Lecture 9-Cost of Capital & Capital Structure Flashcards
What are the providers of capital?
- depends on the rate of return investors require, to be willing to provide capital in the first place
- The return investors will demand will depend on the risk they are exposed to:
Ordinary shareholders – Highest Risk, Highest Return
Preference shareholders – Medium Risk, Medium Return
Bondholders – Lowest Risk, Lowest Return
What to use as a provider of capital?
On average, of all new funds used each year:
~50% comes from retained earnings
~35% comes from debt
~15% comes from equity
What are retained earnings?
is the amount of net income left over for the business after it has paid out dividends to its shareholders
What are the advantages of retained earnings?
- No dilution of ownership i.e. ownership decrease when a new equity is introduced
- No issuing costs
- No nee to explain how the funds will be used.
What are the disadvantages of retained earnings?
- Uncertain may not be enough
- Managers may think that it is ‘free’ capital its not as shareholders are foregoing dividends
- Equity holders will expect the same return on retained earnings, as on the rest of their investment
What are the advantages of debt for the company?
- Cheaper than equity due to lower issuing costs, lower rate of return
- Fixed payments, don’t change irrespective of profits, easy to plan
- No loss of control (bondholders have no votes)
- Tax advantages
What are the advantages of debt for the investors?
- Low risk
- Guaranteed income each year (From coupon)
What are the disadvantages of debt for the company?
Has to be repaid
Usually involves regular cash flows which can’t be avoided
Non-payment can force the company into liquidation
Too much debt is considered harmful
What are the disadvantages of debt for the investors?
Because they are low risk they only offer a low return
Limited upside, do not share in any abnormal returns
No voting rights
What is equity?
-degree of ownership in any asset after subtracting all debts associated with that asset.
Equity represents the shareholders’ stake in the company.
What are the advantages of equity for company?
- No principal sum to be repaid
- Dividends are optional
What are the advantages of equity for investors?
- Can make very high returns
- Voting rights give some control over company
- Potential for dividends
What are the disadvantages of equity for the company?
Have to offer a higher return
Relatively high issuing costs
No tax advantages
Dilution of control of the company
What are the disadvantages for investors of equity?
Potential for big losses
No guarantee to any cash flows
What is gearing?
- Gearing refers to the amount of debt a company has.
- A highly geared company is one with a high level of debt
What are the two types of gearing?
- Capital gearing
- Income gearing
What is capital gearing?
Focuses on how much of the firm’s capital is in the form of debt
What is income gearing?
Focuses on how much of the firm’s income is used to pay off interest charges associated with that debt
What is the Weighted average cost of capital (WACC)?
- If the firm has more than one source of capital then we need to know what average return the company has to make in order to keep everybody happy
- This is the discount rate we use to find the NPV
Non-traded securities
If the bonds or shares are not traded then we won’t be able to observe prices or calculate betas
But we can estimate the rates of return by finding similar bonds or shares that are traded and use the returns on those as a “best guess”
As always, by similar we mean the securities would be in the same risk class, i.e. expose the holder to the same level of risk
Bank Loans in the WACC
We could include bank loans as a separate source of funds
Not traded so can’t observe market value
But unless chances of default are high, market value ~ book value
How can you estimate the return on bank loans?
Looking at market rate for equivalent loans, or
Assume its the same as for the firm’s bonds, or
Calculate as interest paid/outstanding loans
What is the right discount rate?
The required returns to debt, equity, etc. were dependent on the risk
This depends to a large extent on what the firm is doing
WACC thus represents the average return needed, for the current given level of risk
Even if a new project is to funded entirely by debt
Still use the WACC as discount rate and not 𝒓_𝒅
Who uses WACC
Today ~80% of firms use it but often in arbitrary ways, e.g.
Guesses for cost of equity instead of using the CAPM or DGM
Coupon rates for required return on debt instead of the YTM
Target Debt/Equity ratios or book values rather than proportions based on current market values
How can the WACC be used as a discount rate?
It can use the WACC as the discount rate in project appraisals – providing the new projects are of the same risk class as existing projects
The moment it starts to invest in projects with different risks (safer or riskier), it needs to use a different discount rate
Remember: The discount rate must always reflect the risk of the project being considered
What is a good WACC?
greater the value of (conventional) projects and hence the greater the value of the firm
Since companies want to maximise their value, they will want to minimise their WACC
Why shouldnt the WACC just consist of debt?
-The returns on debt and equity are not constant
-As debt levels change the risks for equity holders and debt holders change
At each new debt level we should re-calculate a new r_e and r_d
Other ways to view risk?
Business risk
The risk associated with doing a particular kind of activity
Determined by industry factors, competition, pricing volatility, market power, etc.
Financial risk
Additional risk to shareholders because of the existence of debt
Who are Modigliani & Miller (M & M)
In 1958 they first proposed their now famous theory of capital structure
What were the key assumptions of the M&M model?
No taxes
Perfect information
No transaction costs
No cost of bankruptcy or financial distress
No cost in monitoring debt
Investors can borrow at same rates as companies
No costs involved in raising capital
Firms can be grouped into
“homogeneous risk classes”, firms in the same class offer the same return
The first proposition of the M & M model?
The value of the firm is independent of its capital structure
What is financial distress?
is where a firm cannot, either now, or in the near future, meet its financial obligations
A firm in financial distress faces lots of additional costs - known as the costs of financial distress and bankruptcy
As debt increases, the probability of distress increases, and the costs become greater
At some point these additional costs begin to outweigh the tax shield advantages of the extra debt
What are the costs of financial distress?
Direct costs
Lawyers fees, court fees, late payment penalties, etc.
Indirect Costs
These can continue long after the immediate danger of financial difficulty/default has passed
Examples include; Lost customers Higher operating costs Higher financial costs Extra staffing costs Reduced investment, R&D spending
What is the trade-off theory
- Theory that says capital structure is based on a trade-off between tax savings and costs of financial distress
That is, companies will increase their debt until the additional costs of financial distress start to outweigh the additional tax savings
Trade-off theory once again implies there is an optimum level of gearing for a company
What does the trade-off theory say in relation to WACC?
-WACC varies with gearing meaning there is an optimal capital structure
How does risk vary from company to company?
The risk of financial distress varies from company to company
It depends on things such as:
- The ability to generate cash
- The volatility of the firms income stream
- The proportion of fixed to variable costs
- The liquidity of the firm’s assets
Investors are therefore willing to tolerate higher gearing levels in some industries than in others
What is pecking order theory?
An alternative view of capital structure is that there is no “optimal” or target gearing level
Firms simply “prefer” retained earnings in preference to debt, and debt in preference to equity for reasons of:
Ease of raising each source of funds
Returns offered on each source of funds
Issuing costs associated with each source
Pecking order implies firms with high profits will use less debt, i.e. have low gearing
M & M theory I
No matter the construction of the capital structure for the company, if the overall risk fo the firms is the same, then the returns must be the same
-Doesn’t matter if you invest in a mix of equity and debt, or just debt the returns will be the same
Alternative explanation of M & M
The value of the firm is the discounted sum of the future cash flows
The cash flows depend on the projects, assets, employees, management, etc. – not funding
Imagine a single investor
holding all debt and equity of a firm – they receive all firm income
Switching between debt and equity will not result in any extra income for the investor hence it can’t add any value to the their total investment
M & M theory proposition II
If M&M theory is true and WACC is constant i.e. Issuing more debt will not change the WACC
Issuing new shares will not change the WACC
Then every time you increase the proportion of debt, the cost of equity increases, i.e. Imagine a single investor holding all debt and equity of a firm – they receive all firm income
Thus we don’t need to worry about how a project is funded when deciding which projects to do i.e.
Financing decisions can be and should be made separately from investment decisions
What does the formula for the second proposition of M & M mean?
-The required rate of return on the equity of the firm increases in proportion to its debt-equity ratio
Tax in relation to M & M
-The “no tax” assumption of M&M is very unrealistic
Firms are allowed to deduct interest from their profits before they work out their tax liability
- Interest payments thus create a tax shield
- This saves money and hence adds value
What is tax in relation to interest?
-Companies pay less in tax because interest is tax deductible
What is the true cost of debt?
Required rate of return
They expect this return or they will not hold the debt
The company must pay 〖 𝑟〗_𝑑 to the debt-holders
But it recoups part of the cost in tax savings
What is a tax shield?
A tax shield is a reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest
M &M modified assumption that allow for corporation tax
- Increasing gearing always reduces the WACC and hence increases the value of the firm
- Optimal capital structure is all debt
What does an uncertain tax shield assume?
-we always have enough profits to pay interest
But as the level of debt increase:
Probability of having sufficient profits to capture all the tax benefits decreases
As the risk of the tax shield increases, we should discount it at a higher rate, reducing its value
In the extreme case, high debt
-Thus implies tax shield is overvalued
