CFDM- Week 5 (WACC)

Non-tax impacts on capital structure: agency costs

1) Debt overgang (underinvestment) - When firm in financial distress, SH may prefer to pay out cash to SH than fund projects (even positive NPV) because most benefits go to firms existing creditors 2) Excessive risk-taking (asset substitution) - SH have unlimited upside but bounded losses - When firm faces financial distress SH tempted to gain by gambling (negative NPV projects) at the expense of debt holders

Effective company tax rate- te

(1-te)kd reflects tax savings associated with debt Under an imputation tax system in Canada, Australia and NZ corporate tax is reimbursed to resident shareholders as tax credits attached to dividends (so called franking credits) Thus, the effective corporate tax rate can be lower than the statutory corporate tax rate - Reimbursement of corporate tax to shareholders is basically what credits are

Optimal capital structure

Common measure of a firms capital structure is debt to capital (or leverage) ratio= D/(D+E) To find optimal or target capital structure, minimise the cost of capital (firm value according to DCF method)

Intuition for levered beta

Consider a firm whose cash flows (subject to business risk) can be decomposed into safe and risky cash flows Suppose its an all equity firm, both CFs go to SHs If they have debt - Large part of safe CFs go to debt holders - Residual CFs left for SH are mostly from risky CFs, placing additional risk on SH (financial risk)

Trade off theory: debt tax shields

Debt increases firm value by reducing the tax burden Government gets a slice too (taxes) Because interest payments are tax-deductible, the PV of the government slice can be reduced by using debt rather than equity

Modigliani-Miller "irrelevance" theorem

Assume "perfect" markets - No transaction or bankruptcy costs, no agency costs - No taxes and no asymmetric information - Market efficiency and perfect market competition (no arbritrage opportunity) Then - The value of a firm is independent of its capital structure (VL= VU) - VU: value of unlevered firm - VL: value of levered firm Financing decisions do not matter

WACC for a diversified firm

Assume Wesfarmers has a 17% WACC, annual meeting being held to decide on capital expenditure for following year - Head of resources division proposes mining project withe expected return of 24% - Retail proposes new store with expected return of 12% Using company wide WACC to accept/reject projects biases towards mining (and riskier) projects and away from retail Needs to find publicly traded companies in same industry as project, obtain info about expected returns and use to accept/ reject decision WACC should only be used as benchmark rate of return for a new project if project has same basic risk as rest of company

Using CAPM to estimate ke

Beta reflects how the underlying stock moves with the market (correlation or diversification measure) Stocks with higher risk (high beta) require a higher expected rate of return for an investor

Weights in the WACC

Calculated using MARKET VALUES rather than book values Ideally use firms target (or optimal) capital structure Current capital structure can be use if its optimally chosen and will not change following the acceptance of the project Equity- share prices*number of shares Debt- just the book value normally

Estimating a synthetic rating

Can be estimated by using one or a collection of financial ratios A simple, common ratio is the interest coverage ratio= EBIT/Interest Expenses

Probability of financial distress

Cash flow volatility (or business risk) - Is industry risky? Is the firm's strategy risky? - Are there uncertainties induced by competition By regulatory changes? - Is there risk of technological change - Sensitive to macroeconomic shocks or seasonal fluctuations As debt increases, probability of financial distress also increases

Debt tax shields: value implications graph

This suggests that having enough debt financing is optimal so as to reduce the tax bill Imputation tax neutralises tax benefit of debt (e.g. the PV of tax shields, teD is zero in pure imputation system), implying lower leverage

Cost of equity- ke

Two methods to calculate ke

WACC formula

WACC - Puts weights on cost of debt and cost of equity - Must earn at least this rate to maintain value of firm Interpretations - The overall return the firm must earn on its existing assets to maintain the value of its securities or - The required return on any investments by the firm that essentially have the same risks as existing operations

How to get minimum cost of capital

When you increase debt ratio... Cost of debt increases because default risk will go up and bond ratings will go down, requiring a higher default spread Cost of equity increases with leverage because shareholder of leveraged firm need to bear business and financial risk (stock ß and therefore ke captures both risks) - ßL: levered beta (stock beta of a firm with leverage) - ßU: beta (or asset beta) only reflects business risk - Levered beta is a function of unlevered beta and D/E ratio

Firm age, characteristics and capital structure

Young, R&D intensive firms have low leverage because - Risky cash flows- high probability of financial distress - High human capital- large loss in case of financial distress - Have few tangible assets Low growth, mature, capital intensive firms have high leverage because - Stable cash flows- low probability of financial distress - Tangible assets- lower costs of financial distress - Few investment opportunities- debt overhang problem is unlikely

Debt tax shields: value implications

teD is present value of perpetual tax shield generated by debt With corporate taxes (but no other imperfections), the value of levered firm equals

Costs of fiancial distress

Direct costs (tend to be call) - Legal expenses, court costs, advisory fees Indirect costs (larger, hard to measure) - Opportunity costs (e.g. management distraction and effort) - Scare off customers and suppliers (damage reputation) Debt holders bear realised bankruptcy costs, but - Shareholders bear expected bankruptcy costs in the form of more expensive debt - Debt holders increase interest rate to reflect probability of default and costs incurred in case of default - Greater risk of firms core activities (business risk), the greater the probability of default - Greater default probability --> higher interest rate charged - Higher interest rate charged --> lower leverage

Pecking order theory based on asymmetric information

Does not lead to optimal capital structure Rather capital structure reflection of firms need for external finance Insight: firms in same industry with different debt levels due to profitability More general and accommodating, closer to reality

What should we do with these theories

Each theory makes statement about what is of primary importance - Trade off: tax shield and distress costs - Packing order: information (market response), managerial agency costs, issuing costs These theories need not be incompatible - Use each when you think they emphasise the right issues - When getting far away from target, TO type issues dominate - When reasonably close to target, PO type issues dominate

An integrative approach

Establish long run target capital structure Evaluate true economic costs of issuing equity rather than debt - Real cost of price decrease and issuance costs vs forgone investment or increase in expected costs of distress If still reluctant to issue equity - Are there ways to reduce cost (e.g. give more info) - Will the cost be lower if you issue later? - Can you use hybrid securities

Trade off theory: implications

Firms should - Issue equity when leverage rises above the target level - Buy back stock when leverage falls below the target capital structure Stock market should - React positively (or neutrally) to announcements of securities issues

Non-tax impacts on capital structure: free cash flow

Free Cash Flow (FCF) - Cash flow in excess of that needed to fund all positive NPV projects Managers reluctant to pay out FCF to SH - Prefer empire building through unprofitable acquisitions - Invest in pet projects, consume perks etc. This problem more severe for 'cash cows' - Firms with lots of cash (profitable) and few good investment opportunities Can leverage reduce FCF problem? - Debt= commitment to distribute CF in future - Debt reduced FCF available to managers This may also explain why cash cow firms have higher leverage

Non-tax impacts on capital structure: asset type

General use vs firm specific - Value of general use assets easier to realise than value of firm-specific - Debt holders risk lower if company's value largely attributable to general use assets - Companies with high proportion of general use assets able to borrow more than companies with high proportion of firm specific assets Tangible v intangible - In case of default, value of tangible assets easier to realise than intangible - DH risk lower if company's value largely attributable to tangible assets - High tangible proportion can borrow more than companies with intangibles

Trade off theory: optimal leverage

Graph showing value of a levered firm Optimal capital structure maximises firm value

Hybrids

Hybrid securities are securities displaying characteristics of debt and equity Two main types Convertible notes (ST) or bonds (LT) - Debt security (bond) with option to convert to equity at maturity - Debt security with promised interest payments over life - Option to convert if value of equity is greater than face value of debt at maturity Preference shares - Equity with preferred status over ordinary equity with respect to dividend payments and return of capital - Different characteristics make it more/ less equity/ debt-like Many different flavours of convertibles and preference shares

Pecking order and capital struicture

If pecking order holds, company's leverage ration reflects - No attempt to approach target ratio - But its cumulative requirements for external finance - High CF --> no need to raise debt and can repay debt --> leverage ration decreases - Low CF --> need to raise capital (but prefer issuing debt rather than equity) --> leverage ratio increases

Expected costs of financial distress

If taxes were only issue, companies would be 100% debt financed Common sense suggests otherwise - If debt burden too high= bad - Result is 'financial distress' --> bankruptcy (court supervision) in some cases Expected costs of financial distress = probability of distress * costs of in distress

Expected cost of distress with leverage

Increase sharply with leverage (both probability and actual costs increase) SH bear expected distress costs in the form of more expensive debt (higher IR, more covenants) Companies with high expected distress costs should be more conservative in using debt

What MMs irrelevance theorem applies to

Initially meant for capital structure But applies to all aspects of financial policy under perfect markets assumptions - Capital structure is irrelevant - Long term vs short term debt is irrelevant - Dividend policy is irrelevant - Risk management is irrelevant

Cost of debt- kd

Market interest rate that the firm has to pay on its long term borrowing today kd= risk-free rate + default spread Rating the firm - If the firm is rated, using the rating and a typical default spread on bonds with that rating - If not rated, use the interest rate on a bank loan or estimate a proper default spread based on a synthetic rating

Cost of capital

Projects have to earn at least a benchmark rate of return (minimum acceptable hurdle rate) to be accepted Benchmark return should be higher for riskier projects than for safer ones Different terminology reflects different viewpoints of the same thing - From investors view: required rate of return or market determined opportunity cost - From the firm viewpoint: cost of capital

Changing cost of capital as debt ratio increases

Red box is lowest possible cost of capital

How to incporporate these concerned

So far, we've assumed - No distinction between existing and new SH - No conflicts between managers and SHs - No costs of financial transactions Departing from these can explain packing order preference 1. Asymmetric information: managers have more info than outside investors 2. Agency costs of equity (or free CF problem) managers may not act in interest of SH 3. Different flotation costs: issuing equity more expensive than debt (direct underwriting fees, legal registration fees

Trade off theory: what really happens

Stock prices drop (on average) at the announcements of equity issues Companies reluctant to issue equity They follow a pecking order in which they finance investments, as follows 1. Internally generated funds 2. Debt 3. Hybrids 4. Equity Willingness to issue equity fluctuates over time So target leverage view seems incomplete

Capital structure: checklist

Taxes - Does the company benefit from debt tax shield Expected distress costs - What is the probability of distress (CF volatility; business risk) - What are the costs of distress( competitive threat if pinched for cash, customers care about distress, assets difficult to redeploy?, agency costs of debt Information problems - Do outside investors understand funding needs of firm? - Would equity issue be perceived as bad news by market? Managerial agency problems - Does firm have FCF problem Issuing costs

A note about imputation system of taxation

The imputation implies that firm income distributed as dividends is effectively taxes at SH marginal rate (juts like interest income) Capital gains may be tax advantaged for some investors, therefore So there may be a tax induced reason to issue equity rather than debt where SH generate their returns via capital gains

Trade off theory

The optimal target capital structure is determined by balancing taxes and expected costs of financial distress that also comes with debt (inability to meet obligations) These two ingredients can change the size of the pie that goes to the firm's claim-holders (firm value) in the opposite directions Trading off the two provides an 'optimal' capital structure (but, this theory does not aim to provide precise target but rather a range)

MM Theorem: Proof (pie theory)

The value of a firm is that of the CFs generated by its operating assets (e.g. plants and inventories) The firm's financial policy divides up the cash flow 'pie' among different claimants (debt holders and shareholders) But the size (i.e. value) of the pie is independent of how the pie is divided up

Steps for cost of capital approach

1. Estimate the cost of equity (ke) at different levels of debt - D/E increases → beta increases → ke increases - Estimation requires levered beta calculation 2. Estimate cost of debt (Kd) at different levels of debt - Default risk goes up and bond ratings go down as debt goes up → Kd will increase - Estimation requires estimation of bond ratings 3. Calculate the cost of capital at different levels of debt and choose the optimal level 4. Calculate the effect on firm value and stock price