Session 19: Optimal Financing Mix III - Following up the Cost of Capital Approach

In this session 19 of a 36 session corporate finance class, I'd like to build on the cost of capital approach I introduced in the last session. In particular, I'd like to talk about why minimizing the cost of capital might be good for your stockholders, what can go wrong, and how you can adapt this approach to meet your specific needs as a business. So now that we've talked about using the cost of capital approach to come up with the optimal debt ratio, and that's basically what session 18 was about, let's follow up on that concept. What do you gain by moving to that optimal debt ratio, the point at which your cost of capital is minimized? The answer might seem obvious to you, but as you will see in this session, it's not always that much of a slam dunk. So let's go back. This was the cost of capital schedule we derived for Disney at different debt ratios ranging from 0 to 90%. Just a reminder again, they're right now at about 11.6% debt ratio, and their cost of capital is about 7.81%. And if you believe the schedule at a 40% debt ratio, the cost of capital will drop to 7.16%, right? So if you follow through on the cost of capital approach, here's what we seem to be suggesting Disney can afford to do. Disney's right now at a debt ratio of 11.6%, it has about $15.96 billion in total debt outstanding. At a 40% debt ratio, it can afford to have about $55.1 billion in debt. That effectively means they can go out to borrow about $39 billion in new debt to get to their optimal. We're going further. Not only are we recommending that Disney borrow $39.1 billion, we're suggesting that they buy stock with that $39.1 billion. That's a pretty big decision, right? Borrow $39.1 billion and buy back stock with that money. Well, there are three basic questions I'm sure you will have to address if you make this recommendation. The first is why should we do it? The answer might seem obvious to you, but again, you got to put some flesh on what stockholders in Disney will gain by moving to the Second, what if something goes wrong? You're borrowing an extra $39 billion. You can see why people are worried, right? You have a bad year, your earnings dropped, you might be in trouble. How much trouble could you be in? And third, what if you don't want to buy back stock? Disney, after all, has big plans for the future. It wants to expand ESPN, build more theme parks. It seems silly to go out and borrow money and buy back stock when in fact you can use that debt capacity to take projects instead. So why should we do it? What if something goes wrong? Can we use this money to take investments rather than buy back stock? Let's see if we can answer those questions. Let's start with the first question. Why should we do it? The most simplistic way of answering this question is to go back to that valuation equation that animated why we thought about the cost of capital when we thought about the optimal debt ratio. We said the value of a business is the present value of the expected cash flows in that business, with the cost of being the discount rate. We know what the value of Disney is as a business, right? In fact, let's back out what the market is attaching as a value to Disney's operating assets. This is called Disney's enterprise value, and here's how I'm going to get it. I'm going to take the market value of equity. I'm going to add on the market value of debt, the $15.96 billion, and I'm going to subtract out cash. I get about $133.9 billion as the enterprise value or the market value of operating assets. If I estimate the cash flows for Disney, and that cash flow, roughly speaking, is let's say $3.657 billion. I made the assumption the working capital number is not a big deal. We'll come back and revisit this number, but if I have that cash flow, I know the value of the business is $133.9 billion. I have the cash flow of $3,657 million, and I also know that the existing cost of capital is 7.81%. I can back out the growth that the market is assuming for Disney in the future, right? That's called an implied growth rate, and when I solve for that implied growth rate, I get about 4.94%. Now, here's where things get dicey. If I continue to assume that growth rate, I keep the cash flows the same, and I replace the 7.81% cost of capital by the 7.16% optimal, I get a new value for the firm of about $172.9 billion. That effectively means that by moving to my optimal, I increase my value about $39 billion. That seems too good to be true, right? And probably is too good to be true, and here's the fatal flaw on this page. See that growth rate of 4.94% that I'm assuming is a growth rate in perpetuity? That's a growth rate that's way too high to be a constant growth rate forever, because if Disney grew at that rate, the economy growing at 2% or 2.5%, it's going to outstrip the economy. So here's a more realistic way of estimating the change in Disney's value from moving to the optimal. I took the existing enterprise value for Disney, the $133.9 billion that I estimated in the previous page, and I estimated what the cost of funding Disney as a company would be at their existing cost of capital, which is 7.81%, and then again at their new cost of capital, which is 7.16%. This is really an implicit cause. It's a way of thinking about what the cost of capital is, the cost of financing your entire business today. The savings I get each year is $866 million from moving to the optimal. My value as a company should increase by the present value of those savings over time, that $866 million over time. Here's what I'm going to assume about the $866 million. I'm going to assume it's a growing perpetuity, but rather than assume it's going to grow at the 4.94% implied growth rate we estimate in the previous page, I'm going to assume it grows at the risk-free rate. Earlier in one of the sessions, I argued that the risk-free rate is not a bad proxy for the nominal growth rate of the economy in the long term. Here's why. Built into the risk-free rate are two numbers, an expected inflation rate and an expected real interest rate. Built into the nominal growth rate in the economy are two numbers, an expected inflation rate and expected real growth rate. To me, the risk-free rate is not a bad proxy for the nominal growth rate of the economy. So I'm going to use 2.75% as my growth rate in perpetuity. I have everything I need. I have $866 million as my savings, 7.16% as my cost of capital, a 2% growth rate, and what I get as my value, as my increase in value is $19.6 billion. That I think is a more realistic assessment of what will happen if I move to the optimal. So why should Disney do this? My answer won't be that they can move their cost of capital to 7.16%. My answer will be if they do this, their value as a business will increase by $19.6 billion. Now let's get to specifics. The way we're suggesting they do this is to buy back stock, right? So let's suppose you came back to me with a legitimate follow-up question. We're going to buy back stock. What price should we pay on this buyback? Or what will happen to my stock price if I go out and borrow this much money, $39.1 billion, and buy back stock? Here's my answer. I'm going to take the $19.6 billion increase in value and divide it by the total number of shares outstanding, which is $1.8 billion. Now that might strike you as strange because remember we're going to buy back shares. You're saying won't the number of shares drop? I call this my rational solution and here's why. I'm going to assume that the people who sell their shares back to you, that stock buyback, know what you're doing and are going to demand their fair share of the spoils. The spoils here are $19.6 billion. This solution assumes that everybody in the company gets an equal share of that $19.6 billion. So the people who sell their shares back will get $10.9 per share and the people who stay in the company will get $10.9 per share. The stock price after you do this will increase from what it is right now, $67.71 to $78.61. Let me explain or let me go through this process so you can see how this plays out. More generally here's how you solve for what the stock price will be after you do a stock buyback with borrowed money. First you compute how many shares you buy back with the borrowed money. You take the debt that you take on. You divide by the price you pay on the buyback. That'll tell you how many shares you buy back. Then look at the remaining shares outstanding. Then compute the value of equity after the buyback. Remember you borrowed all the money so look at the remaining value equity. Then divide by the remaining shares outstanding. That should give you the value per share of the remaining shares. So you have the buyback, the price per share on the buyback and price per share for the remaining shares. So let's take an example. The best case scenario if you're one of those stockholders who plans to remain a Disney stockholder is that you're able to do the buyback at the old stock price. Very unlikely to happen because this will require investors being willing to sell their shares back at the old price. But let's say you could pull this off. If you can buy the shares back at the old stock price, here's the first step. Take the $39.1 billion in additional debt divide it by $67.71 at the old stock price and take out those shares from the existing shares outstanding. That leaves you with remaining shares of 1,221.43 million shares. That's the remaining number of shares. The value of equity in this company after the borrow and buyback transaction is going to be the new firm value $153.53 billion which we computed based on the cost of capital. You add back the cash, you subtract out the new debt that's going to be outstanding $55.1 billion. That gives you a value for the equity of $102.3 billion. You divide that by the number of remaining shares $1,221.43 million. That gives you an increase in the stock price to $83.78. By being able to buy the shares back at the old price, the remaining shareholders benefit because they get to keep all of the spoils. Remember earlier I said the $78.61 was a rational price? You can see why. If I buy the shares back at $78.61 the remaining shares will be only 1,301.65 million shares. If I divide the remaining value of equity by that, the value per share for the remaining shares will also be $78.61. It's rational in the sense that everybody gets exactly $78.61, the people who sell back and the people who don't sell back. So why should we do it? An increase of about $10.90 per share for the shareholders in the company. That's about a 15% stock price increase. That's a pretty good increase in price from moving to the optimal debt ratio. Now here's the second question. What if something goes wrong? Now that's actually a serious question. Whenever you borrow money it's a question worth asking and answering. Here's the first way you can answer it. The big number driving your optimal debt capacity is your capacity to serve as interest expenses, is the operating income. If that operating income comes under assault either because you have a bad year or there are macroeconomic factors driving the earnings down, then you're going to be in trouble making your interest expenses. So the first approach to dealing with what if something goes wrong is to do what if analyses around the operating income. You can do this purely statistically by looking at the historical operating income and looking at standard deviation and then taking one standard deviation or two standard deviations off or you can do a more economically intuitive what if analyses where you can look at the last recession or the last bad year and see how bad it was and try to see the effect of building that bad year into your operating income on your optimal. So one way to ask what if questions about what if something goes wrong is through the operating income. The other is to go and to put in a constraint on your bond rating and I'll come back and talk about this but let me start with the operating income approach first. In this table I've shown you Disney's operating income going back in time to 1987. Disney's had some bad years. In fact its worst year during this period was 2000 when it saw its operating income drop by almost 30 percent. So basically I look at this history to get a sense of what a bad year for Disney will look like and at least looking at these numbers and looking at them over time. A 20 to 30 percent drop in operating income looks like a really bad year right. So here's what I did. I took my base case analysis the one that gave me the optimal debt ratio at Disney and I started dropping the operating income by 10 percent 20 percent 30 percent 40 percent to see what would happen to my optimal debt ratio. In other words I wanted to see how sensitive my optimal debt ratio of 40 percent was to changes in my operating income because it's clear that Disney can have a bad year and here's what I found. Even if I drop my operating income by as much as 30 percent that's a pretty big that's as bad as the worst year Disney's had in the last 25 to 30 years. My optimal stays at 40 percent. If my operating income drops by more than 30 percent then I'm in trouble but what I read out of this table is there's a pretty solid buffer built in here for mistakes. Disney can have a bad year and should not be getting into any trouble even at a 40 percent debt ratio. So that's one way to process what if analyses is through the operating income. The other is to put a constraint on your ratings. Let me back up. When I told you the optimal debt ratio for Disney was 40 percent I based on the fact that the cost of capital was minimized at that debt ratio right. I never mentioned what bond rating the company would have at that debt ratio. What if I told you that the rating for Disney would be a double B the 40 percent debt ratio. I'll wager that if you are Disney managers you would not accept this optimal because that's too low a rating. You're saying what do you mean too low. Every company has some constraint on a rating or a bond rating below which they don't want it to fall. For most U.S. companies that rating is often triple B or investment grade because if you fall below that investment grade becomes both much more difficult for you to raise capital and also your indirect bankruptcy costs kick in. You get in the news for all the wrong reasons and your customers stop buying your products your suppliers start demanding cash and your costs start to underapply. So I think it's reasonable for companies to put a ratings constraint. That ratings constraint can be triple B it can even be single A. But if your company puts in an unrealistic ratings constraint and says we want this rating at any cost rise to the challenge give them the bill. So let me take Disney as my example. At their optimal of 40 percent the synthetic rating for Disney I give them a single A which is actually a pretty good rating. If they insisted on a double A rating then I have to stop at a debt ratio of 30 percent. That'll cost them about 5.7 billion. So if they insist on a double A rating the cost I would give them is the 5.7 billion. The way I come up with this cost is I value Disney without any constraint on the rating and I come up with the total value. Then I revalue the company at that constrained rating of 30 percent. Cost you 5.8 billion. If they want a triple A rating they can't get above 20 percent in which case they're constrained to lose about 12.1 billion. Why? Because they want a triple A rating. When companies demand rating constraints that are unreasonable it costs their stockholders billions of dollars and that's got to be put on the table before they make that judgment. Which brings me to the third and final question that you probably will get asked. This entire process is built on the premise that I will go out and borrow 39.1 billion and buy back stock. But as I said Disney has big plans. So let's assume the question you're asked is will my optimal be different if instead of buying back stock I took projects? I'll give you the easy answer first and the more complex answer later. The answer is no. Your optimal will actually be unchanged if you remain in the same business. In other words if Disney's planning to expand broadcasting, build another theme park, stay in the same business mix, I think the optimal still carries. It's still 40 percent. If they're planning however and expanding their technology business, their interactive gaming business, a negative cash flow high risk business, I think their optimal will go down. So what I'm saying here is I can't give companies blank checks. Just because you have excess debt capacity doesn't mean you can go out and make whatever investments you want with that excessive capacity. I need to know what you're investing in to make a judgment on what the optimal debt ratio will be after that investment. So in summary, why should Disney do it? Not because their cost of capital go to 7.16 percent but because their value as a firm will increase by 19.6 billion. And let's be very clear on where that increase in value is coming from. It's coming from the tax benefits of debt. Second, what if something goes wrong? At least in the case of Disney there seems to be enough buffer built in that they can go all the way up to 40 percent and still really not be in trouble even if they have a bad year. And if they really want to be conservative, maybe they should stop at 30. And finally, can they make investments with the debt capacity? I think so, as long as they can find good investments and stay with the same business mix they have right now. That in a sense wraps up how we think about cost of capital as a way of coming up with the right mix of debt and equity for a company and how we answer the rest of the questions that are going to follow when we come up with that optimal debt ratio. Thank you very much for listening.