Ch 6 Flashcards
WACC Formula
WACC Impact of Change in Capital Structure
ratio of debt to equity is key variable in WACC formula, thus changing capital structure/gearing will evidently change WACC
also - since value of an entity company (debt plus equity) can be calculated as PV of post-tax operating cash flows (before financing) discounted at WACC => when WACC changes, business value does as well
Link between capital structure and company value
key question - what structure should org aim for to maximize company value?
main studies exist, are based on different assumptions, and come to different conclusions:
traditional view
Modigliani-Miller view, ignoring tax
Modigliani-Miller view, taking into account tax relief on debt interest payments
Two opposing forces impacting WACC as amount of debt in capital structure increases
DOWNWARD FORCE ON WACC
kd generally cheaper than ke b/c:
(1) interest is an obligation whereas dividends are not - thus debt holders face less risk and accept lower returns
(2) interest is tax deductible expense whereas dividends are not
UPWARD FORCE ON WACC
increased gearing => extra interest payments to debt holders => reduced likelihood entity can pay dividends
perceived risk by sh/h increases => they demand higher returns => ke increase pushes up WACC
WHAT IS THE NET EFFECT? – no simple answer to this question
Impact of Capital Structure on Equity Investor
high gearing = large proportion of PRIOR CHARGE CAPITAL vs equity => higher financial risk to equity investor, offset by increased dividends when profits rise
conversely - low gearing plays out in the opposite way - equity investors are first to feel effect of falling profits
low/no gearing not necessarily in equity investor’s interests b/c entity may then fail to exploit potential benefits offered by borrowing
as long as return generated from borrowed funds > cost of funds, gearing could be increased
extent to which this applies depends on multiple factors - e.g. type of industry, cost of funds in market, availability of investment opps, extent to which company can continue to benefit from “tax shield”
share price of highly geared entities tends to be depressed in times of rising interest rates
Traditional View of Gearing and Cost of Capital
as org introduces debt, WACC falls initially b/c benefit of cheap debt finance more than outweighs increased ke required to compensate sh/h for higher financial risk
then, as gearing continues to increase, sh/h demand increasingly higher returns - thus ke rises as gearing increases
eventually ke increase outweighs benefit of cheap debt finance, thus WACC rises
at extreme levels, kd also rises as debt-holders worry about security of loans (also pushing up WACC)
Graph - Traditional View of Gearing and COC
ke = cost of equity // kd = cost of debt // ko = WACC
X shows optimal capital structure where WACC is minimized
combine market value of entity’s debt and equity securities will also be maximized at this point
b/c value of entity’s debt and equity is inversely proportional to WACC – discounting operating cash flows at lower WACC => higher value
Graph - Optimal Capital Structure (Traditional View)
Modigliani and Miller’s view on capital structure - without tax
M&M spent 20 years putting forward several proposals as to why traditional view of gearing might be wrong - they began by assuming that effect of tax relief on debt interest could b ignored
proposition that orgs operating in same “type” of business with similar operating risks must have same total value, irrespective of capital structures
this view based on belief that value of company only depends on future post tax (pre-financing) operating income generated by assets
debt/equity split should make no difference in total value (equity + debt)
M&M assume investors indifferent between personal and corporate gearing
thus, gearing changes do not affect total value of company - thus WACC does not change with gearing
Graph - Modlgliani and Miller’s View on Capital Structure - without tax
WACC remains constant at all gearing levels => any benefit from increased proportion of cheaper debt finance (WACC downward force) is exactly offset by increased ke (upward)
in conclusion, ignoring tax, an org should be indifferent between all possible capital structures - they support this by demonstrating that market pressures will ensure that two orgs identical in every respect except gearing will have same overall MV
Modigliani and Miller’s revised work - including tax impact
earlier argument was that size of org’s operating earnings stream determines value > split of funding between equity and debt
however, tax deductibility of returns to debt-holders (interest) means that geared companies have advantage over ungeared b/c they pay less tax, thus have greater MV, and lower WACC
Graph - Modigliani & Miller model - including tax
gearing increases => WACC decreases => value of company increases
with tax, downward force on WACC (impact of more debt finance) > upward force (increased ke)
if other implications of this view are accepted, introduction of tax to the M&M model suggests that higher taxes result in lower combined COC
Modigliani & Miller Formulae
VALUE OF COMPANY (DEBT+EQUITY)
Vg = Vu + TB
Vg = value of geared company, Vu ungeared, TB = PV of tax shield
COST OF EQUITY
keg = keu + (keu - kd) VD (1 - t) / VE
keg = cost of equity in geared company, keu in geared, kd = cost of debt (gross of tax), VD = MV of debt, t = corp tax rate, VE = MV of geared company’s equity
WACC
kadj = keu [1 - ( VD t / ( VE + VD ))]
kadj = WACC in geared company, keu = cost of equity in ungeared co, VD = MV of debt, t = corp tax rate, VE = MV of geared company’s equity
Interpreting M&M Graphs and Formulae - without Tax
Company value (Vg = Vu)
horizontal line on graph backed up by formula - if T=0, values of geared and ungeared companies are the same
Vg = Vu + TB
WACC (kadj = keu)
horizontal line on graph backed up again - if t=0, formula reduces to kadj = keu - thus WACC of geared and ungeared are always same, irrespective of gearing
complete formula should be: kadj = keu [1 - ( VD t / ( VE + VD ))]
Interpreting M&M graphs and formulae - with tax
VALUE OF COMPANY => Vg = Vu + TB
upward sloping line on graph - formula shows that higher value of B (value of debt) increases company value; thus higher gearing increases value of entire company (debt plus equity)
COST OF EQUITY => keg = keu + (keu - kd) VD (1 - t) / VE
ke slopes upwards as gearing increases b/c sh/h face more risk thus demand inc’d returns
shown in formula that keg increases as VD (amount of debt) incrases relative to VE (value of equity)
(1 - t) means that slope of graph reduces if tax increases - thus steepness of ke will always be lower with tax than without
hence why upward WACC force is smaller with tax, hence why downward WACC force caused by (net of tax) debt finance is NET stronger force in the with-tax theory
WACC
kadj = keu [1 - ( VD t / ( VE + VD ))]
WACC reduces as gearing (debt div [debt+eq]) increases - shown by downward sloping line
Modigliani and Miller’s Assumptions & Key Belief
ASSUMPTIONS
1) there exists a perfect cpital mkt in which there are no tx costs or info costs
2) debt is risk-free and kd remains constant at all levels of gearing
3) investors are indifferent between personal and corporate gearing
4) investors and companies can borrow at same rate of interest
KEY BELIEF
market will not reward companies for sthg that can be achieved at zero cost and zero risk
if market believes that company has made too little use of gearing, investors can correct this by borrowing (themselves), then using borrowed funds to buy more shares
same overall effect as company borrowing more - only if assumptions above are valid
Capital Structure in the Real World vs Modigliani and Miller
Most unrealistic of M&M’s key assumptions = debt is risk free
in reality, higher risk to lenders and sh/h with very high levels of gearing = risk company cannot service debt and may end up in distress or insolvent
thus lenders will demand higher interest if they perceive a greater risk of default
Main Practical Considerations for an org when determining Capital Structure
Company’s ability to borrow money = “debt capacity”
Existing debt covenants
Increasing costs of debt finance as gearing rises
Views of other st/h and rating agencies
Tax exhaustion
Determining capital structure - company debt capacity
Debt Capacity = the extent to which an entity can support and/or obtain loan finance
company can only increase gearing if there is a lender happy to provide debt finance - not a given in recessionary times
capacity to borrow increasd when high quality assets available as collateral
debt capacity is a function of org’s credit-worthiness and credit scoring (assessment of credit-worthiness of person or org by numerically rating fin and non-fin aspects of position and perf)
Determining capital structure - existing debt covenants
debt covenants reduce mgmt flexibility, may even prevent mgmt from further borrowing
mgmt must keep plenty of headroom to ensure flexibility is maximized, i.e. stay well within terms of existing covenants
Determining capital structure - increasing costs of debt finance as gearing increases
M&M assumed that debt was risk free and that kd would be constant at all levels of gearing
in fact, increased gearing likely perceived as risky by lenders, thus interest rates on borrowings generally increase as gearing increases
Determining capital structure - views of other st/h and ratings agencies
gearing theories focus on sh/h and lender positions at different gearing levels; other st/h should also be considered
many st/h regard high levels of gearing as risky - which could impact credit score/worthiness of org
reduction in cdt worthiness => downgrade by credit rating agencies
e.g. customers may not buy from orgs with poor cdt worthiness b/c worried about guarantees/warranties not being honored
suppliers may not supply or advance credit b/c worried about default
employees/mgrs may leave b/c worried about job security
Determining capital structure - tax exhaustion
M&M’s with-tax theory suggests benefits of tax relief on debt interest help reduce company cost of capital at all levels of gearing - not the case in practice
at some level of gearing, interest payable will be so high that taxable profit will drop to zero - beyond this point, no benefit to raising debt finance
in order for tax exhaustion to apply, company must be loss-making and will have breached any interest cover covenants - thus likely to have bigger problems than the loss of tax relief
Formula for Gearing Ratio
Impact of Finance Decisions on ratio analysis - debt covenants
gearing ratio often used in debt covenants - entity may have to keep it < set target
e.g. if a covenants requires that gearing should not > 30%, calculate ratio assuming a financing decision has been made and see if result remains < 30%
Additional Considerations when structuring debt/equity profile of group companies
TAXATION ISSUES
sensible to maximize borrowings in areas with highest tax rates to maximize tax relief - although this can be limited by transfer pricing issues and thin capitalization rules
COUNTRY RISK
less exposure to risk if org borrows money where it generates net income - thus servicing costs can be paid out of income without worrying about forex costs
TYPE OF FINANCE PROVIDED BY PARENT
subsidiaries receive cash financing from parents irrespective of funding being as debt or equity; thus the choice of capital structure for a sub is independent of the decision for the entire group
TRANSFER PRICING
transfer pricing adjustments may be necssary for txs between connected companies to ensure orgs do not reduce tax liability by setting price above/below arm’s length rate
thus, is groupco A has borrowed from groupco B, adjustment req’d if interest rate charged is not = market rate
Thin Capitalizaiton Rules
no tax relief on company dividends, but yes on loan interest - thus orgs prefer debt financing to equity
thin cap rules aim to stop orgs getting excessive tax relief on interest
usually occurs b/c org enters into a borrowing with a RELATED PARTY that exceeds the amount a 3P would be prepared to lend (typically the parent company)
thin cap rules ensure the portion that a 3P would have lent is allowable, excess is disallowed, AND borrowing capacity of individual company and subsidiaries is considered (although not the rest of the group)
Two areas when considering thin capitalization
GEARING
ratio of debt to equity
higher proportion of debt could cause thin cap problems
UK tax authorities consider around 50:50 as reasonable
INTEREST COVER
ratio of earnings before tax and interest to interest on borrowings
measures riskiness of loan for the lender
many commercial lenders target 3, so tax authorities consider this reasonable
