Risk-Adjusted Rates of Return

Corporate Finance 101

Alan White
Rotman School of Management University of Toronto

Overview
What does corporate finance tell us about required rates of return? Weighted average cost of capital Capital structure theory
Modigliani and Miller

Application to pension plans

Defined benefit plan Defined contribution plan
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Corporate Model
Debt Assets
Earn rate k Interest rate r

Equity
Cost of equity ke

A market value balance sheet Assets = Debt + Equity Assume no taxes

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Investment Rule - WACC

Borrow $60 (D) at 5% interest (r)
Annual cost is $3 (D r)

Raise $40 equity (E) Investors require a 10% return (ke)

Annual cost is $4 (E ke) Annual income is $100 k

Invest the assets (A = $100 = D + E) at rate k Investment rule is income should exceed costs A k D kd + E r
D E k r+ ke = 0.6 5% + 0.4 10% = 7% D+E D+E
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Levering Up Traditional View

Lower WACC implies makes it easier to attain our objective Debt is cheap so use more debt. For example, use 90% debt financing
WACC = 0.8 5% + 0.2 10% = 6%

If assets earn 7% ($7 per year) we earn enough to pay interest ($4) plus shareholders required return ($2) and have $1 residual The residual accrues to the shareholders increasing the stock price
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Leverage and the Cost of Capital Traditional View

WACC Traditional View

12% 10% 8% 6% 4% 2% 0% 0% 20% 40% 60% 80% 100% Debt / Debt + Equity
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WACC

ke

Changing Capital Structure

Modigliani and Miller

Procedure:
Start with our $60 debt, $40 equity firm Borrow an additional $20 (D*) Repurchase $20 of equity or pay a $20 dividend

Result:
Debt is now worth $80 (D + D*) Equity is now E* Shareholders have $20 in cash

Are Shareholders Better Off? part 1

Formerly earned
100 k 60 r

Now earn
100 k 80 r and have $20

If shareholders invest the cash in bonds they would earn (100 k 80 r) + (20 r) = 100 k 60 r

Are Shareholders Better Off? part 2

Now earn
100 k 80 r and have $20 in cash

Before the capital structure change shareholders could have borrowed $20. In this case they would earn (100 k 60 r) 20 r = 100 k 80 r
and have $20 in cash
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MM Conclusion
Capital structure changes can be replicated or undone by homemade leverage As a result there is no value to a capital structure change Value of equity after the change plus the cash (E* + cash) equals the value of equity before the change (E)
In our example E = $40, cash = $20 so E* = $20

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MM: Implications for Cost of Equity

If assets earn 7% ($7 per year) we earn enough to pay interest ($4 = 5% of $80) and to pay the shareholders $3 The equity value is $20 (E*) Shareholders require and earn a rate of return of 15% As the firm levers up from 60% debt to 80% debt shareholders increase their required rate of return from 10% to 15%
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MM: Implications for Cost of Capital

Cost of capital is independent of capital structure Cost of debt is assumed constant Cost of equity rises as we lever up
D U ke = k + ke r ) ( A D
U e

where keU is the cost of equity when there is no debt, in our example 7%
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Leverage and the Cost of Capital MM View

WACC MM View

20% 15% 10% 5% 0% 0% 20% 40% 60% 80% 100% Debt / Debt + Equity
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WACC

ke

MM: Implications for Equity Risk

Cost of equity rises as we lever up
D U ke = k + ke r ) ( A D
U e

Similar relation holds for both systematic and firm specific risk measures. If debt is riskless
A e = A A D A A and e = A D
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Application to DB Plan
The balance sheet of a DB plan looks quite a bit like a corporate balance sheet Assets are a portfolio of 60% equity, 40% debt
Asset beta is about 0.6, asset volatility is about 12%

Pension liabilities are lot like debt What are the characteristics of the surplus?
Translating this into the corporate model surplus = A D

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Risk of Surplus
Surplus Risk Typical DB Plan
60 50 40 30 20 10 0 0% 5% 10% 15% 20% 25% Surplus / Assets
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Beta Volatility

Required Return on Surplus

(Riskfree rate 4%, Risk Premium 4%)

Required Return on Surplus Typical DB Plan

250% 200% 150% 100% 50% 0% 0%

5%

10%

15%

20%

25%

Surplus / Assets
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DB Plan
The risks of the surplus are substantial Betas and volatilities apply to rates of return The dollar volume of risk is the return based risk measure times the size of the surplus
$ = A A or $ = 0.12 A

Are these the types of risks that a corporation wants on its balance sheet?
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Impact on Corporate Balance Sheet

(Assume no taxes, Risk premium = 4%)

Assets Debt Equity Asset beta Equity beta kd ke WACC

Boeing 43.2 12.3 30.9 0.50 0.70 4.0% 6.8% 6.0%

Dupont 49.4 6.8 42.6 0.50 0.58 4.0% 6.3% 6.0%

Kodak 11.8 3.2 8.6 0.50 0.69 4.0% 6.7% 6.0%

Textron 13 7.1 5.9 0.50 1.10 4.0% 8.4% 6.0%

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Impact on Corporate Balance Sheet

(continued part 2)

Assets Debt Equity

Boeing 43.2 12.3 30.9

Dupont 49.4 6.8 42.6

Kodak 11.8 3.2 8.6

Textron 13 7.1 5.9

Pension Assets Liabilities Surplus

33.8 32.7 1.1

17.9 18.8 -0.9

7.9 7.4 0.5

4.5 3.9 0.6

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Impact on Corporate Balance Sheet

(continued part 3)

Assets Debt Equity Asset beta Equity beta kd ke WACC

Boeing 77 45 32 0.54 1.31 4.0% 9.2% 6.2%

Dupont 67.3 25.6 41.7 0.53 0.85 4.0% 7.4% 6.1%

Kodak 19.7 10.6 9.1 0.54 1.17 4.0% 8.7% 6.2%

Textron 17.5 11 6.5 0.53 1.42 4.0% 9.7% 6.1%

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Application to DC Plan
The balance sheet of a DC plan is different from a corporate balance sheet Assets are a portfolio of 60% equity, 40% debt
Asset beta is about 0.6, asset volatility is about 12%

There is no surplus Pension liabilities act like equity absorbing all risks and returns This is like an all equity firm
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DC Plan Pension Risk

Pension risks are the same as the asset risks
pension = A = 0.6 and pension = A = 12%

The value of pension assets has an annual volatility of about 12% Over a 25-year horizon the standard deviation of asset returns and the standard deviation of pension values is about 60% Are these the risks that pensioners are likely to prefer?
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Conclusions
Pensions that invest in risky assets create great risk for the sponsor For DB plans the shareholders absorb a high level of risk For DC plans the pensioners absorb the risk

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