FM213 Principles of Finance

Part 2
Lecture 4

Kim Fe Cramer

LSE Finance
Assistant Professor
What Did We Do?

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

1
What Did We Do?

• Types: Dividends and stock repurchases

• How much cash should a company pay out?

(1) Theory: it doesn’t matter!

(2) Managers and markets: it matters!

(3) Arguments why it matters

(4) Best practice rule of thumb

• Should you use dividends or stock repurchases to pay out?

(1) Theory: it doesn’t matter!

(2) Managers and markets: it matters!

(3) Arguments why it matters

2
This Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

3
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

4
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

5
Definition of Capital Structure

Capital structure is the composition of different financing securities,

such as debt and equity

6
Definition of Equity

(1) Equity

• Equity (stock/share) holders are owners of the firm and have

voting rights
• They receive dividends and can trade their shares

• They are protected by limited liability (they are only

responsible for their firm’s debts up to the value of their
shares)

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Definition of Debt

(2) Debt

• Many kinds of debt: loans, bonds, notes

• Debtholders typically receive interest payments (fixed or
floating rates), and the repayment of the fixed principal at
maturity
• Interest payments are paid out of pre-tax profits

8
Value of A Firm

Method 1
(1) Value = Price of shares x shares outstanding

Method 2
(2) Value = Debt + equity

9
Leverage Ratio

• One important measure of the capital structure is the leverage

ratio. If debt is high relative to equity, then the leverage ratio is
high

Debt Debt
= (1)
Firm Value (Debt + Equity)

10
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

11
What Happens if You Increase Debt?

• Assumption: interest rate on debt is less than the expected

return on equity ("debt is cheaper")

What are the effects of higher debt on:

(1) Equity holders’ returns

• In absolute $ terms (= earnings per share)
• In % terms (= return on share)

(2) Equity holders’ risk

(3) Firm value

12
Effect of More Debt: Example
Benchmark: No Debt ("Unlevered")

Data
Nr of shares 1,000
Price per share $10
Market value of shares $10,000

Outcomes A B C D
Operating income $500 $1,000 $1,500 $2,000
Earnings per share $0.5 $1.00 $1.50 $2.00
Return on share 5% 10% 15% 20%

• The company expects to earn C $1,500, but is not certain

• Return on share = EPS/price=operating inc/market value shares

13
Effect of More Debt: Example
With Debt ("Levered")

• Raise leverage to 50% debt at 10% interest

Data
Nr of shares 500
Price per share $10
Market value of shares $5,000
Market value of debt $5,000

Outcomes A B C D
Operating income $500 $1,000 $1,500 $2,000
Interest $500 $500 $500 $500
Income after interest $0 $500 $1,000 $1,500
Earnings per share $0 $1.00 $2.00 $3.00
Return on share 0% 10% 20% 30%

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Effect of More Debt: Example
Comparison

Outcomes A B C D
Operating income $500 $1,000 $1,500 $2,000

No debt: Earnings per share ($) $0.5 $1.00 $1.50 $2.00

No debt: Return on share (%) 5% 10% 15% 20%

Debt: Earnings per share ($) $0 $1.00 $2.00 $3.00

Debt: Return on share (%) 0% 10% 20% 30%

Effects of higher debt:

(1) Equity holders’ returns
• In absolute $ terms (= earnings per share): up in expectation
• In % terms (= return on share): up in expectation
(2) Equity holders’ risk: up
(3) Firm value: ?

15
Effect of More Debt: Example
Comparison

The effect of debt

depends on the
company’s income:

• If it is greater than
$1,000, equity
holders’ return is
increased by debt
• If it is lower than
$1,000, equity
holders’ return is
decreased by debt
• At $1,000, return on
share is 10%, which
is equal to interest
rate

16
What Is the Effect on Firm Value?

• Equity holders’ return increases in expectation

• Equity holders’ risk increases

• But what is the overall effect on firm value?

• To learn that, we turn again to Modigliani-Miller

17
Modigliani-Miller

Theorem: Debt does not affect firm value

Assumptions

1. Investment decisions don’t change

2. No transaction costs

3. Efficient capital markets

4. Managers maximize shareholders’ wealth

5. New: No taxes

6. New: No bankruptcy costs

18
Main Argument

• Step 1: Replication: Show that equityholders can replicate the

return of a levered firm by investing in an unlevered firm (and
vice versa)

• Step 2: Law of one price: Things that have the same return
should also have the same price. Thus, firm value must be
identical

19
Replication: Example
From Unlevered to Levered

Data
Nr of shares 1,000
Price per share $10
Market value of shares $10,000

Outcomes A B C D
Operating income $500 $1,000 $1,500 $2,000
Earnings per share $0.5 $1.00 $1.50 $2.00
Return on share 5% 10% 15% 20%

20
Replication: Example
From Unlevered to Levered

Data
Nr of shares 1,000
Price per share $10
Market value of shares $10,000

Outcomes A B C D
Operating income $500 $1,000 $1,500 $2,000
Earnings per share $0.5 $1.00 $1.50 $2.00
Earnings on two shares $1.00 $2.00 $3.00 $4.00
Interest $1.00 $1.00 $1.00 $1.00
Earnings after interest $0.00 $1.00 $2.00 $3.00
Return on $10 investment 0% 10% 20% 30%

• Investors can buy a second share for $10 by borrowing $10 at

10%. Since under replication she gets the same return as on a
levered firm, the firm values must be identical
21
Replication: Formulas

• We just saw that investors can replicate with an example

• We can also conduct the argument using formulas

• Assume there is an unlevered firm ("U") and a levered firm ("L")

• We will show that these two firms have the same value

22
Replication: Formulas
From Unlevered to Levered

• What we do now is exactly what we did before; we start with an

unlevered firm and replicate the payoff of a levered firm
• Goal: If you buy 1% of shares of firm L, you get:
Investment Return
Equity 1% of EL 1% of (profit-interest)
=1% of (VL -DL )
• Replication: If you borrow 1% of DL on your own account and
purchase 1% of the stock of the unlevered firm, you get the same
return. Note that the first row is negative because you owe
money. Also note that EU = VU because DU =0
Investment Return
Borrowing -1% of DL -1% of interest
Equity 1% of EU 1% of profit
Total =1% of (VU -DL ) 1% of (profit-interest)

• Law of one price: Since these to strategies give the same

return, it must be that VU = VL 23
Replication: Formulas
From Levered to Unlevered

• Now we start with a levered firm and replicate the payoff of an

unlevered firm

• Goal: If you buy 1% of shares of firm U, you get:

Investment Return
Equity 1% of EU =1% of VU 1% of profit

• Replication: If you buy the same amount of equity and debt of

firm L, you get the same return:

Investment Return
Debt 1% of DL 1% of interest
Equity 1% of EL 1% of (profit-interest)
Total =1% of (DL +EL )=1% of VL 1% of profit

• Law of one price: Since these to strategies give the same

return, it must be that VU = VL
24
Summary

• Leverage does affect:

• Equity holders’ returns

• Equity holders’ risk

• Leverage does not affect:

• Firm value

How can that be? It must be that the advantage in increased return is
exactly offset by the disadvantage of increased risk

25
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

26
Firm’s Cost of Capital

• We learned how debt affects firm outcomes

• Next, we want to understand how much the firm has to pay for
the capital it raises

• We often get from an exercise or observe in the market how much

return equity holders require (rEquity =rE ) and how much interest
debt holders require (rDebt =rD )

• But what is the firm’s overall (average) cost of capital?

27
Weighted Average Cost of Capital

• Suppose an investor holds all debt and all equity; she is therefore
entitled to all operating income

• We say she gets return rAssets =rA , so the return on all the assets

• The return on the portfolio of debt and equity equals the weighted
average of the expected return on all individual positions

D E
rA = ( ∗ rD ) + ( ∗ rE ) (2)
D+E D+E

This is the weighted average cost of capital (WACC)

28
Return on Assets is Independent from Leverage

• In the example we saw, that neither operating income nor firm

value (= market value of all securities, since V = D + L) is
affected by debt

• Since rA is what the investor gets (= all expected operating

income), divided by what she invested (=market value of all
securities), rA is independent from leverage

expected operating income

rA = (3)
market value of all securities

29
Solving for Return on Equity

• We can solve the WACC formula for rE with some algebra

D E
rA = ( ∗ rD ) + ( ∗ rE )
D+E D+E
rA ∗ (D + E) − rD ∗ D = E ∗ rE
D D (4)
rE = rA ∗ + rA − rD ∗
E E
D
rE = rA + (rA − rD ) ∗
E

• We see (as in the example) that the return on equity of a levered

firm increases in proportion to the debt-equity ratio (D/E). Note
that rE = rA if the firm has no debt.

30
Example

• We can solve the formula for rE

D
rE = rA + (rA − rD ) ∗ (5)
E

• We can apply the formula to our example without leverage:

exp operating income 1, 500

rE = rA = = = 0.15 (6)
market value of all sec 10, 000

• ... and with leverage:

D 5, 000
rE = rA + (rA − rD ) ∗ = 0.15 + (0.15 − 0.1) = 0.20 (7)
E 5, 000

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Return on Equity as D/E Rises

Return on equity increases as debt-equity ratio rises

32
Risky Debt

• Normally, we think debt is risk-free. But debt can also be risky.

For instance, interest rate can increase with your leverage (=
more debt, higher interest rate)

• Higher return on debt lowers the return on equity according to

our WACC formula

D
rE = rA + (rA − rD ) ∗ (8)
E

• This gives us a new graphical picture, in which rD increases with

more debt, and rE increases slower and slower with more debt

33
Return on Equity Under Risky Debt

34
Relation to the CAPM

• Recap of CAPM: We remember the CAPM from the previous

part of the course. It gives us the return that investors require for
a given risk. The risk is measured by beta ("systematic risk"). A
β = 1 means that the asset is equally risky as the market
rA = rf + βA (rm − rf )
rD = rf + βD (rm − rf ) (9)
rE = rf + βE (rm − rf )

• If the CAPM is true, then the returns (rA , rD , and rE ) are

linearly related to their market betas. Thus, we can simply
replace the returns for betas in the WACC and return-for-equity
formulas
D E
βA = ( ∗ βD ) + ( ∗ βE )
D+E D+E (10)
D
βE = βA + (βA − βD ) ∗
E
35
Using the WACC as a Discount Rate

• The WACC accounts for the rate of return expected by

shareholders (rE ) and debt holders (rD )

• Thus, it can and should be used by firms as a discount rate in

their NPV calculations

36
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

37
Exercise

• Assume there is an all-equity firm with $60 cash. The firm has
only one project that requires an investment of $60 and will
generate uncertain cashflows of $60 or $100 (equally likely)

• The market price of risk is 8.4%, the risk-free rate is 6.6%, and
beta of the assets is β=1

1. Calculate the return on assets rA using the CAPM

2. Calculate the NPV of the project and firm value

38
Exercise

CAPM

rA = rf + β(rm − rf ) = 0.066 + 1 ∗ (0.084) = 0.15 (11)

Note market price/premium of risk = rm − rf

NPV
0.5 ∗ 60 + 0.5 ∗ 100
N P Vproject = −60 + = 9.6 (12)
1 + 0.15
0.5 ∗ 60 + 0.5 ∗ 100
N P Vf irm = V = 60 − 60 + = 69.6 (13)
1 + 0.15

39
Exercise

• Now assume that the firm issues $30 in corporate bonds. Beta
of debt is 0 and the risk-free rate is 6.6%, so the firm needs to
repay $30*1.066=$32 on the bond

• The firm uses this money to distribute $30 in dividends.

Consequently, the size of the firm is unchanged

1. Calculate the equity value E

2. Calculate the expected return on equity rE

40
Exercise

Expected
Today Bad state Good State Cashflow
Total FCF 0 60 100 80
FCF to debt -30 32 32 32
FCF to equity 30 28 68 48

41
Exercise

Method 1 (= solving two equations with two unknowns)

• You can use the formulas for value of equity and return on equity
to solve this exercise
F CF
E=
1 + rE
D
rE = rA + (rA − rD )
E
$48
E= (14)
1 + rE
$30(1 + rE )
rE = 0.15 + ∗ (0.15 − 0.066)
$48
rE = 0.214
E = $39.6

42
Exercise

Method 2 (= firm value)

• By Modigliani-Miller, the value of the firm is unchanged

(NPVf irm =69.6)

• The value of debt is $30. Consequently, the value of equity is

E=V-D=$69.6-$30=$39.6

• Expected cash flow to equity is $48, the return on equity is:

F CF $48
rE = −1= − 1 = 21.4% (15)
E $39.6

43
What Did We Do?

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

44
Lecture Overview (Chapter 13.3, 16, and 18.4)

• Definitions

• The effects of increasing debt

• Firm’s cost of capital

• Exercise

45
Next Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

46
Logistics

• Hand-in problem set 1 due to next Friday, Week 5,

11.59pm

• Submission links on Moodle

• Graded, but does not count towards assessment

• Valuable to get feedback

47
End

Questions?
• Ask during lectures

• Ask during classes

• Class teacher office hours see Moodle (approach first)

• Kim’s office hours Friday after lecture (5-6pm, MAR 7.35)

• Moodle forum

• Email only for sensitive/personal questions

48