Chapter 11 Flashcards
Weighted Average Cost of Capital
The WACC represents a company’s average cost of long-term finance.
WACC is a potential discount rate for project appraisal using NPV.
Business risk
Variability in the operating earnings of the company associated with the industry in which it operates. It is determined by general business and economic conditions
Financial risk
Additional variability in returns as a result of introducing fixed interest debt into the capital structure. Interest on debt is a committed fixed cost which creates more volatile profits
Problems caused by high gearing
High level of financial risk: The high levels of committed interest expense make earnings to equity investors more volatile, thereby pushing up the cost of equity.
Financial distress costs: The company may lose customers due to concerns about its survival and may lose key staff if employees become concerned about job security.
Increased credit risk: The ratings agencies may cut the company’s credit rating, pushing up its cost of debt.
Agency costs: Debt contracts would include increasingly restrictive covenants (e.g. limiting dividend payments or forcing the company to stay within low-risk projects). In this way the directors become agents of debt holders rather than of the equity investors and shareholder returns are subsequently damaged.
Implications for project financing and appraisal
If it is optimally geared: finance should be raised so as to maintain the existing gearing ratio.
If sub-optimally geared: raise debt finance so as to increase the gearing ratio towards the optimal level.
If supra-optimally geared: raise equity finance so as to reduce the gearing ratio back to the optimal level.
Once optimal gearing has been achieved:
Appraise the project at the existing WACC: If the NPV of the project is positive the project is worthwhile.
Appraise the additional finance: If marginal cost of the finance exceeds the WACC the finance is not appropriate and should be rejected
Financial distress risk
At very high levels of gearing, cost of debt rises due to the risk of default on debt payments
MM’s assumptions
Investors are rational.
Capital markets are perfect.
There is no tax (either corporate or personal) in the initial MM theory. (But this assumption is relaxed in a later theory.)
Investors are indifferent between personal and corporate borrowing.
There is no financial distress risk (i.e. no risk of default even at very high debt levels).
There is a single risk-free rate of borrowing (Rf).
Corporate debt is irredeemable.
Conclusions to be drawn from no tax theory MM
Only investment decisions affect the value of the company.
The value of the company is independent of the financing decision
practical factors to be considered
The project’s business risk. It is not wise to finance high-risk projects with debt, as payment of interest is a legally binding commitment.
Existing level of financial gearing.
Existing level of operational gearing, which is the proportion of fixed to variable operating costs. If this is high, the company may prefer to avoid more debt as this increases the level of fixed costs even further.
Quality of assets available for security on debt.
Personal tax position of the shareholders and debtholders.
Market sentiment (e.g. frozen debt markets following the 2007 US sub-prime meltdown).
Tax exhaustion (i.e. not enough profit to fully utilise the interest tax shield).
A company may restrict its level of gearing from the point at which interest payments exceed profits (i.e. debt loses its tax advantage), as the cost of debt rises significantly (from kd(1 − T) to kd).
Issue costs.
Agency costs. At high levels of financial gearing, the control of the company may move away from the shareholders towards the debt investors (e.g. restrictive debt covenants may restrict dividends or limit operations to low-risk areas). Limiting operations to low-risk areas may reduce returns to shareholders.
Costs of financial distress. At dangerous levels of financial gearing, the company may find that its costs of doing business start to rise (e.g. suppliers may ask for payment in advance, staff turnover may rise, customers may lose faith in the warranties on the company’s products).
Assumptions of the traditional view
ke rises slowly at low levels of gearing and, therefore, the benefit of using lower-cost debt finance outweighs the cost of the rising ke.
At higher levels of gearing, the increased financial risk outweighs this benefit and WACC rises.
At very high levels of gearing, the cost of debt rises due to the risk of default on debt payments (i.e. credit risk). This is referred to as financial distress risk; it should not be confused with financial risk, which occurs even at relatively safe levels of debt.
