725= 39% Tax (Tax rate) 7,725 EBT -746 Interest 7,725+746= 8,471 EBIT+other income -1,491 D&A 9,962 EBITDA 153. Company Analysis Disney Model Output See p. 44 154. Application Spreadsheet 155. Company Analysis Telenor 156. Company Analysis Telenor Income Statement EBT For tax see notes D&A For interest see notes 157. Company Analysis Telenor Interest & Tax Interest Tax @ effect.Rate of 18.6% 158. Company Analysis Telenor Equity & IB Debt Market cap = NOK180,000 159. Company Analysis Telenor Input into the Model (@ Corp. Tax Rate of 18.6%) 74,655 B Equity 39,725+7,521 =47,249 IB Debt 74,655/180,000 =0.41 BV/MV 16,189 Profit 3,782 3,782/19,971= 18.6% Tax (Tax rate) 19,971 EBT -2,650 Interest 22,621 EBIT+other income -14,333 D&A 19,971+14,333+2650 =36,954 EBITDA 160. Company Analysis Telenor Model Output (@ Eff. Tax Rate of 18.6%) See p. 44 161. Company Analysis Telenor At Corporate Tax Rate Tax @ corp. rate of 28% 162. Company Analysis Telenor Input into the Model (@ Corp. Tax Rate of 28%) 74,655 B Equity 39,725+7,521 =47,249 IB Debt 74,655/180,000 =0.41 BV/MV 16,189 Profit 5,592 5,592/19,971= 28% Tax (Tax rate) 19,971 EBT -2,650 Interest 22,621 EBIT+other income -14,333 D&A 19,971+14,333+2650 =36,954 EBITDA 163. Company Analysis Telenor Model Output (@ Corp. Tax Rate of 28%) See p. 44 164. Application Spreadsheet 165. Company Analysis Henkel 166. Company Analysis Henkel Input into the Model 5,643 B Equity 3,142 IB Debt =5,643/5,010 =1.13 BV/MV 941 Profit 309 309/1250= 25% Tax (Tax rate) 1,250 EBT -269 Interest 1,344+84+91 =1,591 EBIT+other income 337 D&A 1,344+337=1,681 EBITDA 167. Company Analysis Henkel Model Output 168. Application Spreadsheet 169. Comparison Capital Structure & Rating Electrolux Coca-Cola P&G Nestl 170. Comparison Capital Structure & Rating @ T = 18.6% @ T = 28% Henkel Telenor Disney Telenor 171. Comparison Capital Structure & Rating A A+ Disney A A- Henkel BBB+ A Telenor BBB+ A- Electrolux AA A Nestl A+ AA- Coca Cola AA- A P&G S&P rating Model rating Firm 172. Special Request Company Analysis Grundfos 173. Company Analysis Grundfos Income Statement (p. 51) EBIT Tax see note 5 Interest-See note 4 174. 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. 175. Company Analysis Grundfos Tax (note 5) 176. Company Analysis Grundfos D&A (note 3) 177. Company Analysis Grundfos IB Debt (exclude pensions) BV of equity = 7,421+1,069 = DKK8,490m Debt 178. Company Analysis Grundfos Other information

Internal rating = Arange

BVof equity/ MVof equity (for the sector) assumed as 0.50(could be varied)

179. Company Analysis Grundfos Input into the Model (mDKK) 7,421.7+1,069.8 B Equity 893.4+742.2+1720.7 +0.2 IB Debt Guess 0.5 BV/MV 935.6 Profit 437.2 437.2/1,372.8 =32% Tax (Tax rate) 1,372.8 EBT -201.5 Interest 1,609.6-118-1.2+21+63 =1,574.3 EBIT+other income -879.1 D&A 1,696.6+879.1=2,488.7 EBITDA 180. Company Analysis Grundfos Model Output compare 181. Application Spreadsheet 182. End of Part 10 183. In-class Case Study Template Necessary Data * BP market cap = USD 217.5B Shareholder (Book) Equity Book/Market Equity IBDebt (Incl. capital leases & pensions) Tax Rate Gross Interest Expense Other Income Dep. & Amort. EBITDA Amount Financial Statement Item 184. 11. Depository Institutions 185. Depository Institutions Seeking the Optimal Capital Structure 186. Depository Institutions A depository (or lending) institution is a simple bank that generates revenues from lending the assets on itsBS . Depository Institution Counterparty (Borrower) Equity Investor Depositor/ Bond Investor D E D+E R T [ D+E ] Tax 187.

Significantly more complicated than corporate firms because:

Two entities, rather than one, are subject to credit/default Risk

• TheBank (as borrower from investors/depositors)and

• the Counterparty (as borrower from the Bank).

The operating income ( EBIT ) of the bank isnotconstant, but varies with the size of itsBS

There are limits to lending

• In order to protect depositors and investors, banks cannot lend to the third party only what they borrow.A pre-determined amount of the money lent out must be equity.

• This amount of equity is dictated by certain regulatory capital ratios, determined by the borrowers risk rating and the size of the banks BS.

Above limitations create strong interdependence between bank and borrower

Depository Institutions Main Differences with Corporate Firms 188. Depository Institutions M&M Treatment of a Simplified Financial Statement

Operating income EBIT=R T ( D + E )

Interest expense =R D D

Profit =R E E =[ R T ( D + E ) -R D D ] (1- T )

ISValue =

189. Depository Institutions Fundamental Relationships

Form of M&Ms proposition II is preserved.

Inverse proportionality relation betweenWACC&FVis lost.

Fundamental constant in this case isD/E , instead ofD (1- T )+ E

190.

To protect depositors/bond investors from borrowers risk, a banks BS must adhere to certain limitations imposed on some of its financial ratios.

Limitations are known as Regulatory Capital and the ratios involved are called Tier 1, Tier 2, etc., going down in order of importance.These are used to describe the capital adequacy of the bank and e nsure that capital allocation is risk sensitive.

Tier 1 capital is the core capital, which includes equity capital and disclosed reserves.

Tier 2 capital is the secondary bank capital.It includes items such as undisclosed reserves, general loss reserves, subordinateddebt , and more.

These restrictions make the bank and borrower highly interdependent on each other and, thus, significantly complicate the analysis.

Depository Institutions Limitations 191.

Recall:

Depository Institutions Possible Cases Case R T R D I Constant Constant II Constant Variable III Variable Constant IV Variable Variable Depository Institution Out:R D In:R T 192. Depository Institutions Case I -R T&R D constant Depository Institution R D R T 193. Depository Institutions Case II R Tconstant, R Dvariablewith Depository Institution R D R T 194.

Definition - Tier 1 capital is the core capital.It includes equity capital and disclosed reserves.This is assigned a maximum limit of typically 8%.

Applied to the simplified financial statement of a lender, lending assetsE + Dto asingleborrower:

• RWA= risk weighted assets

• r= risk weighting of borrower

Depository Institutions Impact of the Tier 1 Capital Restriction 195.

WithT 1= constant, above may be written as:

Recall:ris the borrowers risk weighting.Therefore,

Combining:

Depository Institutions Relationship Between r and R T 196. Depository Institutions Case III R Dconstant, R Tvariableas Depository Institution R D R T 197. Depository Institutions Case IV R Dvariableas , R Tvariableas Depository Institution R D R T 198. Depository Institutions Case IV Impact of T 1 199. Depository Institutions Where is the Optimal?

Consider the most realistic case, being Case IV, whereR D as andR T as :

WACCis a decreasing function of leverage, .

Note that not allT 1 s have a max at some finite leverage.

Note that maxR Edoes not coincide with minWACC .

Etc., etc.,...

200. Conclusions

• Reasons for complications

• • Lenders risk

• • Borrowers risk

• • Interdependence between the two

• Discussed different scenarios

• Concluded that there is no straightforward way to define theOCS

201. End of Part 11