As a general rule, we should always estimate and use the opportunity cost of capital.  Financial subsidies should not reduce the cost of capital. 

We will also practice how to unlever and relever downside risk measures.  

Class #13, Friday, February 22, 2002

Topic: Cost of Capital, Leverage and Financial Subsidies

Case: Structuring Repsol's Acquisition of YPF S.A., UVA-F-1282.

Note 1:  Professor Bruner is updating this case.  The exhibits included in the case are outdated and some are incorrect.  Please use the excel file below to replace the printed exhibits.  A list of corrections to the case is given below under the heading of Errata.

Note 2: This case describe a complex valuation and financing situation to support a hostile takeover in Argentina.  In preparation for this class, focus on the valuation issues.  The exhibits that are most central to this class are Exhibits 8, 12 and 13.

File: UVA-S-F-1282-wei.xls

Errata:

1. Page 9, second paragraph of "Financial Effects of the Combination", last sentence.  "40 percent of the assets" should be replaced by "51 percent of the market value of equity".

2. Page 9, middle of the last paragraph.  The numbers in "WACC for YPF (10.09 percent), Repsol (6.6 percent) and the new firm, Repsol-YPF (8.26 percent)" are wrong.  Please refer to Exhibit 8 for the updated numbers.

Assignment Questions:

1. As a stand alone company, YPF has a debt-to-capital ratio of 34% and a levered downside risk measure of 1.85.  Its cost of equity estimated using the downside risk approach is then 5.18% + 1.85*6% = 16.28% (Exhibit 8).  Now suppose that YPF increases its debt-to-capital ratio to 71.5%.  The increased leverage raises YPF's financial risk.  How would you adjust the cost of equity to reflect the increased financial risk?  (Hint: Treat the downside risk measure as it were beta.)

2. Suppose that Repsol finances its acquisition of YPF with 100% debt.  And suppose that for Repsol as a stand alone company, the Lessard COE formula is appropriate; and for YPF as a stand alone company, the downside risk formula is appropriate.  How would you calculate the cost of equity of combined company?  (Hint: The combined company is an equity portfolio of Repsol and YPF.)

3. What is the impact of government subsidy on a firm's actual cost of debt?  What is the impact of government subsidy on a firm's opportunity cost of debt?  Conceptually should we use subsidized cost of debt in calculating WACC?  In early April 1999, YPF's U.S.$ corporate bond yield spread over the U.S. treasuries was around 3.5%, and Repsol's U.S.$ bond yield spread over the U.S. treasuries was around 1.6%.    Give this information, estimate the cost of debt for Repsol as a stand alone company, and estimate the cost of debt for YPF as a stand alone company. 

4. Assume that Repsol would finance the acquisition with a mixture of debt and equity as in Exhibit 13.   What is the value of YPF's equity as a stand alone company?  What is the value of the synergy between YPF and Repsol?  Is $44.78 per YPF share a good price for Repsol?