FNBU 3221 Lecture Notes - Lecture 11: Tax Shield

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Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of company’s bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCo’s tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 – Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 – .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return – Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 – 2014 = 7%

Beta = PepsiCo’s Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return – Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCo’s has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a company’s cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 – Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 – Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 – .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business’s net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let’s say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company’s return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

Financial Analysis Exercise IV

Part A: Weighted Average Cost of Capital (WACC)

Here again is the formula for WACC. For simplicity the term for preferred stock has been removed:

Go to http://thatswacc.com/[1] and enter the ticker symbol for the stock you selected and click on the tab entitled “Calculate WACC.”

Complete the following tables:

From the http://thatswacc.com/ results for your company:

CAPM Components

Using data in the table confirm the accuracy of the site’s WACC calculation:

Part B: Dividend Payout and Growth Ratios

Recall from Module 1 the following two ratios:

Internal growth rate = (ROA ∙ RR) / [1-(ROA ∙ RR)] (Eq. 3-30)

where RR = Retention ratio = (Addition to retained earnings)/Net income (Eq. 3-31)

The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets

Sustainable growth rate = (ROE ∙ RR) / [1-(ROE ∙ RR)] (Eq. 3-33)

If the firm uses retained earnings to support asset growth, the firm’s capital structure will change over time, i.e., the share of equity will increase relative to debt

To maintain the same capital structure managers must use both debt and equity financing to support asset growth

The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio

1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:

2. Calculate the firm’s sustainable growth rate for the last fiscal year:

Part C.

Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.

If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?

If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.

[1] The accessibility of this site is assumed. Should it not be accessible, please follow the instructions in the Appendix at the end of this document.

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a firm would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. These assumptions are necessary for the M&M theory on capital structure. For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, the figure also shows that the debt costs are also going up; similarly, if the equity costs are going down, then the debt costs are going down also as the debt-to-value decreases. This is shown on page 500 in Figure 14.1. And, of course, the weights of debt and equity (0/100, 25/75, 50/50, 75/25, 100/0) count. But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example. So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

Questions:

1. Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

2. Assume you are doing a financial analysis for Kroger Inc. Here is one of the income statements that you analyze (all figures in $ Millions):

Which year does Kroger Incorporation have the highest tax shield and why? Be very specific.