Issues with WACC and capital structure policy

Issues with WACC and capital structure policy

1. Weighted average of cost of capital (WACC)

   • Cost of capital
     • aka required rate of return
     • represents expected rate of return on an asset after taking into consideration into account time value of money and risk
     • Market determined rate, externally determined
     • Opportunity cost (the return offered in the market in investment of equivalent risk)
     • cost of capital (issuer of financial security)
     • expected return (investors)
   • WACC estimate the required rate of return as a weighted average of the required return on debt and equity
     • Cost of equity (ke)
       • CAPM
     • Cost of debt (kd)
       • is then estimated
     • Taxes
       • should be treated consistently in the net cash flows and in the cost of capital
       • project is evaluated after tax basis
       • *insert FORMULA
     • WACC calculation
       • Determine the permanent source of capital the company utilises
         • Debt
           • - Bank overdraft - Money market loans - Commercial bills - Promissory notes - Bonds - Debentures - Unsecured notes - Mortgage loans - Finance leases - Term loans
         • Equity
           • - Ordinary shares - Preference shares - Retained earnings
       • Cost each component of capital are based on CURRENT conditions Historical value is irrelevant
         • Calculate after tax cost of debt: after tax kd= before tax kd (1-te)
           • te: effective company tax rate
         • Calculate cost of equity
           • CAPM
           • DFC approach (Dividend Valuation Models)
       • Weight each component to determine the WACC (value each source of funds and total value of projects)
         • Appropriate weights: the proportion that each source of funds represents of the total sources used to finance proposed projects
         • Current capital structure can be used
           • if cap structure is expected to change, use company's target capital structure
         • Weight should be calculated using current market values rather than book values
           • consistent with the way source of fund is calculated
           • reflect the amounts investors can realize from selling the investment
   • Issue with WACC
     • do not take into account risk of a project

2. Capital Strucuture

   • Mix of securities which serves to divide those CF between diff classes of investors
     • Debt
     • Equity
   • Modigliani and Miller Propositions
     • Assumptions
       • 1. Capital markets are perfect 2. Companies and individual can borrow at the same interest rate 3. There are no taxes 4. There are no cost associated woth the liquidation of a company 5. Companies have fixed investment policy so that investment decisions are not affected by financing decisions
       • Proposition 1 Conservation of Value
         • The value of an asset remains the same, regardless of how the net operating CF generated by the asset are divided between different classes of investors
         • Two firms with identical operating CF but different capital structures should have the same total value
         • If one firm is more valued than the other(VL>VU)
           • In a competitive market, investors will recognise the relative mispricing of shares in the two companies and will seek to make an arbitrage profit by selling shares in L and buying shares in U
           • This will force the price of L down and price of U up until the mispricing is eliminted
       • Proposition 2 Conservation of Risk
         • Firm value is expected cashflow/cost of capital
           • ke>kd
           • k is the weighted average of ke and kd
           • So it follows therefore that we can decrease k by getting funds from a cheaper source (debt)
           • By lowering k we increase the value of the firm
         • The cost of equity of a levered firm ke=k0+(k0-kd)(D/E)
           • k0= compensation for business risk
           • (k0-kd)(D/E) is compensation for financial risk
           • When debt increases total risk is conserved, but it is concentrated upon a smaller number of shareholders and hence required returns increases
         • The introduction of relatively cheap debt into the firm's capital CF will not decrease cost of capital of the firm's CF nor the value of the firm
           • Direct cost of debt (explicit): debt
           • Indirect cost of debt (implicit): increased required return required by the shareholder
   • The impact of taxes on capital strucuture
     • Claasical tax system
       • Leverage will increase firm value because interest on debt is a tax deductible expense resulting in an increase in the after tax net CF to investors
         • PV of tax shield= tcD
       • M&M Proposition1 with taxes
         • value of levered firm is equal to value of an unlevered firm of the same risk class plus the present value of the tax saving
           • VL=VU+tcD
             • k=ke(E/V)+kd(1-tc)(D/V)
     • Imputation tax system
       • The imputation system implies that firm income distributed as dividends is effectively taxed at the shareholder's marginal rate - just like interest income
         • capital gains may be tax-advantaged for some investors
           • t interest = t dividends t dividends > t cap gain hence, t interest >t cap gain
             • There might be a tax-induced reason to issue equity rather than debt where shareholders generate their returns via capital gains
   • Non tax impact on cap structure
     • Bankruptcy cost: The trade off theory
       • As debt increases, financial risk increases and thus the probability of default (bankruptcy or risk of financial distress also increases
         • Debtholder bear realised bankruptcy costs
           • Greater default probability, higher interest rate charged by debtholder
             • Higher interest charged, lower leveraged
         • Shareholder bear expected bankruptcy costs in the form of more expensive debt
       • The possibility of a tradeoff between opposing effects of benefits of debt finance and cost of financial distress may mean that optimal capital structure exists
         • VL=VU+tcD-PV(expected bankruptcy costs)
           • GRAPH! VERY IMPORTANT
     • Agency cost: Pecking-order theory
       • Management's announcement of a new equity issue may be interpreted as a sign that management believes that its equity is overpriced
         • cause a decrease in share price
           • prefer debt than equity
             • but debt involves transaction costs and open company to external scrutiny
               • Preference for using retained earnings over debt finance
       • This theory does not lead to optimal cap structure
         • Rather cap structure is reflection of the firm;s need for external finance
           • It explains that
             • negative inta-industry correlation between profitability and D/E
             • Negative share price reaction on annonucement of equity issue
     • Asset type
       • Companies with general used assets can borrow more than firm specific assets
       • Company with tangible assets are able to borrow more than the intangible assets
     • Free Cash Flow
       • Unless CF is paid to investors, manager could destroy value
         • Invest in -ve NPV
         • Increase consumption of perquisites
         • Increase leverage to soak up free CF
     • Agency cost
       • Asset substitution problem
         • Shareholder in a company with outstanding debt own a call option on the assets of the company Call option values increase with increasing volatility
         • A company with outstanding debt may have an incentives to take higher risk projects, even the project may reduce overall market value of the firm
       • Underinvestment problem
         • Firm close to bankruptcy may pass up +ve NPV projects because nobody will be willing to finance them
         • Existing s/h will not contribute equity as first gains from investing in +ve NPV projects accrue to debtholders New s/h will not buy equity at existing prices but require a substantial discount -Existing s/h will reject as their interest is diluted
       • knowing this debtholder will
         • build into their required return compensation for any expected losses from this activity, making debt more expensive
         • insist on restrictive lending condition that inhibit these activities