Ch 6

Question 1

WACC Formula

Answer 1

Question 2

WACC Impact of Change in Capital Structure

Answer 2

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

Question 3

Link between capital structure and company value

Answer 3

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

Question 4

Two opposing forces impacting WACC as amount of debt in capital structure increases

Answer 4

DOWNWARD FORCE ON WACC

k_d generally cheaper than k_e 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 => k_e increase pushes up WACC

WHAT IS THE NET EFFECT? – no simple answer to this question

Question 5

Impact of Capital Structure on Equity Investor

Answer 5

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

Question 6

Traditional View of Gearing and Cost of Capital

Answer 6

as org introduces debt, WACC falls initially b/c benefit of cheap debt finance more than outweighs increased k_e required to compensate sh/h for higher financial risk

then, as gearing continues to increase, sh/h demand increasingly higher returns - thus k_e rises as gearing increases

eventually k_e increase outweighs benefit of cheap debt finance, thus WACC rises

at extreme levels, k_d also rises as debt-holders worry about security of loans (also pushing up WACC)

Question 7

Graph - Traditional View of Gearing and COC

Answer 7

k_e = cost of equity // k_d = cost of debt // k_o = 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

Question 8

Graph - Optimal Capital Structure (Traditional View)

Answer 8

Question 9

Modigliani and Miller’s view on capital structure - without tax

Answer 9

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

Question 10

Graph - Modlgliani and Miller’s View on Capital Structure - without tax

Answer 10

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

Question 11

Modigliani and Miller’s revised work - including tax impact

Answer 11

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

Question 12

Graph - Modigliani & Miller model - including tax

Answer 12

gearing increases => WACC decreases => value of company increases

with tax, downward force on WACC (impact of more debt finance) > upward force (increased k_e)

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

Question 13

Modigliani & Miller Formulae

Answer 13

VALUE OF COMPANY (DEBT+EQUITY)

V_g = V_u + TB

V_g = value of geared company, V_u ungeared, TB = PV of tax shield

COST OF EQUITY

k_eg = k_eu + (k_eu - k_d) V_D (1 - t) / V_E

k_eg = cost of equity in geared company, k_eu in geared, k_d = cost of debt (gross of tax), V_D = MV of debt, t = corp tax rate, V_E = MV of geared company’s equity

WACC

k_adj = k_eu [1 - ( V_D t / ( V_E + V_D ))]

k_adj = WACC in geared company, k_eu = cost of equity in ungeared co, V_D = MV of debt, t = corp tax rate, V_E = MV of geared company’s equity

Question 14

Interpreting M&M Graphs and Formulae - without Tax

Answer 14

Company value (V_g = V_u)

horizontal line on graph backed up by formula - if T=0, values of geared and ungeared companies are the same

V_g = V_u + TB

WACC (k_adj = k_eu)

horizontal line on graph backed up again - if t=0, formula reduces to k_adj = k_eu - thus WACC of geared and ungeared are always same, irrespective of gearing

complete formula should be: k_adj = k_eu [1 - ( V_D t / ( V_E + V_D ))]

Question 15

Interpreting M&M graphs and formulae - with tax

Answer 15

VALUE OF COMPANY => V_g = V_u + 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 => k_eg = k_eu + (k_eu - k_d) V_D (1 - t) / V_E

k_e slopes upwards as gearing increases b/c sh/h face more risk thus demand inc’d returns

shown in formula that keg increases as V_D (amount of debt) incrases relative to V_E (value of equity)

(1 - t) means that slope of graph reduces if tax increases - thus steepness of k_e 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

Question 16

Modigliani and Miller’s Assumptions & Key Belief

Answer 16

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

Question 17

Capital Structure in the Real World vs Modigliani and Miller

Answer 17

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

Question 18

Main Practical Considerations for an org when determining Capital Structure

Answer 18

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

Question 19

Determining capital structure - company debt capacity

Answer 19

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)

Question 20

Determining capital structure - existing debt covenants

Answer 20

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

Question 21

Determining capital structure - increasing costs of debt finance as gearing increases

Answer 21

M&M assumed that debt was risk free and that k_d 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

Question 22

Determining capital structure - views of other st/h and ratings agencies

Answer 22

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

Question 23

Determining capital structure - tax exhaustion

Answer 23

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

Question 24

Formula for Gearing Ratio

Answer 24

Question 25

Impact of Finance Decisions on ratio analysis - debt covenants

Answer 25

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%

Question 26

Additional Considerations when structuring debt/equity profile of group companies

Answer 26

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

Question 27

Thin Capitalizaiton Rules

Answer 27

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)

Question 28

Two areas when considering thin capitalization

Answer 28

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